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In re R & S ST. Rose Lenders, LLC

United States District Court, D. Nevada

March 8, 2017

R & S ST. ROSE LENDERS, LLC, et al., Appellants. BRANCH BANKING AND TRUST, Appellant,



         Appellants Branch Banking and Trust (BB&T) and Commonwealth Land Title Insurance Company (Commonwealth) appeal the bankruptcy court's order denying their request to substantively consolidate the bankruptcy estates of debtors R & S St. Rose Lenders, LLC (Lenders) and R & S St. Rose, LLC (St. Rose). Substantive consolidation is an equitable tool that allows a bankruptcy court to combine the assets and liabilities of separate but related legal entities into a single pool from which all claims against the consolidated debtors are satisfied and inter company claims are extinguished. The upshot in this case is that if Lenders' and St. Rose's estates are substantively consolidated, an inter-company secured debt of $12 million would be extinguished, putting BB&T in first priority position to recover the proceeds from a sale of property in St. Rose's estate. If substantive consolidation is denied, Lenders' estate, against which BB&T has no claim, would receive the sale proceeds.

         The Ninth Circuit adopted a two-factor test in In re Bonham to guide the determination of whether substantive consolidation is appropriate. Under the Bonham factors, the bankruptcy court considers: “(1) whether creditors dealt with the entities as a single economic unit and did not rely on their separate identity in extending credit; or (2) whether the affairs of the debtor are so entangled that consolidation will benefit all creditors.” 229 F.3d 750, 766 (9th Cir. 2000). The bankruptcy court previously denied substantive consolidation under both factors. On a prior appeal, the district court affirmed denial of consolidation under the second factor but remanded for reconsideration under the first factor. After holding an evidentiary hearing, the bankruptcy court again denied substantive consolidation. BB&T and Commonwealth appeal that second denial. I affirm the bankruptcy court's order denying substantive consolidation.

         I. BACKGROUND

         The facts are largely undisputed. Debtors Lenders and St. Rose are owned and operated (through intermediary companies) by Saiid Forouzan Rad and R. Phillip Nourafchan. Rad and Nourafchan formed St. Rose for the sole purpose of acquiring a piece of property in Henderson, Nevada, which they planned to sell within a year to Centex Homes. They formed Lenders for the sole purpose of creating an entity through which private individuals could loan money to St. Rose to help purchase the property.

         In 2005, St. Rose purchased the property through a $29 million loan from Colonial Bank, N.A. (the “Acquisition Loan”). This loan was secured by a first deed of trust encumbering the property. Rad and Nourafchan personally guaranteed the Acquisition Loan.

         To complete the purchase, St. Rose also received a $12 million loan, purportedly from Lenders. This loan was evidenced by a promissory note and secured by a second position deed of trust on the property (the “Lenders DOT”). Although the loan nominally was from Lenders, at that time Lenders had no assets, no separate books and records, and no bank account. Instead, Rad and Nourafchan obtained the funds through loans from their friends and family. The individual lenders' checks to fund the $12 million loan were not made out to Lenders. Instead, the checks were made out to St. Rose or another entity of Rad and Nourafchan's, R & S Investment Group, LLC. St. Rose deposited the funds into its bank accounts or directly into escrow. Lenders issued promissory notes to the individual lenders. Despite Lenders' obligation to pay interest under the promissory notes, from 2005 to 2008 St. Rose made the interest payments to the individual lenders. St. Rose (and not Lenders) also issued tax forms to the individual lenders showing the interest payments. The promissory note between Lenders and St.

         Rose required St. Rose to make annual interest payments to Lenders, but St. Rose never made those payments. The Lenders DOT secured the $12 million promissory note, but the individual lenders actually advanced over $19 million to St. Rose.

         Centex chose not to buy the property. St. Rose and Colonial Bank executed a modification of the Acquisition Loan to extend the maturity date. As a condition of that modification, Colonial Bank required Lenders to subordinate the Lenders DOT. Lenders did so, and both the modification and the subordination agreements were recorded.

         St. Rose and Colonial Bank subsequently took a second loan from Colonial Bank for approximately $43 million (the “Construction Loan”). This loan was intended to pay off the Acquisition Loan and to construct improvements on the property. The loan was secured by a deed of trust on the property and by Rad and Nourafchan's personal guarantees. Colonial Bank expected that it would obtain a first position deed of trust on the property to secure repayment of the Construction Loan. Colonial Bank's escrow instructions to Nevada Title Company required a first position deed of trust and conditioned disbursements under the loan on Colonial Bank having a first position deed of trust. To obtain that first position, Lenders would have had to agree to subordinate the Lenders DOT to the Construction Loan deed of trust. Commonwealth issued title insurance to Colonial Bank for the Construction Loan.

