Whom the Debtor Does Business With Can Be A Valuable Asset – The Power of the Federal Court to Fashion Remedies for Creditors

In a recent decision out of the federal district court for the Eastern District of New York, the district court, in the context of a post-judgment proceeding, was faced with the issue of whether the 100% owner of an insolvent debtor could enter into a consulting agreement with a competitor of the debtor, whereby the debtor’s owner agreed to move the debtor’s “book of business” to the competitor in return for a payment of some $300,000.00. In a very reasoned decision, the district court held that the “book of business” was property of the debtor, and not the debtor’s owner; and therefore subject to New York’s fraudulent conveyance act (Article 10 of the Debtor and Creditor Law). Mitchell v. Lyons Professional Services, Inc., 09 Civ. 1587 (EDNY, Decided June 8, 2015).

Originally commenced as a post-judgment proceeding in the district court based upon Article 52 of New York’s Civil Practice Law and Rules (“CPLR”), the following facts were presented. The debtor, a company providing security guard services, had a certain number of customer accounts. While these customer accounts were not represented by written agreements, they did represent on-going business of the debtor. Shortly after entry of the judgment, Christopher Lyons (“Lyons”), the debtor’s owner, entered into a consultant agreement with a competitor of the debtor, whereby Lyons represented that he was terminating his employment with the debtor; that he had the right to solicit the debtor’s customers; that the debtor’s customers were developed through his efforts and that after payment of the consultant fee, the competitor would become the owner of the accounts.

Based upon these facts, the district court ruled that the customer accounts were the property of the debtor for the purposes of CPLR Section 5201 and that the customer accounts had been fraudulently transferred. However, on appeal, the Second Circuit remanded the case to the district court with instructions for the district court to consider whether the customer accounts or what the Court referred to as the “book of business” was property for the purposes of CPLR Section 5201, and specifically, whether the “book of business” was assignable or transferable.

On remand, the district court narrowed the focus of the inquiry to whether the book of business contained other property such as customer lists or other proprietary information and if so, whether such other property was transferable. Analogizing such property as a form of goodwill which courts have found to be transferable, the district court embarked upon a line of reasoning to prevent Lyons from exploiting a clear business opportunity of the debtor to the detriment of creditors.

The district court determined that while the creditors had plead their enforcement proceeding as one governed by CPLR Article 52, which focuses more on the nature of the property rather than the broader considerations of New York’s fraudulent conveyance statute, which focuses on the conduct of the transferor, the proceeding, in fact, was not handled as a summary proceeding. Rather, the case was treated by the district court as a plenary matter, since there had been document production and depositions. Accordingly, the district court determined that it was not bound by the procedural definitions of CPLR 5201 and was free to consider the broader and more substantive fraud standards of New York’s Debtor and Creditor Law.

Under the standards of fraudulent transfer, the district court determined that clearly the debtor’s “book of business” had value since it garnered an acquisition price of $300,000.00 from a competitor of the debtor. Hence, as a valuable asset of the debtor, who was insolvent, the debtor, and its owner, had a duty to hold this asset in trust for the benefit of the debtor’s creditors, including, or course, the plaintiffs. Fittingly, the district court observed: “Having chosen to operate not as a sole proprietorship but as corporation, and having developed and mined those contacts for the benefit of LPS [i.e the debtor], I do not believe that Mr. Lyons had the right to pull back that business opportunity like a yo-yo for his own benefit and the detriment of his creditors…”

In the end, the district court, recognizing the power to enforce its own judgments, correctly did not exalt form over substance. Rather, in a practical application of the law, the district court stopped an improper removal of a business opportunity, which is exactly what the fraudulent conveyance laws were designed to prevent.