Fidelity Bond and Mortg. Co. v. Brand, Civil Action No. 06-2127.
| Decision Date | 18 July 2007 |
| Docket Number | Civil Action No. 06-2127. |
| Citation | 371 B.R. 708 |
| Parties | FIDELITY BOND AND MORTGAGE COMPANY, v. Steven D. BRAND, et al. |
| Court | U.S. District Court — Eastern District of Pennsylvania |
This bankruptcy appeal presents the issue of who — the creditor or the grantee — has the burden of proof in a constructive fraud action under the Pennsylvania Uniform Fraudulent Transfer Act1 ("PUTA") — a question that has not been decided by the Pennsylvania courts or the Third Circuit. Fidelity Bond and Mortgage Company ("Fidelity") challenges the Bankruptcy Court's placing the burden on Fidelity by a preponderance of the evidence rather than on the defendants to prove by clear and convincing evidence that Fidelity had been left with too few assets to run the business and was unable to pay its debts as they became due, rendering them fraudulent transfers under the PUFTA.
The dispute centers on Fidelity's giving the defendants, then Fidelity's sole shareholders, $1,705,000 in cash and $1,200,000 in promissory notes immediately prior to its merger with another mortgage banking company. In an adversary proceeding in the Bankruptcy Court, Fidelity Bond and Mortgage Company2 sought to avoid and recover the cash distribution and the promissory notes. Fidelity asserted that the cash distribution and promissory notes left Fidelity with too few assets to run the business and unable to pay its debts as they became due, rendering them fraudulent transfers under the PUFTA. Fidelity also claimed that in taking the cash distribution and promissory notes, the shareholders of Fidelity had breached their fiduciary duty to the company in violation of the Pennsylvania Business Corporation Law of 1988, 15 Pa.C.S.A. §§ 1551 and 1553.
The Bankruptcy Court determined that although Fidelity had not received reasonably equivalent value for the distribution, Fidelity had failed to prove that it had been left with unreasonably small assets and was unable to pay its debts. Because the Bankruptcy Court correctly concluded, as a matter of law, that Fidelity had the burden of proving, by a preponderance of the evidence, all of the elements of its constructive fraud claims brought under the PUFTA, and its factual findings are supported by the record, the Bankruptcy Court's decision will be affirmed.
Before the merger, Fidelity and Phoenix Mortgage Co. ("Phoenix") were mortgage banking companies that engaged in the origination, purchase, sale and servicing of mortgage loans. The companies had different emphases. Phoenix was engaged primarily in origination, underwriting and funding of mortgage loans. Fidelity concentrated on mortgage servicing, that is, collecting mortgage payments and remitting them, after deducting a fee, to the mortgage holder.
A mortgage servicer's primary asset is the right to collect payments from borrowers. Consequently, as loans are paid off or defaulted upon, the value of a mortgage servicing portfolio diminishes. To continue earning fees, a mortgage servicer must offset the decrease by replenishing its portfolio of mortgage servicing rights by buying mortgages, buying mortgage servicing rights from the owners of mortgages or other servicers, or originating mortgages that it can service.
Because lower interest rates tend to increase the rate of new home buying and refinancing, they instigate mortgage originations. On the other hand, low interest rates tend to hurt mortgage servicing portfolios because refinancings through different lenders who are serviced by others eliminate mortgages in the portfolios. Thus, when interest rates decrease, a mortgage servicer that has a strong mortgage origination affiliate may increase its servicing portfolio when the affiliate generates more new mortgages than the number of mortgages refinanced out of the servicing portfolio.
Approximately a year before the merger, First Republic Bank ("First Republic") proposed acquiring Fidelity and merging it with a mortgage origination company to create a mortgage banking entity that would engage in the business of jointly originating, selling and servicing residential mortgage loans. The concept was a marriage of complementary companies, Fidelity and Phoenix, to assure stability.
On January 7, 1998, Fidelity, Phoenix and First Republic executed a letter of intent, outlining the structure of the proposed transaction and the bases of the parties' understanding concerning the negotiations of a final agreement. The agreement executed by the parties, dated May 1, 1998, incorporated the terms of the letter of intent and effectuated the merger.
