When Does Knowing Equal "Knowledge"

What happens when a chapter 7 trustee brings an action to avoid a prepetition transfer of garnished funds as preference and tries to recover such transfer not only from the judgment creditor but also its attorney? Here’s an example. George Washington retains Law Firm to prosecute John Adams for an injury that Washington suffered on Adams’ property. Law Firm, not surprisingly, agrees to take the case on a contingent-fee basis. Washington is awarded damages and is very happy with Law Firm, which was able to recover X amount of the awarded damages from Adams. The state court distributes one-third of the total award (plus costs) to Law Firm, pursuant to its contingent-fee arrangement with Washington, and the remaining amount to Washington. After the trial, but before X amount is distributed, Adams tells Law Firm that he is going to file for bankruptcy and, therefore, the total recovery, including the one-third contingent fee, will have to be returned as an avoidable preferential transfer pursuant to the Bankruptcy Code, but Law Firm refuses to return its contingent fee. A few weeks after Law Firm is paid, Adams files for bankruptcy relief and the chapter 7 trustee files a complaint against Washington (as the initial transferee) and Law Firm (as the immediate transferee) for recovery of avoidable preferential transfer. Although this issue has not been specifically addressed by many courts, it is clear from a reading of the Code that law firms face potential liability under 111 U.S.C. §§ 547 and 550.

In order to prevail on an action for recovery of a preferential transfer under 11 U.S.C. § 547, a trustee (or debtor in possession) must establish that a transfer was (1) to or for the benefit of the initial transferee; (2) for or on account of an antecedent debt; (3) made while the debtor was insolvent; (4) made on or within 90 days before the filing of the petition; and (5) enabled the initial transferee to receive more than it would receive if (a) the case were a case under chapter 7, (b) the transfer had not been made and (c) the initial transferee received payment of such debt to the extent provided by the provisions of this title.

Once a transfer has been avoided pursuant to one of the enumerated Code sections (such as § 547), § 550 of the Code permits the trustee to recover either the property transferred or, if the court so orders, the value of that property. [1] Section 550 is structured so as to restore the bankruptcy estate to the position it would have enjoyed in the absence of the transfer.[2] Liability under § 550(a)(1) is strict by its very nature as to the initial transferee.[3] However, the immediate transferee is not subject to strict liability.[4]

In the above example, it could not be reasonably disputed that Washington is the recipient of a preferential transfer as the initial transferee. Therefore, pursuant to § 550(a)(1), Washington is strictly liable to the bankruptcy estate of Adams for the amount of the transfer.

Where this gets interesting is when a trustee decides to pursue recovery from the law firm that received a portion of the preferential transfer as its contingent fee. In other words, a trustee is more likely to seek recovery from a law firm when the initial transferee is insolvent or judgment proof. Pursuant to § 550(a)(2), “to the extent a transfer is avoided under [Bankruptcy Code] section…547…the trustee may recover, for the benefit of the estate, the property transferred…from…any immediate or mediate transferee of such initial transferee.”[5]

It is clear that Law Firm is an immediate or mediate transferee of Washington with respect to the preferential transfer. Therefore, pursuant to the explicit and unambiguous language of § 550(a)(2), a trustee may recover the amount of the contingent fee from Law Firm, subject to the affirmative defense found in § 550(b)(1).

The Code gives law firms, and, for that matter, other immediate transferees, a defense for liability under 11 U.S.C. § 550(a)(2). Section§ 550(b)(1) provides an immunity to liability as an immediate or mediate transferee as long as the following three conditions are satisfied: the transferee takes (1) for value, (2) without knowledge of the avoidability of the transfer avoided and (3) in good faith.[6]

In the typical example, there is no doubt that Law Firm takes its contingent fee for value and in good faith. The real issue and ambiguity lies in the second condition of 11 U.S.C. § 550(b)(1):  the transferee takes without knowledge of the avoidability of the transfer avoided. Specifically, the issue is what level of knowledge that a law firm must have with respect to a preferential transfer. A trustee would argue that if a law firm is alerted to the likelihood that a judgment debtor will file for bankruptcy relief within 90 days of collecting on a judgment, such law firm has the requisite knowledge of the avoidability of the preferential transfer, because lawyers presumably understand preference law and know that property received from a bankrupt debtor within 90 days of the petition date will have to be returned to the bankruptcy estate.

