The Importance of Good Faith in Fraudulent Transfer Analysis

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Mar 2003

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Often, when asserting a §548(c) or 550(b) exception to
avoidability, practitioners evaluating the exception focus on the value or
lack of value paid or realized by the debtor in the transfer at issue. However,
this focus on value risks minimizing—or even overlooking—the
important aspect of good faith explicitly set forth in both §§548(c)
and 550(b). Failure to consider the good-faith prongs of these exceptions could
be a mistake, for while a given transaction might satisfy the requirement of
value, it might still be avoided for lack of good faith. Conversely, a
transaction that was determined to lack sufficient value might still be
successfully defended if the good-faith requirement is met.

In light of the
possible impact the good faith requirement might have on the §548(c) or
550(b) exception analysis, independent of a transfer valuation analysis,
litigants, both trustees and transferees, would be well advised to consider
the presence or absence of good faith as a crucial element of their examination
of any fraudulent transfer.

<h3>General Statutory Framework</h3>

In
a fraudulent transfer action brought under §548 of the Bankruptcy Code,
the debtor-in-possession (DIP) or trustee has two goals. The first goal is to
avoid a transfer, the effect of which is either to place putative property of
the estate beyond the reach of the general body of creditors, or to burden the
estate with an obligation, such as a mortgage or security agreement that stands
in the way of a meaningful distribution to unsecured creditors. The second goal
is to utilize §550 of the Code to recover the value of property for
creditors or rid the estate of the obligation incurred, thereby enhancing the
value of the estate's existing property.

Section 548 provides, in
relevant part:

<blockquote>
(a) (1) The trustee may avoid any transfer of an interest of the
debtor in property, or any obligation incurred by the debtor, that was made or
incurred on or within one year before the date of the filing of the petition,
if the debtor voluntarily or involuntarily— 
(A) made such transfer or incurred such obligation with actual
intent to hinder, delay or defraud any entity to which the debtor was or
became, on or after the date that such transfer was made or such obligation was
incurred, indebted or 
(B)(i) received less than a reasonably equivalent value in exchange
for such transfer or obligation; and 
(ii)(I) was insolvent on the date that such transfer was made or
such obligation was incurred, or became insolvent as a result of such transfer
or obligation;

(II) was engaged in business or a transaction, or was about to
engage in business or a transaction, for which any property remaining with the
debtor was an unreasonably small capital; or 
(III) intended to
incur, or believed that the debtor would incur, debts that would be beyond the
debtor's ability to pay as such debts matured...
</blockquote>

Section 550 says, in relevant part:

<blockquote>
(a) Except as otherwise provided in this section, to the extent that
a transfer is avoided under §544, 545, 547, 548, 549, 553(b) or 724(a) of
this title, the trustee may recover, for the benefit of the estate, the
property transferred, or, if the court so orders, the value of such property,
from—
<blockquote>
(1) the initial transferee of such transfer or the entity for whose
benefit such transfer was made; or 
(2) any immediate
or mediate transferee of such initial transferee.
</blockquote>
</blockquote>

Like many sections in the Code,
§548(c) also provides an exception to the trustee's avoidance power
that shapes the analytical framework of fraudulent transfer actions in
bankruptcy:

Except to the
extent that a transfer or obligation voidable under this section is voidable
under §544, 545 or 547 of this title, a transferee or obligee of such a
transfer or obligation that takes for value and in good faith has a lien on or may
retain any interest transferred or may enforce any obligation incurred, as the
case may be, to the extent that such transferee or obligee gave value to the
debtor in exchange for such transfer or obligation. (emphasis added)
</blockquote>

Likewise, §550(b) provides safe harbor for a good-faith
immediate or mediate transferee of the initial transferee, as follows:

<blockquote>
(b) The trustee may not recover under §(a)(2) of this section
from—
<blockquote>
(1) a transferee that takes for value, including satisfaction or
securing of a present or antecedent debt, in good faith, and without knowledge
of the voidability of the transfer avoided; or 
(2) any immediate or mediate good faith transferee of such transferee.
</blockquote>

</blockquote>

Section 550(b) was
specifically tailored to prevent an initial transferee from whom a trustee
could recover under §550(a)(1) from "washing" the transaction
through to a subsequent transferee who might be acting in concert. This
technique is forestalled by requiring that the subsequent transferee also act
in good faith. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=C…
re Commercial Acceptance Corp., 1993 U.S. App.
LEXIS 23158 (9th Cir. 1993)</a>.