First Republic and the Phoenix shareholders formed FBMC Acquisition Co. ("FBMC"). First Republic contributed $1,645,000 in cash; the Phoenix shareholders, 100% of their stock; and Phoenix shareholder Ronald White, $70,000 in cash. Phoenix became a wholly owned subsidiary of FBMC.
FBMC used the $1,715,000 to purchase 80% of Fidelity's outstanding common stock from the defendants and gave them 20% of the common stock of FBMC in exchange for the remaining 20% of Fidelity stock. The defendants also received $1,200,000 in promissory notes from FBMC.3
Fidelity became a wholly owned subsidiary of FBMC, and Phoenix was merged into Fidelity. FBMC's stock was distributed as follows: 47% to First Republic; 31% to former Phoenix shareholders; 20% to the defendants; and 2% to Ronald White.4
On April 28, 1998, as a condition precedent to the merger, Fidelity entered into a Revolving Credit and Term Loan Agreement with Summit Bank, the obligations of which were assumed by the new Fidelity. Summit provided' New Fidelity with a term loan of $7 million and extended a $500,000 working capital line of credit, secured by New Fidelity's mortgage servicing rights and certain other assets.
Two covenants were part of this loan arrangement. The first, the Paragraph 2(e) loan-to-value covenant, provided that if, at anytime prior to December 31, 1998, the outstanding principal balance of the term loan exceeded 85% of the value of New Fidelity's mortgage servicing portfolio ("portfolio valuation"), New Fidelity would have to immediately pay down the term loan to bring it into compliance with the 85% ratio. The ratio was set to reduce to 80%, starting in 1999. The second loan-to-value covenant, Paragraph 6(p)(4), provided that the outstanding principal balance of the term loan plus the $500,000 revolving line of credit could not exceed 85% of the portfolio valuation.
For purposes of determining compliance with the loan covenants, the portfolio valuation was calculated by multiplying the unpaid principal balance of the mortgages in the servicing portfolio by a multiplier dictated by Summit. The market value of the loan servicing portfolio was fixed by a third party evaluator hired by Fidelity, Prestwick Mortgage Group. Summit submitted this third-party portfolio evaluation to its own outside experts who reviewed the reasonableness of the assumptions underlying the evaluation and provided its range of multipliers to Summit, which then selected a multiplier from that range. The unpaid principal balance of the loans in the loan-servicing portfolio was then multiplied by the multiplier.
The agreement provided that at closing New Fidelity would have $1,000,000 on hand to operate, consisting of $500,000 in cash and a $500,000 working capital line of credit. It also allowed Fidelity, immediately prior to closing, to distribute to its shareholders all but $500,000. Accordingly, on April 30, 1998, Fidelity distributed $1,705,000 in cash dividends to its shareholders, the defendants.
On the day of the merger, New Fidelity had $611,918 in cash. It immediately dispersed $300,000 as follows: $70,000 for Summit's loan origination fee; $130,000 for Phoenix's pre-merger payroll; and $70,000 to bring Phoenix's escrows into compliance with federal guidelines. Thus, New Fidelity's available cash was reduced to $311,918.
In the months following the merger, the loan servicing portfolio's unpaid principal balance decreased at a higher rate than had been anticipated, accounting for $1,074,000 of New Fidelity's losses between May 1 and December 31, 1998. As a consequence, shortly after the merger, New Fidelity was not in compliance with the loan covenants, shutting down access to the $500,000 line of credit with Summit.
On September 28, 1998, the Summit loan agreement was amended to remove the $500,000 line of credit factor from the calculation of the Paragraph 6(p)(4) Loan-to-Value Covenant. Nonetheless, because Summit used a lower figure than had been anticipated to determine the portfolio's valuation, Fidelity was out of compliance with the Paragraph 2(e) Loan Covenant by $283,509. Finally, on December 22, 1998, Summit Bank declared the loan in default.
In December of 1998, Fidelity attempted to sell the company to Keystone Bank. In February of 1999, Keystone proposed purchasing almost all of New Fidelity's assets for about $10 million. First Republic essentially scuttled the chances of a deal resulting in Keystone's withdrawing its offer in April of 1999.
On July 6, 1999, Fidelity filed a voluntary petition for reorganization under Chapter 11 of the Bankruptcy Code.
After filing for reorganization, Fidelity instituted an...
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