Second Circuit Defines a Prohibited Double Recovery on Fraudulent Transfers

Affirming Bankruptcy Judge Alan S. Trust, the Second Circuit explained when a trustee is prohibited from making a double recovery following an avoided transfer. Basically, a trustee can recover from multiple transferees until the cash taken in by the trustee equals the value of the avoided transfer.

Creditors filed an involuntary petition against the debtor, who owned a home with her husband as tenants by the entireties. The home was worth $260,000 above the first mortgage. 

The debtor hired a lawyer to represent her in bankruptcy. Six months after the order for relief, the debtor was indicted for defrauding her creditors. The debtor then retained the same lawyer and two others to represent her in the criminal proceedings.

To fund her legal defense, the debtor and her husband borrowed $250,000 from a friend, secured by a second mortgage on their home. The original lawyer drafted the note and mortgage loan documents. The friend transferred $250,000 cash to the debtor’s original lawyer, who in turn gave slightly more than half to the other two criminal lawyers.

The chapter 7 trustee sued the friend for avoidance of the second mortgage as an unauthorized post-petition transfer under Section 549. The friend settled by allowing the second mortgage to be avoided and preserved for the benefit of the estate.

The trustee then sought to sell the home under Section 363(h). Bankruptcy Judge Trust, of Central Islip, N.Y., refused to permit a sale of the property, concluding that the interest of the husband and the couple’s child in the home outweighed the economic benefit to the estate. 

Meanwhile, the trustee had also sued the first lawyer for the $119,000 that he had retained from the $250,000. The lawyer argued that a money judgment against him would be a double recovery barred by Section 550(d), because the trustee had already avoided the second mortgage.

Bankruptcy Judge Trust overruled the objection and entered judgment against the lawyer for about $59,500. Judge Trust reasoned that $125,000 from the loan was the amount the trustee was authorized to recover, given the wife’s half interest in the home. The $59,500 represented half of the $119,000 that the lawyer had retained for himself.

After the lawyer appealed, the district court upheld Judge Trust, resulting in a second appeal to the Second Circuit. Circuit Judge Gerard E. Lynch affirmed in an opinion on July 25.

Judge Lynch began by citing circuit authority for the proposition that a bankruptcy court has “broad discretion” in applying post-petition avoidance powers under Section 549 and in ordering the return of transferred property or its value pursuant to Section 550(a). 

On appeal in the circuit, the lawyer did not challenge the idea that granting the mortgage was avoidable under Section 549(a), which permits a trustee to recover a transfer that “occurs after the commencement of the case” and that was “not authorized under [the Bankruptcy Code] or by the court.”

Instead, the lawyer focused on the fact that the trustee had already avoided and preserved the second mortgage “for the benefit of the estate” under Section 550(a). The lawyer argued that a money judgment against him contravened Section 550(d), which says that a “trustee is entitled to only a single satisfaction under subsection (a) of this section.”

Judge Lynch explained that Section 550(d) “commonly applies” when a trustee seeks to recover transferred property from more than one transferee, possibly allowing the trustee to recover more than the value of the transferred property.

The case on appeal was different, Judge Lynch said, because the “Trustee had not realized any part, let alone all, of the value of the debtor’s equity interest” in the home. The preserved second mortgage, he said, “carries only a right to foreclose.” He noted that the bankruptcy judge had already prohibited the trustee from selling the home.

Furthermore, Judge Lynch said, the settlement with the friend, which preserved the second mortgage for the estate, “did not provide for any payment to the Estate.” He went on to say that the estate “realized none of the equity value of the Second Mortgage for the benefit of creditors and, notably, did not obtain title to real property.” 

The “Trustee’s only route to realize any recovery for the Estate . . . was by seeking the proceeds” of the loan received by the lawyer, Judge Lynch said. Under the “plain language” of the statute, he therefore held that the trustee’s “recovery of a portion of the [loan] does not violate the single satisfaction rule of Section 550(d).” 

Having upheld Judge Trust’s judgment against the lawyer, Judge Lynch ended the opinion by saying what happens next. If the trustee eventually manages to recover from the preserved second mortgage, Judge Lynch said the trustee is entitled to retain the debtor’s equity in the home less the $59,500 that he recovered from the lawyer. Judge Lynch said nothing about the right to contribution, if any, among the recipients of fraudulent transfer.