<h3>Two Types of Fraud—Actual and Constructive</h3>

The
starting point for analyzing any transfer under §548 necessarily begins with
the fraudulent nature of the challenged transfer. There are two types of fraud
that are avoidable under the Code: actual fraud and constructive fraud.

While
proof of actual fraud, or fraud in fact, is often difficult, the criteria for
establishing actual fraud are expressly set forth in §548: "a
transfer made or an obligation incurred with actual intent to hinder,
defraud or delay any entity to which the debtor was
or became on or after the date such transfer was made or such obligation was
incurred, indebted[.]" <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §548(a)(1)(A)</a> (emphasis added). Here,
the Bankruptcy Code is concerned with the debtor's actual, subjective
intent to hinder, defraud or delay its present or future creditors.<a href="#1" name="1a">1</a>

A
determination of such intent treats the three elements of
intent—hindrance, delay or fraud—as "distinct elements, any
one of which is sufficient to render the transaction fraudulent."<a href="#2" name="2a">2</a>

Recognizing
that proof of subjective fraudulent intent is a difficult evidentiary hurdle to
overcome, courts typically look at the totality of circumstances, relying on
the so-called "badges of fraud" to draw an inference of fraudulent
intent.<a href="#3" name="3a">3</a> The badges of fraud include, but are by no means limited to, finding
that (1) the transfer or obligation was to an insider; (2) the debtor retained
possession or control of the property transferred after the transfer; (3) the
transfer or obligation was concealed; (4) before the transfer was made or
obligation was incurred, the debtor had been sued or threatened with suit; (5)
the transfer was of substantially all the debtor's assets; (6) the debtor
absconded; (7) the debtor removed or concealed assets; (8) the value of the
consideration received by the debtor was not reasonably equivalent to the value
of the asset transferred or the amount of the obligation incurred; (9) the
debtor was insolvent or became insolvent shortly after the transfer was made or
the obligation was incurred; (10) the transfer occurred shortly before or
shortly after a substantial debt was incurred; and (11) the debtor transferred
the essential assets of the business to a lienor who transferred the assets to
an insider of the debtor."<a href="#4" name="4a">4</a> It is noteworthy that proof of a
debtor's insolvency at the time of the transfer or immediately
thereafter, while a possible indicia of fraudulent intent, is not by itself
determinative when a trustee is seeking to demonstrate actual fraud.<a href="#5" name="5a">5</a>

In
short, proof of actual fraud focuses more on the debtor's intent than on
the transferee's payment of value or the debtor's insolvency either
at the time of the transaction or immediately thereafter.<a href="#6" name="6a">6</a>

Constructive
fraud, however, requires proof that the debtor was insolvent at the time of the
transaction, or that, as a result of the transaction, the debtor received less
than reasonably equivalent value.<a href="#7" name="7a">7</a> While an examination of the definitions of
"insolvency" and "value" is beyond the scope of this
article, it is important to note that transfers that may have been made for a
reasonably equivalent value, and therefore, in satisfaction of the standards
examined in a constructive fraud analysis, may nonetheless have been made in
the absence of good faith, thereby exposing the transaction to avoidance by a
trustee. In other words, even though a transferee paid value under §548(c)
or 550(b), his lack of good faith may nevertheless doom the transaction. To
examine the transaction from another, and perhaps more important, perspective,
payments made to a debtor in furtherance of that debtor's fraudulent
scheme, or in a transaction where the value paid is less than a reasonable
equivalent, may not be avoidable if a transferee acted in good faith so long as
some value is given. Note, however, that proof of the existence of good faith
under either §548(c) or 550(b) rests squarely with the transferee, and
establishing good faith in the absence of reasonably equivalent value may be
very difficult indeed.<a href="#8" name="8a">8</a> Nevertheless, given that good faith is expressly set
forth as a distinct criteria for examining any fraudulent transfer under
§§548 and 550, and despite any problems associated with proof and the
potential to blur the analytical distinctions between good faith and value, the
presence or absence of good faith in any fraudulent conveyance action is a
crucial element to the transferee's defense.

