Arnold v. First Citizens Nat'l Bank (In re Cornerstone Homes, Inc.)

• Decision Date: 07 February 2017
• Docket Number: Adversary Proceeding No. 16–2007–PRW,Bankruptcy Case No. 13–21103–PRW,Adversary Proceeding No. 16–2005–PRW
• Citation: 567 B.R. 37
• Parties: IN RE: CORNERSTONE HOMES, INC., Debtor. Michael H. Arnold, as Chapter 11 Trustee, Plaintiff, v. First Citizens National Bank, Defendant. Michael H. Arnold, as Chapter 11 Trustee, Plaintiff, v. Community Preservation Corporation, Defendant.
• Court: U.S. Bankruptcy Court — Western District of New York

567 B.R. 37

IN RE: CORNERSTONE HOMES, INC., Debtor.

Michael H. Arnold, as Chapter 11 Trustee, Plaintiff,

v.First Citizens National Bank, Defendant.

Michael H. Arnold, as Chapter 11 Trustee, Plaintiff,

v.Community Preservation Corporation, Defendant.

Bankruptcy Case No. 13–21103–PRW

Adversary Proceeding No. 16–2005–PRW

Adversary Proceeding No. 16–2007–PRW

United States Bankruptcy Court, W.D. New York.

Signed February 7, 2017

Gregory J. Mascitti, LeClair Ryan, Rochester, NY, for Plaintiff.

Allan L. Hill, Phillips Lytle LLP, Rochester, NY, Nickolas Joseph Karavolas, Phillips Lytle LLP, New York, NY, Ronald M. Terenzi, Stagg, Terenzi, Confusione & Wabnik, LLP, Garden City, NY, for Defendant.

DECISION AND ORDER DENYING MOTIONS TO DISMISS CAUSES OF ACTION ALLEGING ACTUAL AND CONSTRUCTIVE FRAUD

PAUL R. WARREN, United States Bankruptcy Judge

The Chapter 11 Trustee ("Trustee") brought suit against several commercial lenders in connection with similarly structured—but distinct—loans made to Cornerstone Homes, Inc., the Chapter 11 debtor ("Cornerstone"). For the sake of simplicity, the commercial lenders will be referred to collectively as "banks"—with apologies to the dictionary definition of the word. The adversary proceedings in the caption of this decision are two of those actions. The causes of action at issue in each of the Trustee's complaints allege substantially similar facts and identical causes of action. The defendant in each of these actions has moved to dismiss certain of the causes of action in the complaints, under Rule 12(b) FRCP. Because the relevant causes of action in each complaint and the corresponding motion to dismiss are substantially similar in all meaningful respects, the Court will address the issues raised by both motions to dismiss in a single decision, as permitted by Rule 42(a)(1) FRCP. However, the actions are not being consolidated by the Court under Rule 42(a)(2) FRCP, at this time.

In both complaints, the Trustee claims that cash infusions provided by the banks enabled David Fleet ("Fleet"), Cornerstone's tarnished former principal, to operate a Ponzi scheme¹ —by which Fleet successfully duped hundreds of unsophisticated private investors out of millions of dollars. (See Case No. 16–2007, ECF No. 7 at 1–4; Case No. 16–2005, ECF No. 7 at 1–4; see also Sec. & Exch. Comm'n v. Fleet , Case No. 14–cv–06695–MAT (W.D.N.Y. 2014)). As the Trustee sees it, the banks knew or should have known of Cornerstone's financial—and perhaps moral—insolvency, as well as its long-running Ponzi scheme, at the time the banks made each of the loans to Cornerstone. (See Case No. 16–2007, ECF No. 7 at 1–4; Case No. 16–2005, ECF No. 7 at 1–4).

Rather than answering the complaints, Community Preservation Corporation ("CPC") and First Citizens National Bank ("First Citizens") have each moved under Rule 12(b) FRCP to dismiss those causes of action alleging both actual and constructive fraud under New York Debtor Creditor Law ("NYDCL"). (Case No. 16–2007, ECF No. 14 ¶¶ 3–5; Case No. 16–2005, ECF No. 16 at 2–3). The causes of action alleging actual and constructive fraud make up only a portion of the many causes of action asserted in the Trustee's complaints.² CPC asserts that Counts I through VIII of the Trustee's complaint should be dismissed on a variety of legal grounds—including failure to state a claim, absence of standing by operation of the doctrine of in pari delicto , passage of the statute of limitations—and also based on a number of factual arguments going to the merits. (Case No. 16–2007, ECF No. 14 ¶ 5). In a like manner, First Citizens asserts that Counts I through X of the Trustee's complaint should be dismissed for failure to state a claim, absence of standing by operation of the doctrine of in pari delicto , and the passage of the statute of limitations. (Case No. 16–2005, ECF No. 16 at 2–3).

