Defending the Receipt of Fraudulent Transfers
@Law · Fall 2012 · by Mark Schwarz
The basic premise of bankruptcy is that after a debtor files for bankruptcy protection, all qualified assets of the debtor are liquidated and paid to approved creditors. For the majority of bankruptcies, it is a very straightforward process; however, this is not always the case if one or more of the assets have been transferred prior to or in anticipation of the bankruptcy filing. The Bankruptcy Code provides a potential solution for transfers that are deemed fraudulent.
A questionable transaction can either be considered actually fraudulent or constructively fraudulent. A transaction that is actually fraudulent is just as it sounds, the debtor intentionally commits fraud by transferring assets out of the reach of his or her creditors. In this type of case the debtor, in anticipation of bankruptcy, transfers all of his assets to a friend or trust such that his assets are saved from being liquidated. This often happens in cases where a debtor is sued and a judgment is entered against the debtor. The debtor then transfers his house to a friend and attempts to discharge the judgment by filing bankruptcy. In a case such as this, the court can reverse the transfer of the house to the friend and make the friend pay the value of the property, or, in some cases, deny the discharge.
A constructively fraudulent transaction is much less obvious, as the intent of the debtor is immaterial, and the court will look instead to whether the property was transferred for less than reasonably equivalent value and the debtor was left with either the inability to pay his debts as they became due or was rendered insolvent by the transfer. In other words, sometimes the honest actions of a debtor made prior to filing bankruptcy can later be determined to be constructively fraudulent.
In constructive fraudulent transfers the analysis to determine whether the transfer is fraudulent may not be an easy one. A debtor may engage in several transactions prior to bankruptcy, such as selling a vacation home in an attempt to raise capital to stave off bankruptcy. The debtor may have sold the home for a bargain in order to get a quick sale. However, if the sale of the home was not enough to keep the debtor afloat and the debtor nonetheless files bankruptcy, the court can reverse the sale of the home. But there are defenses available to the transferee.
Bankruptcy Code, under 11 USC § 548
Generally, the Bankruptcy Code, under 11 USC § 548, provides for a two-year window for the court or the bankruptcy trustee to attempt to recover assets that have been fraudulently transferred. What this means is that if the transfer of that home happened within the previous two years prior to filing for relief, the transaction can be unwound.
In some cases, where a savvy debtor waited two years and one day to file bankruptcy after a fraudulent transfer, the court can rely on state law. Many states have adopted the Uniform Fraudulent Conveyances Act of 1945 and many others have adopted the Uniform Fraudulent Transfers Act of 1988. Section 544 of the Bankruptcy Code allows a court to rely on the governing state law fraudulent transfer statutes, if they are more beneficial to the creditors than those provided by the Bankruptcy Code. Many states have statutes of limitation that exceed the federal two-year limitation and are thus more favorable to creditors. For instance,Washingtonhas a four-year statute of limitation, whileMinnesotahas a six-year statute. Should the court rely on the state’s fraudulent transfer statute of limitations, an adversary proceeding alleging the state’s laws must be brought within the two-year limitation imposed in § 548.
A transferee claiming that the statute of limitations has expired is a popular defense to the creditor recovering from an alleged fraudulent transfer; however, there are other defenses as well. One such other defense is that the transferee acted in good faith, was unaware of such fraudulent intent, and exchanged reasonably equivalent value for the property received. However, much confusion arises when the property exchanged is intangible, such as a promise not to do something. In these instances, determining if the transfer was reasonably equivalent to the property received is a difficult one.
Good faith is equally as troubling for courts to determine. For instance, a victim of a Ponzi scheme may seek to recover some of the losses he has suffered by the scheme and confront and demand a payment from the schemer. The court could unwind this preferential treatment, stating that the creditor could not have acted in good faith since he or she was aware of the Ponzi scheme. When determining good faith, the bankruptcy courts have traditionally used an objective analysis to determine the intent of the transferee. Essentially, the question is what the transferee knew or should have known with respect to the debtor and the transaction. The seminal case in this area is In re Agricultural Research and Technology Group, Inc., 916 F.2d 528 (9th Cir. 1990).
Agricultural Research case
The Agricultural Research case involves a Ponzi scheme. In this case, Palm Seedlings-A (“PSA”) was in the palm tree business, purchased seeds from a third party, and hired the debtor, Agretech, to germinate the seeds. Once the seeds germinated, Agretech would purchase the germinated seeds from PSA. Unfortunately, many of the seeds failed to germinate; however, PSA required Agretech to purchase all of the seedlings regardless of the failures. PSA needed Agretech’s money to purchase more seeds to put together a new investment opportunity. Agretech complied and purchased the failed seeds. PSA later put together another investment and transferred a new batch of seeds to Agretech. Again many of the seeds failed to germinate and again PSA demanded that Agretech pay full price for the seedlings notwithstanding the failed seeds. PSA had sent over $140,000 to Agretech for germinating services and Agretech used the same amount to purchase the failed seedlings from PSA. The bankruptcy trustee sought a recovery of payments made to PSA, whereupon PSA claimed that it had received the payments in good faith.
The court determined that, objectively, PSA should have known about the Ponzi scheme and therefore did not act in good faith. The court also noted that PSA had stated that the purchase of worthless seeds would facilitate additional investments and that because the seeds were worthless, PSA failed to transfer reasonably equivalent value. Since 1990, this objective analysis has been the controlling method for determining good faith, that is until 2011.