<h3>What Is Good Faith?</h3>

The good-faith analysis under
§548(c) or 550(b) is not made any easier because, as with many important
terms used in the Code, "good faith" is not defined. Therefore, one
must look beyond the Code for guidance. Revised Article 9 contains a somewhat
opaque definition that, one might hope, comes as close to capturing the spirit
of this elusive term:

<blockquote>
"Good
faith" means honesty in fact and the observance of reasonable commercial
standards of fair dealing. Rev. Art. 9, §9-102(43).
</blockquote>

It
does not seem, however, that the standard set forth in the Uniform Commercial
Code fits the exigencies of a fraudulent transfer inquiry. In fact, it has been
said that "[t]he unpredictable circumstances in which courts may find its
presence or absence render any definition of 'good faith'
inadequate, if not unwise." Collier,

¶548.07[2][a] at 548-60. Instead, the relevant inquiries made by courts
deciding good-faith issues seem to be not merely what did the transferee know
and when did he know it, but how hard did he try to find out what objectively
he should have known? In other words, courts confronted with challenges to
transfers under §§548 and 550 have set up an objective standard in
which they "examine whether circumstances would place a reasonable person
on inquiry of a debtor's fraudulent purpose."<a href="#9" name="9a">9</a>

Note
that this standard works both in the case of actual fraud and constructive
fraud. If the transferee knew, or should have known, of the debtor's
fraudulent purpose, then even though the transferee gave value, the transaction
is not one carried out in good faith. Furthermore, if circumstances were such that
they would have placed a reasonable person on notice, and "diligent
inquiry would have discovered the debtor's fraudulent purpose, then the
transfer is fraudulent."<a href="#10" name="10a">10</a> Indeed, it is not enough that a diligent
transferee make inquiry of the debtor's fraudulent purpose. Even if that
element is lacking, the transferee must not ignore facts that would lead a
reasonable person to conclude that the debtor is insolvent at the time of the
transfer.<a href="#11" name="11a">11</a> Finally, a transferee will find no shelter under §548(c) in remaining
willfully ignorant of the foregoing signs of fraud or insolvency.<a href="#12" name="12a">12</a>

<h3>Some Lessons in the Case Law</h3>

The
Cuthill case provides some valuable guides on
the presence or absence of a successful good faith defense to a fraudulent
conveyance complaint. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…,
supra at 641</a>. In that case, a chapter 7 trustee sued a number of defendant
brokers whom the trustee accused of being participants in a Ponzi scheme by
virtue of the brokers' sales of the debtor's promissory notes,
obligations that the trustee alleged the debtor never intended to honor. The
trustee further alleged that the commissions paid to the defendants were
fraudulent conveyances and should be avoided and paid into the chapter 7
estate.

The
brokers raised a number of defenses, including that they were independent
contractors servicing the debtor for commissions that were in accord with
industry standards that automatically made them fair and reasonable. In
addition, the brokers stated that, because they were independent third parties
and not insiders of the debtor, they had no reason to know of the
debtor's insolvency.

The Cuthill court disagreed with the defendants' assertions and found for
the trustee. In deeming all of the commissions paid by the debtor to be
avoidable fraudulent transfers, the court said:

<blockquote>
The defendants did
not perform the minimal due-diligence steps needed to demonstrate that they
acted in good faith... If the defendants had completed any true investigation,
the defendants quickly would have learned of the debtor's insolvency, the
debtor's lack of a legitimate business...[and] the fraudulent nature of
the notes. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; at 660</a>.

</blockquote>

In
a similar set of circumstances, the Max Sugarman Funeral Home case is instructive as to what constitutes good faith under
§550(b)(1). In that case, the First Circuit found that an immediate
transfer of the debtor's transferee (the defendant), whom the court found
had full knowledge of the debtors' prior fraudulent transfers, was not
acting in good faith and therefore could not claim the protection of
§550(b)(1). The court first found that the subject transfers were shams.<a href="#13" name="13a">13</a>

Having
found that the transfers were fraudulent, the court then upheld the
"well-supported findings of the bankruptcy court" that the principal
officer/shareholder of the defendant had "knowledge of the
voidability" of the transfers. Of course, this is the crucial element in
this case. If the court had found that the defendant had acted without
knowledge, even after diligent inquiry, then it would have found that the good
faith element of the statute had been fulfilled. It was the defendant's
misfortune that it knew of the voidability of the transfers, but it would have
been equally as culpable had it, by and through its corporate principal, been
required to make an "inquiry of the debtor's fraudulent
purpose." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…,
supra at 659</a>.

The
problem for defendants in this position is that it puts them almost in the
unenviable posture of having to prove a negative; that is, a defendant must
show not only did it not know of the debtor's fraudulent purpose, it must
also show that there was no way, after reasonable inquiry, that it could have
known. In the murky circumstances of a fraudulent transfer action, it might be
easier to prove the sun rises in the west.

