Civil Litigation Flash Points April 2014

Seventh Circuit’s Message to Fraudsters Playing Shell Games: “If You’re in a Hole, Stop Digging!”

The “shell game,” which dates back to Ancient Greece, involves a swindler luring passersby to guess which of his ever-shuffling three shells contains the pea. What the victims do not realize, however, is that there is no way to win. A master in sleight of hand, the swindler tricks the participant by moving the pea, undetected, so that participant can never correctly guess where the pea is.

The shell game continues today. As recently recounted by Hon. Judge Posner in Centerpoint Energy Services, Inc. v. Halim, 743 F.3d 503 (7th Cir. 2014),fraudsters use ever-shuffling shell companies to move and hide their assets to the detriment of their creditors.

Factual Background

The fraudsters at issue in Centerpoint were Mr. and Mrs. Halim, a married couple that operated 41 rental properties in the Chicago area. Wilmette Real Estate & Management Co., LLC, wholly owned by the Halims, managed and leased these properties. In 2006, Wilmette contracted with Centerpoint Energy Services, Inc. (CES), to provide natural gas for these properties. In November 2007, Wilmette stopped paying CES for the gas, and by March 2008, Wilmette had accumulated $1.2 million in unpaid gas bills. Wilmette could have paid CES. It had billed its lessees for the gas, and the lessees had paid the entire $1.2 million. Nonetheless, the Halims caused Wilmette to transfer the money to their personal accounts.

CES thereafter sued Wilmette in Illinois state court for breach of contract. In December 2009, the court granted summary judgment and awarded CES $1.7 million, which included interest and attorneys’ fees. (Wilmette’s contract with CES provided that Wilmette would be liable to CES upon breach “ ‘for all costs and expenses incurred by [CES] (including reasonable attorney fees) to collect amounts due and owning’ under the contact, and to pay interest on the unpaid balance at an uncompounded rate of 1.5 percent per month (18 percent per year).” 743 F.3d at 505.) But by then, Wilmette was just an empty shell. Just three weeks after CES filed its state court suit, the Halims transferred all of Wilmette’s assets(including its contracts and employees) to a newly formed company, WR Property Management LLC. The Hasims also wholly owned WR.

Unable to collect on the debt owed by Wilmette, CES in April 2010 sued the Halims and WR in federal court to recover Wilmette’s fraudulently transferred assets. CES also brought claims against the Halims under an alter-ego theory (alleging that they were liable for Wilmette’s debts, due to Wilmette’s lack of corporate formalities) and successor liability claims against WR.

The district court granted CES’s motion for summary judgment on the fraudulent transfer and successor liability claims and dismissed the alter-ego claim as moot. (Illinois fraudulent transfer law prohibits a debtor from transferring his assets to another party under two scenarios: The first, “actual” fraud, exists when a debtor transfers assets “with actual intent to hinder, delay, or defraud any creditor.” 740 ILCS 160/5(a)(1). The second, “constructive” fraud, occurs when the debtor transfers assets “without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor . . . intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay them as they became due.” 740 ILCS 160/5(a)(2)(B). CES moved for summary judgment under the second scenario.) The district court entered a judgment against the Halims for $2.7 million, which consisted of the unpaid state court judgment, post judgment interest, and attorneys’ fees incurred by CES in the district court proceeding.

Seventh Circuit’s Analysis

The defendants’ arguments on appeal to the Seventh Circuit strained credulity. The defendants claimed that because the Halims comingled their assets with Wilmette, Wilmette’s assets actually belonged to the Hasims. Therefore, the defendants argued, Wilmette could not be liable for fraudulently transferring its assets. Perhaps the Halims thought they could use this comingling of assets argument as a “sword” to defeat the fraudulent transfer claims because the district court did not rule on CES’s alter-ego claims. This tactic failed. Judge Posner noted that “the Halim’s managed Wilmette’s finances in such a way that the company would have a ‘zero balance’ so that creditors could not collect a judgment against it.” 743 F.3d at 506. Judge Posner explained how the Halims controlled Wilmette’s accounts:

If [Wilmette] incurred a debt that the Halims wanted paid, for example a debt to a contractor who did work on one of their properties, the Halims would deposit money in Wilmette’s bank account to enable Wilmette to pay the debt. If there was money left over after the debt was paid, or when Wilmette received rental or other money, the Halims would cause Wilmette to transfer the money to them for deposit in their personal bank accounts, leaving Wilmette with a zero balance. Id.

Indeed, from 2005 to 2008, the Halims caused Wilmette to transfer $10.9 million to their personal account. The Halims argued that these transfers were not intended to evade the judgment, but were really repayments of “loans” they made to Wilmette. The Halims also argued that they had deposited $26 million into Wilmette’s account during this period. The court found neither of the Halims’ arguments to be credible. First, the Halims did not present any documents to substantiate the supposed loans. Second, the Halims provided no proof of the $26 million in capital deposits. Judge Posner ruled:

The absence of documentation supports CES’s claim of alter ego liability; Wilmette was the Halim’s piggy bank. If, moreover, they provided Wilmette with a net capital infusion of $15.1 million ($26 million [−] $10.9 million), what happened to that money? Wilmette reported a net loss during the three-year period of the supposed transfers to and from the Halims. They do not explain where the $15.1 million went. Id.

Therefore, the Seventh Circuit agreed that CES proved the fraudulent transfer of $10.9 million from Wilmette to the Halims. The Seventh Circuit also relied on the fact that (1) shortly after CES filed the state court suit, the Halims transferred all of Wilmette’s remaining assets to WR; and (2) the Halims had already transferred to themselves the $1.2 million Wilmette collected by reselling CES’s gas to its lessees. In addition, the court also upheld the judgment against WR based on successor liability.

The Seventh Circuit also addressed CES’s alter-ego claim, even though the district court ruled that this claim was moot. The court found the alter-ego theory to be strong, noting that the Halims commingled Wilmette’s assets with their own and failed to comply with corporate formalities that would evidence the allocation of assets between them and Wilmette.

Finally, the court also upheld CES’s attorneys’ fees award, noting that the contract language between CES and Wilmette made WR and the Halims derivatively liable for CES’s attorneys’ fees. The court disagreed with the defendants’ arguments that merger prevented the fee award. The court held that “[m]erger would encourage the kind of contumacy displayed by the Halims in this case, because by voiding the attorneys’ fees provision in the gas contract it would reduce the cost to them of unlawfully resisting efforts to collect a judgment awarded against them and upheld on appeal.” [Emphasis added.] 743 F.3d at 508.

Going Forward

Perhaps the most important facet of Centerpoint is that the same day Judge Posner issued his opinion, he apparently learned that the Halims were still playing shell games: “And now they are doing the same with WR’s assets. They began in April 2011 to drain WR’s assets into yet another company of their creation, CH Ventures, LLC, and the process is, it appears, now complete, leaving WR the same kind of empty shell as Wilmette.” [Emphasis added.] 743 F.3d at 507 (noting, “ ‘Contact Us’ page on CH Venture’s website lists the company’s name as ‘WR Property Management, LLC.’ (visited Feb. 18, 2014).”). He rebuked them: “If the Halims are wise, they will start heeding the adage: if you’re in a hole, stop digging.” Id.

All creditors should take note. When dealing with fraudsters, creditors must rapidly obtain intelligence, search for fraudulent transfers, constantly look for newly formed companies, and, if possible, trace the assets back to the fraudster. If you play only by the fraudster’s rules — just like in the shell game — it may not be possible to follow the pea. The wise creditor, on the other hand, should overturn every shell. If the pea isn’t in any of the shells, check the fraudster’s sleeves.