Domestically Avoiding International Fraudulent Conveyances—Can It Be Done? The Answer Is Far From Certain

Introduction

Can a debtor-in-possession or trustee use §548 of the Bankruptcy Code to avoid an extraterritorial fraudulent conveyance? Based on the Fourth Circuit’s recent decision in In re French, 440 F.3d 145 (4th Cir. 2006) (cert. denied, 127 S.Ct. 72 (Oct. 2, 2006)), one would think the answer would be a resounding “yes.” However, the U.S. Bankruptcy Court for the Central District of California recently concluded that 11 U.S.C. §548 does not apply extraterritorially. In re Midland Euro Exchange Inc., 347 B.R. 708 (Bankr. C.D. Calif. 2006). While the Midland Euro decision does not create a circuit conflict, it is arguably a better reasoned opinion and should be carefully considered as one contemplates whether §§547 and 548 actions may be applied extraterritorially.

Midland Euro

The Midland Euro decision stems from an adversary proceeding filed by a chapter 7 trustee who sought to recover allegedly fraudulent transfers totaling approximately $897,000. The chapter 7 proceedings involved three related companies that were owned by Moshe and Zvi Leichner. The Leichners used the companies in an investment Ponzi scheme, which ultimately resulted in total claims against the estate exceeding $100 million.

In May 2002, Swiss Financial Corp. Ltd. (SFC) opened a trading account for Midland Group Inc. (MGI)—one of the three Leichner companies. Subsequently, MGI transferred $1 million from its London bank account to an account held by SFC in New York. SFC later forwarded the monies to another account in England. Ultimately, SFC transferred $897,000 of the $1 million deposit to itself.¹ The trustee subsequently brought an adversary action seeking set aside and recover the $897,000 transfer under 11 U.S.C. §§548 and 550. SFC responded by filing a motion to dismiss on the grounds that, among other things, §548 did not apply extraterritorially.² The parties agreed that allowing the trustee to pursue his claim would be an extraterritorial application of §548 because MGI was a Barbados corporation, SFC was an English corporation, and the monies originated from a London bank account and eventually were deposited in another English account.

In considering whether §548 applies extraterritorially, the court initially noted the general rule that unless there is congressional intent to the contrary, federal legislation only applies within the territorial jurisdiction of the United States. The trustee had argued that the presumption against extraterritorial application did not apply because the transfers constituted “regulated conduct” that were “intended to, and resulted in, substantial effects within the United States.” Id. at 715. The court did not accept the trustee’s argument. First, “regulated conduct” constitutes an “act or process” that is “controlled by either judicial or administrative rule or restriction.” Id. at 716. Examples of regulated conduct included a foreign airline that participated in anti-competitive behavior and a creditor’s attempt to collect a debt abroad that had been discharged in a U.S. bankruptcy. Thus, the mere transfer of funds did not constitute “regulated” conduct. Second, the criteria used for determining whether particular conduct had a substantial impact within the United States is the number of people affected, the amount of damages and the overall economic impact within the United States. Using these guidelines, the court found that the impact was not substantial because only a single plaintiff in a prior action had been hurt by SFC’s conduct, the total damages were relatively insignificant, and the overall economic impact was de minimis. Thus, the exception to the presumption against extraterritorial application did not apply.

The court then considered whether any congressional intent existed such that §548 could be deemed to apply extraterritorially. First, it concluded that the plain statutory text did not indicate any intent that it be applied abroad. It then considered whether §548 in the context of the entire Bankruptcy Code—and particularly §541—indicated congressional intent that it be applied extraterritorially. Although there is a split among courts as to whether “property of the estate” includes property that is potentially recoverable as a fraudulent conveyance, the court followed the majority view and concluded that such property does not become part of the estate until the transfers are actually avoided. Thus, whether read alone or in conjunction with other Code provisions, there was no indication that Congress intended §548 to apply extraterritorially.

The court then noted that policy considerations clearly favored an extraterritorial application of §548. Indeed, “[f]ailure to extend application of §548 to transfers outside the territorial borders of the United States creates a loophole for unscrupulous debtors to freely transfer their assets to shell entities abroad and avoid the reach of the Bankruptcy Code.” Id. at 718. Notwithstanding this powerful rationale, however, the court was obliged to follow the Ninth Circuit’s holding that the presumption against extraterritoriality could not be overcome by policy considerations alone. See Subafilms Ltd. v. MGM-Pathe Communications Co., 24 F.3d 1088, 1096 (9th Cir. 1994) (en banc).

The court then considered the Fourth Circuit’s decision in In re French, which had extended the extraterritorial reach of §548. The French “reasoning…presumes that the debtor retains a ‘legal or equitable’ interest in the property transferred pre-petition.” 347 B.R. at 719. However, “[i]t ignores the language in §541(a)(1) and (a)(3) that the debtor must have an interest in the property ‘as of the commencement of the case’ and that the property of the includes ‘any interest in property that the trustee recovers under section…550.’” Id. Accordingly, the court found the French reasoning to be unpersuasive.

Practical Lessons from Midland Euro
           
What are the practical lessons from Midland Euro? While there is still no federal circuit conflict on the issue, the French decision is certainly at odds with both Midland Euro and the Southern District Court of New York, which held that §547 does not apply extraterritorially. See In re Maxwell Communication Corp. PLC, 186 B.R. 807 (S.D.N.Y. 1995). Based on the existing statutory scheme, it is the author’s opinion that Midland Euro is the better-reasoned approach because it better comports with governing rules of statutory construction. Indeed, while not considered by Midland Euro, chapter 15’s limitations on §§547 and 548 actions create a strong presumption that Congress did not intend those sections to apply extraterritorially.³
           
In evaluating avoidance actions, trustees, debtors-in-possession and/or creditor committees must carefully lay out their plan of attack. Are some of the voidable transfers extraterritorial? Does the estate have sufficient resources to fund foreign litigation? To maximize overall recoveries, it may be necessary to pursue domestic actions to fund future international actions. In some instances, a preferential and/or constructively fraudulent transfer may be not avoidable under the laws of the foreign jurisdiction. See 347 B.R. at 714 (SFC argued that fraudulent intent must be shown under English law, whereas §548 allows avoidance of fraudulent transfers without proving intent). In those instances, the only viable option may be to file the action domestically and strenuously argue that (a) the claim inherently is domestic rather than international and/or (b) that the French reasoning should apply.

In contrast, creditors that defend preferential- and/or fraudulent-transfer actions should immediately ascertain how their particular adversary action relates to the big picture. How much money does the estate have? What other potential avoidance actions exist? Will they involve extraterritorial application of §§547 or 548? While a creditor will never know the full scope of the avoidance actions, it is remarkable how much one can ascertain through careful study of the bankruptcy filings and “chatting” with opposing counsel regarding settlement of the existing adversary action. If more lucrative but costly avoidance actions are yet to be filed, a creditor’s counsel might obtain a significant savings through an early settlement. Likewise, if the adversary action involves international transfers, then one should be able to negotiate a settlement discount associated with the uncertainty of an extraterritorial application in a domestic setting.