<h3>Conclusion</h3>

As
the Cuthill opinion makes clear, a
transferee—particularly a transferee of a transferor whose financial
condition is suspect—cannot simply rely on the existence of an exchange
for reasonable value to erect an impermeable shield to later challenges to such
transfers under §§548(c) and 550. As the brokers in Cuthill found to their dismay, equivalent value alone may be insufficient
to assure survival of a fraudulent transfer action. The transferee appears to
be charged with an affirmative duty to make reasonable inquiry not only into
the transferor's financial condition and the nature of the transfers, but
into the circumstances underlying such transfers to ferret out any fraudulent
intent implicated by such transactions. In the absence of this level of due
diligence, good faith may be found lacking, and payment of value will fail as a
complete defense.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
Sugarman Funeral Home Inc. v. A.D.B. Investors,

926 F.2d 1248, 1254 (1st Cir. 1991)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> See 5 Collier
on Bankruptcy, ¶548.04[1] at 548-23; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
v. Greenmark LLC, et al. (In re World Vision Entertainment Inc.), 275 B. R. 641, 656 (Bankr. M.D. Fla. 2002)</a> (finding that
actual fraud looks at totality of circumstances and elements of fraud
surrounding the circumstances). See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
v. Wilgus, 287 U.S. 348 (1932)</a> (debtor's transfer of all assets to newly formed corporation after
creditor threatened to sue, in effort to obtain additional time to repay all
creditors, was part of scheme to hinder or delay creditors); <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
Sav. Bank. v. Parr, 81 A.2d 655, 656 (2d dept.
1981), appeal dismissed, 54 N.Y. 2d 770
(1981)</a> ("hinder" and "delay" are in the
disjunctive and "exist independently of an intent to defraud"). <a href="#2a">Return to article</a>

<a name="3">3</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…
v. Third Nat'l. Bank (In re Sherman), 67
F.3d 1348, 1354 (8th Cir, 1995)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…,
supra, at 656</a>, citing <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Goldberg, 299 B.R. 877, 885 (Bankr. S.D.
Fla. 1998)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Brantz, 106 B.R. 62, 67 (Bankr. E.D. Pa.
1989)</a> (setting forth a number of the badges of fraud
from which a fraudulent intent may be inferred). <a href="#4a">Return to article</a>

<a name="5">5</a> See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; <a href="#5a">Return to article</a>

<a name="6">6</a> See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…; <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §548(a)(1)(B)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…,
supra at 657</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
States v. Tabor Court Realty Corp., 803 F.2d
1288,1296 (3d. Cir. 1986)</a>, cert. denied, sub.
nom. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=4…
Realty Co. v. United States, 483 U.S. 1005
(1987)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
re M & L Business Machine Co. Inc., 84 F.3d
1330, 1338 (10th Cir. 1996)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
v. Hunter (In re National Liquidators Inc.),

232 B. R. 99, 102 (Bankr. S.D. Ohio 1999)</a>. See,
also, 5
Collier on Bankruptcy, ¶548-04[1] at 548-24. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…,
supra at 659</a>; but, see <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Independent Clearing House Co., 77 B. R. at
862</a> (reasoning that good faith is a subjective question). <a href="#9a">Return to article</a>

<a name="10">10</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
v. McKay (In re M&L Business Co.), 84 F.3d
1330 (9th Cir. 1996)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
Sugarman Funeral Home Inc., supra at 1257</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Agricultural Research & Technology Group Inc., 916 F. 2d 528, 535-36 (9th Cir. 1990)</a> (citations
omitted). <a href="#10a">Return to article</a>

<a name="11">11</a> See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=6…
re Sherman, 67 F.3d 1348, 1355 (8th Cir. 1995)</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Model Imperial Inc., 250 B. R. 776, 798
(Bankr. S.D. Fla. 2000)</a> (citation omitted). <a href="#12a">Return to article</a>

<a name="13">13</a> "The Bankruptcy Code §550(b) places
only 'good-faith' transferees beyond the reach of the recovery
powers conferred upon the trustee in bankruptcy by Bankruptcy Code
§550(a)(2). On the record developed before the bankruptcy court, there can
be no doubt that the...transfers effected sham ('wash') transactions
for the benefit of [the defendant]." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
F.2d at 1256</a>. <a href="#13a">Return to article</a>

Journal Authors

Howard N. Gorney

Lee Harrington

Journal Date

Saturday, March 1, 2003 - 12:00

Bankruptcy Rule

2003