Under the pleading standard established by the Supreme Court in Iqbal and Twombly , and the heightened pleading standard required for claims alleging fraud as required by Rule 9(b) FRCP, the Court finds that the Trustee has adequately pled the claims for actual and constructive fraud, to survive a motion to dismiss under Rule 12(b)(6). See Ashcroft v. Iqbal , 556 U.S. 662, 678, 129 S.Ct. 1937, 173 L.Ed.2d 868 (2009) ; Bell Atl. Corp. v. Twombly , 550 U.S. 544, 570, 127 S.Ct. 1955, 167 L.Ed.2d 929 (2007). Further, the common law defense of in pari delicto —and the related federal rule of standing under the Wagoner rule—do not, as a matter of law, strip the Trustee of standing to pursue the avoidance actions, brought under 11 U.S.C. § 544(b). See In re Connie's Trading Corp. , No. 14 Civ. 376 (LAK) (GWG), 2014 WL 1813751, at *4–5, 2014 U.S. Dist. LEXIS 63730, at *16–17 (S.D.N.Y. May 8, 2014) ; In re Madoff , 848 F.Supp.2d 469, 483 (S.D.N.Y. 2012), aff'd sub nom In re Bernard L. Madoff Inv. Secs. LLC , 740 F.3d 81 (2d Cir. 2014). As for the statute of limitations defense raised with respect to Counts I and II of each complaint, the Court finds that questions of fact exist concerning when the alleged fraud was or could have been discovered—starting the clock ticking on the statute of limitations—making a determination on that issue premature. CPC's motion to dismiss Counts I through VIII of the complaint is DENIED . First Citizens' motion to dismiss Counts I through X of the complaint is also DENIED .

I.JURISDICTION

The Court has jurisdiction of these actions under 28 U.S.C. §§ 157(a), 157(b)(1) and 1334. This is a core proceeding under 28 U.S.C. § 157(b)(2)(H).

II.FACTS

A. Cornerstone's Business Model

Fleet founded Cornerstone in 1999.³ (Case No. 16–2007, ECF No. 7 ¶ 16).⁴ Until his termination by the Chapter 11 Trustee on January 31, 2014, Fleet acted as the sole director and officer of Cornerstone. (Id. ¶¶ 17–19). Using the proceeds of loans that Fleet solicited from individual private investors over many years, Cornerstone purchased and then rehabilitated hundreds upon hundreds of (mostly) single family homes located throughout the Southern Tier of New York. (See id. ¶¶ 29, 51). Cornerstone then sold those rehabilitated homes to high-risk low-income borrowers, most of whom would not have qualified for conventional mortgage borrowing—with the goal being to help less fortunate folks buy a home. (See id. ¶ 51). But, what may have begun as a socially laudable endeavor by Cornerstone, is alleged by the Trustee to have become a get-rich-quick scheme for its founder—with a business model built on shaky footers. The problem with Cornerstone's business model—leaving aside for a moment the alleged Ponzi scheme—was that (not surprisingly) its high-risk, low-income borrowers were often financially ill-equipped to repay Cornerstone the mortgage loans on their homes. (See id. ¶ 96). As a result, the cash flow from the high-risk home loans was not sufficient to enable Cornerstone to meet its financial obligations to its individual investors. (Id. ¶ 21).

According to the Trustee, at some point Fleet began operating Cornerstone as a Ponzi scheme, by using the money from new private investor loans to repay the notes held by earlier private investors. (Id. ¶ 21). Cornerstone, acting through Fleet, needed more cash to continue its operations. (Id. ). To attract additional investments in Cornerstone, Fleet sent letters and informational packets to both existing and potential new investors concerning Cornerstone's sound business model and financial health. (Id. ¶¶ 28–38). In these communications, Fleet promised investors double-digit returns and a "safe refuge" for their money away from the volatile stock market, protected by the self-proclaimed sound financial footing of Cornerstone. (Id. ). Fleet also represented to investors that Cornerstone did not use any bank financing—a more expensive source of financing that Fleet proudly avoided—or so he claimed. (See id. ¶ 30).

Cornerstone's real estate empire became quite large. By 2005, Cornerstone had borrowed in excess of $12.7 million from individual investors. (Id. ¶ 45). For a time, Cornerstone's individual investors received a mortgage on Cornerstone real property, as collateral security for their loans to Cornerstone. (See id. ¶¶ 30, 38). However, Cornerstone was unable to generate the cash flow necessary to make good on Fleet's promise to investors of double-digit returns on their investments. (Id. ¶¶ 44–46). Beginning in 2006, Fleet also sought and obtained loans from commercial lenders, including CPC and First Citizens, while continuing to represent to investors that Cornerstone did not utilize bank financing. (Id. ¶ 46). The Trustee claims that, at the time of the loans at issue, Cornerstone was insolvent. (Id. ¶ 39).

B. CPC's Loans to Cornerstone

From 2006 to 2009, CPC entered into five separate loan transactions with Cornerstone (CPC# 1 Loan, CPC# 2 Loan, CPC# 3 Loan, CPC# 4 Loan, CPC# 5 Loan), by which CPC loaned Cornerstone in excess of $12.7 million. (Id. ¶¶ 15, 69–70, 73–74, 82, 90–91, 93). The purpose of the various CPC loans was to refinance the debt that Cornerstone owed to its hundreds of private investors. (Id. ¶ 47, 83, 94). To that end, the CPC# 1, CPC# 2, CPC# 4, and CPC# 5 Loans consolidated the debt owed on certain of the private investor notes and mortgages. (Id. ¶¶ 69–70, 73–74, 90–91, 93–94). Before closing on the CPC# 1 and CPC# 2 Loans, CPC required that private investors execute written assignments to CPC of their Cornerstone notes and the mortgages securing those notes. (Id. ¶¶ 71, 75).⁵ The CPC # 1 Loan and CPC# 2 Loan were structured so that certain of the loan proceeds were earmarked for payment of the amounts owed by Cornerstone to those individual private investors who assigned to CPC their mortgages and the debt secured by those mortgages. (Id. ¶¶ 72, 76). That practice changed, however. CPC did not require assignment of the private investors' mortgages in connection with the CPC# 3 Loan, and only a small portion of the proceeds of that loan were paid to the private...