         In 2008, the project was failing and Colonial Bank commenced foreclosure on the property under the Construction Loan deed of trust. During this process, it was discovered that the Lenders DOT was in first priority position because it had never been subordinated or reconveyed even though that was a requirement of the Construction Loan's escrow and funding. On July 9, 2008, Nevada Title sent an email to Rad requesting reconveyance of the Lenders DOT. Rad did not execute the subordination agreement and instead asked Nevada Title what position the Lenders DOT was on the property. Nevada Title responded on September 5, 2008, informing Rad that the Lenders DOT was in priority position over the Construction Loan.

         The next business day, Lenders created a separate balance sheet and shortly thereafter obtained a bank account for the first time. Additionally, St. Rose and Lenders' financial records were updated to reclassify the debt owed to the individual lenders that previously was booked to St. Rose to instead be reported as Lenders' obligation. Tax liabilities also were shifted from St. Rose to Lenders.

         In 2009, Colonial Bank went into receivership and BB&T became its successor in interest. In 2011, Lenders and St. Rose filed separate petitions for bankruptcy. BB&T and Commonwealth moved for substantive consolidation of the two debtors' cases. The bankruptcy court denied the motion. As to the first Bonham factor, the bankruptcy court found that the debtors “are clearly related entities, and as they acknowledge, it is apparent that they were sloppy with certain corporate formalities during the period in which the underlying business transactions transpired.” ECF No. 34 at 86. The bankruptcy court nevertheless concluded that Colonial Bank did not treat the debtors as a single economic unit when it entered into the Construction Loan. In reaching that conclusion, the bankruptcy court adopted findings made by a Nevada state court in separate litigation. Id. at 86-87. The bankruptcy court also found that BB&T did not meet its burden of showing that the individual lenders dealt with St. Rose and Lenders as a single economic unit. According to the bankruptcy court, BB&T's evidence was based on assumptions about what the individual lenders thought when they sent their payments to St. Rose instead of to Lenders and when they accepted the interest payments from St. Rose instead of from Lenders. Id. at 87. The court therefore held BB&T had not shown Colonial Bank or the individual lenders treated the debtors as a single economic unit. Id.

         As to the second Bonham factor, the bankruptcy court held that BB&T had not shown that the two debtors' affairs were so entangled that consolidation would benefit the creditors because the entities divided their assets in 2008, and thus separation of the two entities' assets had already occurred. Id. at 88. Finally, the bankruptcy court concluded that substantive consolidation would not be in the best interest of all creditors, as BB&T was attempting to use it as a means to undermine the state court's factual finding that the Lenders DOT was in a priority position over the Construction Loan deed of trust. Id. at 89. The bankruptcy court therefore denied substantive consolidation. Id.

         BB&T and Commonwealth appealed that denial. In the meantime, the bankruptcy court approved the sale of the property for approximately $13 million. St. Rose's bankruptcy plan, which the bankruptcy court had confirmed, provided for payment of the sale proceeds to Lenders as the first priority position on the property.

         Senior District Judge Lloyd George remanded the bankruptcy court's order denying substantive consolidation with instructions to decide whether consolidation was warranted under the first Bonham factor. Judge George affirmed the bankruptcy court's ruling that the second Bonham factor did not support substantive consolidation. However, Judge George found the bankruptcy court made two errors related to the first Bonham factor. First, he concluded the bankruptcy court erred by relying on a finding of fact by the state court; he remanded for reconsideration of the first Bonham factor “without reliance on or reference to the state court order.” ECF No. 34 at 137-38. Second, Judge George found the bankruptcy court erred by discounting BB&T's evidence about how the individual lenders treated the debtors. He took issue with the bankruptcy deeming BB&T's arguments merely “assumptions . . . based on conjecture, ” rather than reasonable inferences from the evidence. Id. 138-39. Judge George thus remanded for the bankruptcy court to resolve whether BB&T and Commonwealth “met their burden under the first Bonham factor as it concerns all creditors, not merely Colonial Bank.” Id. at 140.

         Finally, Judge George addressed the purpose substantive consolidation would serve. Id. He stated that “the sole aim of substantive consolidation is fairness to all creditors; the equitable treatment of all creditors.” Id. That does not mean the “best interest of all of the creditors, but an equitable treatment of and fairness to all creditors.” Id. He noted that the best interest of some creditors may be to receive treatment that is unfair to other creditors, but substantive consolidation is concerned with the equitable treatment of all creditors. ‚ÄúSuch inequitable treatment can arise through the continued recognition of a claim created between entities when both entities ...

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