In 2011, the Western District of Michigan published a scathing opinion denouncing the objective test analysis of good faith, stating that “good faith is, in fact, subjective with the focus being upon traditional notions of honesty and integrity.” In re Teleservices Group, Inc., 444 B.R. 767 (U.S.B.C. W.D. Mich. 2011). In this case, Huntington National Bank (“HNB”), a small Ohio bank, was approached by a large computer engineering/reselling company, Cyberco, for a loan. After HNB noticed that Cyberco had overdrawn the account several times and that the bulk of Cyberco’s receivables was coming from Teleservices Group, a subsidiary of Cyberco, HNB became suspicious and launched a lengthy investigation that lasted over a year. HNB audited Cyberco’s financials and ordered a background check of the CEO. Nothing came of the investigations. Regardless, HNB realized it no longer wanted Cyberco as a customer and said that Cyberco would have to pay the balance of loan and find new financing. After HNB extended the deadline several times, the loan was fully repaid. As it turns out, Cyberco and Teleservices were perpetrating a fraud on equipment finance companies and the bankruptcy trustee sought to recover, under 11 U.S.C. § 548, the payments made to HNB to pay off the commercial loan shortly before the bankruptcy. HNB claimed as a defense that it acted in good faith and therefore should not have to return the payments.
The court noted that under Agricultural Research, the “test is whether the defendant requested redemption after learning of a ‘red flag’ which, under an ‘objective’ standard, should have put the defendant on ‘inquiry notice’ of some infirmity.” However, courts have used badges of fraud to assess a debtor’s fraudulent intent, and so these badges should also be used to determine good faith. Essentially, the transferee is able to keep whatever he had received up to the point in time when either (1) he became aware of (or turned a blind eye to) enough badges of fraud to no longer be in good faith, or (2) his attempts to ferret our additional badges no longer represented an honest effort on his part.
This analysis is highlighted in a case where two friends, one with bad credit and one with good credit, desired to co-own a boat. The friend with good credit obtained the loan in his name only from the bank. The friend with bad credit made a few payments on the loan, but a majority of the payments are made by the friend with good credit. When the friend with bad credit filed for bankruptcy and the creditor sought to recover the payments made by the debtor friend towards the boat loan, the bank was able to say it did not know of the arrangement between the friends and therefore acted in good faith. See In re Burry, 309 B.R. 130, 136 (Bankr. E.D. Pa. 2004). The fact that the friend with bad credit made a few payments was not a red flag such that it required the bank to be on inquiry notice.
Teleservices case
In the Teleservices case, the bankruptcy trustee argued that HNB was on inquiry notice of fraudulent activity and because HNB did not do a more thorough investigation, it lacked good faith. The court looked at the legislative intent to determine if the statute required a more modern approach. The court, finding none, determined that HNB’s conduct was to be measured by its own honesty and integrity as it became aware of more and more indicators of the fraud. The Teleservices court applied a subjective test, which is also what the court applied in the case involving two friends and the boat.
The difference between the objective and subjective tests may not seem like much of a distinction at all, but consider the following. An individual (A), in the business of financing real estate, sells an option to purchase a piece of property to B, an investor and developer. B makes several payments towards the option. After receiving several timely payments on the option, A learns that B has been the subject of a lengthy investigation by the Securities and Exchange Commission and has consequently been indicted for fraud. At almost the same time, B files for bankruptcy protection. Under the objective test, A would most assuredly be required to return much, if not all, of the payments it received from B, since A should have known that B was insolvent or could not pay his or her debts as they became due. However, if the court learned that A had gone to the court that had issued the indictment, asked for direction from the court in that matter whether it should continue to receive payments or turn them over to the court’s registry, and the court instructed A to continue to receive the payments under the option contract as agreed, then in that case, the bankruptcy court may find that A had, in fact, acted in good faith. See In re Hanover Corporation, 310 F.3d 796, 800 (5th Cir. 2002).
Hybrid Standard Emerges
However, a few courts have disregarded both an only objective or only subjective standard and instead developed a hybrid of these two approaches. Essentially, the court will look at whether the transferee made an inquiry into the risks and knowledge of the risk will not necessarily result in bad faith. A transferee “cannot stick its head in the sand, clinging to its subjective belief while purporting to ignore signs of fraud or insolvency.” The bankruptcy court in In re Davis, 2011 WL 5429095 (Bankr. W.D. Tenn. 2011) took note of the propensity for a hybrid analysis and furthermore stated that “under the authorities that have been reviewed, a consensus seems to emerge that the court must conduct a three-step inquiry to determine the transferee’s good faith.” Hence, a three-step analysis emerged: first, the court must determine what the transferee actually knew that would suggest insolvency or fraudulent purpose; second, the court must determine whether the transferee undertook a diligent inquiry and the results of that inquiry; and finally, if the diligent inquiry did not discover the fraud, the court must determine whether any reasonable investigation would have disclosed the transferor’s insolvency of fraudulent intent.
Because the Bankruptcy Code does not define good faith, applying a definition of good faith is difficult. However, it appears that the winds are shifting towards a more hybrid analysis of determining if a transferee had good faith when engaging in a transaction with a bankrupt debtor.