A bankruptcy judge in Houston rejected a new defense created this summer by the Tenth Circuit to absolve subsequent transferees from liability for receiving proceeds from a fraudulent transfer, even if they knew fraud was afoot.

In the Tenth Circuit case, the initial transferee took a contract claim in a fraudulent transfer and converted the contract claim into cash. The initial transferee then transferred cash to subsequent transferees whom the trustee sued.

Interpreting Section 550(a) in July, the Denver-based appeals court held that the trustee could not recover cash proceeds from the fraudulently transferred contract claim because the cash proceeds were not the contract claim that was initially transferred. The appeals court cited no caselaw or scholarly authority for its interpretation of the statute. Rajala v. Spencer Fane LLP (In re Generation Resources Holding Co.), 964 F.3d 958 (10th Cir. July 10, 2020); rehearing and rehearing en banc denied Aug. 24, 2020. To read ABI’s report, click here.

Houston Case Similar to Generation Resources

The facts before Bankruptcy Judge Eduardo V. Rodriguez were functionally similar in terms of applying the Tenth Circuit’s defense.

A software development company was in financial distress. The chief executive officer wanted to sell the company, but the sale would not generate much for him because he owned only 3 percent of the stock.

To increase his recovery from selling the company, the CEO secretly arranged for the company to issue convertible preferred stock to him, which he in turn sold for $15 million. Were it not for the preferred stock, the $15 million would have gone to the company, not to the CEO. In return for the stock, the CEO claimed that he gave adequate consideration by agreeing to take on the additional role of chairman.

The CEO transferred about $5 million of the proceeds to those whom we shall refer to as subsequent transferees.

Creditors filed an involuntary petition against the software developer, and a chapter 7 trustee was appointed. Under the Texas Uniform Fraudulent Transfer Act and Sections 544 and 550(a)(2), the trustee sued the subsequent transferees who had received the $5 million.

Notably, the CEO was both indicted by the Justice Department and sued by the Securities and Exchange Commission, but he died not long after bankruptcy.

The defendants filed motions to dismiss raising a plethora of arguments, which Judge Rodriguez denied on October 22. We shall address a pair of important rulings from his 54-page opinion.

The Generation Resources Defense

Citing Generation Resources, the defendants contended that they were not subsequent transferees and therefore could not be sued, because they received proceeds from the preferred stock, not the stock itself. If Congress had intended for trustees to recover proceeds, it could have written Section 550 to say so, they argued.

Judge Rodriguez observed that Generation Resources “is the only circuit-level case directly on point.” He went on to say that the issue of first impression in the Fifth Circuit raised “novel legal arguments that are undeveloped in the case law.” Outside the Fifth Circuit, case law “is practically nonexistent,” he said.

Section 550(a)(2) permits recovery of “the transferred property, or if the court so orders, the value of such property, from . . . any immediate or mediate transferee of such initial transferee.” Judge Rodriguez said he was therefore tasked with deciding whether the defendants were immediate or mediate transferees.

Before launching into his own analysis, Judge Rodriguez cited to articles criticizing Generation Resources. Bruce A. Markell, the Professor of Bankruptcy Law and Practice at the Northwestern Univ. Pritzker School of Law, said the Tenth Circuit “got it wrong.” Bruce A. Markell, Where Does the Flame Go When the Candle Is Blown Out, or Why Can’t Courts Grasp the Concept of Intangibles?, 40 Bankr. L. Letter 1 (2020).

Judge Rodriguez also quoted ABI’s Rochelle’s Daily Wire from August 14, where the writer said that the “Tenth Circuit gutted fraudulent transfer law and blessed a process allowing a fraudster to immunize proceeds from recovery.”

To divine the result, Judge Rodriguez analyzed the statutory language. He conceded that the most natural reading of “transferred property” would allow the trustee to recover the preferred stock. “While this reading makes sense,” Judge Rodriguez said, “it does not give enough consideration to the language used in subsections (a)(1) and (a)(2)” of Section 550.

For Judge Rodriguez, the significant phrase is “any immediate or mediate transferee of such initial transferee.” [Emphasis in original.] The statute, he said, does not say “any immediate or mediate transferee of the property transferred.” [Emphasis in original.]

The initial transferee must have received a transfer of the property, but “that same restriction is not placed on immediate and mediate transferees,” Judge Rodriguez said.

Judge Rodriguez noted that Section 550(b) gives a complete defense to a subsequent transferee who takes for value and in good faith. If Generation Resources were correct, a subsequent transferee could take proceeds with knowledge of the fraud and still escape liability.

“That result,” Judge Rodriguez said, “fails to consider Section 550(a) in context. The complete defense set forth in Section 550(b) adequately protects those who were not privy to the initial transferee’s wrongdoing.”

Like the commentators who criticized Generation Resources, Judge Rodriguez said that the Tenth Circuit defense would create “perverse incentives” for the initial transferee to liquidate the property to make the proceeds “unrecoverable.”

Judge Rodriguez denied the motion to dismiss under Generation Resources, saying it does not “square with the Bankruptcy Code’s policy of maximizing the estate for all creditors.”

“Judge Rodriguez’s meticulous opinion carefully dissects the erroneous Generation Resources opinion, exposing it to the scorn it deserves.” Prof. Markell told ABI in an email.  He added that “Judge Rodriguez’s opinion is not only right on the law, it is right on the policy.”

No Need to Sue the Initial Transferee

The defendants argued that the trustee could not sue them until he “avoided” the initial transfer to the CEO. They based their contention on the language in Section 550(a) that allows recovery “to the extent that a transfer is avoided,” not “avoidable.”

Judge Rodriguez quoted the Collier treatise for saying that a trustee may recover from a subsequent transferee “without suing the initial transferee.” Among lower courts in the Fifth Circuit, however, the authorities “diverge,” the judge said.

Judge Rodriguez decided that Section 550 does not require suing the CEO or his estate before recovering from the subsequent transferees. Rather, the phrase “to the extent that a transfer is avoided” only limits the trustee’s recovery to “the amount of a transfer that could be statutorily avoided.”

“Moreover,” Judge Rodriguez said, “neither § 550 nor § 544 require the transfer to be avoided as to the initial transferee before a trustee can seek recovery from immediate or mediate transferees.”

Once the trustee demonstrates the existence of an avoidable transfer, Judge Rodriguez said that Section 550 “permits recovery from the initial transferee and any immediate or mediate transferees. There is nothing in Section 550 requiring a trustee to seek an avoidance action specifically against the initial transferee before recovery can be realized against the other transferees.”

Judge Rodriguez denied the defendants’ blunderbuss motion to dismiss. He did require the trustee under Section 544(b) to amend the complaint by specifically identifying the creditors who were in existence and could assert the fraudulent transfer claim under Texas law.