The most recent decision on this matter, and the only opinion directly on point, is Michael Stevenson, Chapter 7 Trustee v. Mario Genna, et al. (In re Jackson).[7] In Jackson, the judgment creditors obtained a state court judgment against debtor for $388,260, and the judgment creditors were represented by a law firm. In an effort to collect on the judgment, the law firm garnished several of debtor's accounts. [8] As a result, a check was issued in the judgment creditors’ favor and sent to the law firm in the amount of $166,298.57. Moreover, the law firm was also able to obtain an additional $17,260.93 from other garnishments, which the law firm deposited the funds into its client trust account. [9]

A few weeks later, one of debtor's attorneys sent a letter via facsimile to an attorney at the judgment creditors’ law firm indicating that his client, the debtor, was being represented by an attorney who specialized in bankruptcy “for her impending bankruptcy.”[10] The next day, debtor’s bankruptcy attorney sent an e-mail to an attorney at the judgment creditors’ law firm indicating that he had spoken with his client regarding the chapter 7 filing. Two days later, the debtor’s bankruptcy attorney informed an attorney at the judgment creditors’ law firm by e-mail that his client was “not interested in settling the lawsuit and intends to [file] a Chapter 7 bankruptcy case.” The debtor's bankruptcy attorney further indicated that he would be meeting with his client “early next week to sign the pleading and will file thereafter.”[11]

While discussions regarding a bankruptcy filing were taking place, the state court issued an order approving distribution of proceeds the judgment creditors had received as a result of the garnishments of debtor's accounts. The judgment creditors’ law firm was awarded $73,647.97 in payment of its costs and fees to date. [12] Two days later, the state court entered an order approving distribution of the remaining judgment proceeds ($109,911.53) to the judgment creditors.[13]

Within 90 days after the initial transfer, the debtor filed her petition for bankruptcy relief.[14] The chapter 7 trustee filed an amended adversary complaint against both the judgment creditors and their law firm, asserting several causes of action, including (1) avoidance of a preferential transfer to the judgment creditors pursuant to § 547(b), (2) recovery of the avoidable transfer to the judgment creditors pursuant to § 550(a) and (3) recovery of avoided transfers against the judgment creditors’ law firm pursuant to § 550(a)(2).

The Jackson court did not thoroughly analyze the claim against the judgment creditors, because their liability as initial transferees of a preferential transfer is clear. The court instead spent the majority of its efforts determining whether the second transfer—the contingent fee received by the law firm—could be recovered by the trustee pursuant to § 550(a)(2).

The law firm defendant argued that it took the second transfer for value, in good faith and without knowledge of the voidability of the transfer. Thus, so the argument went, § 550(b)(1) precludes recovery by the trustee. The Jackson court analyzed another case[15] on point:

In [Spinnaker], [the] debtor’s successor brought a preference action to recover funds paid to a judgment creditor and to the judgment creditor’s attorney as an attorney fee. The court found that the judgment creditor was the initial transferee and funds paid to the creditor were recoverable as a preferential payment. The court also held that the law firm defendant was an immediate transferee of the judgment creditor with regard to its attorney fees. The court then went on to discuss the “good faith” and “without knowledge” requirements of…§ 550(b)(1) and concluded that it could not, on the record before it, determine whether the law firm could be held liable as an immediate transferee under…§ 550(b)(1). The court remanded the issue for a determination as to whether the law firm could be held liable under…§ 550(b)(1). The court did not address what knowledge the court would have required the immediate transferee to possess to lose its protection under…§ 550(b)(1).[16]

As the Jackson court recognizes, the Spinnaker decision fails to address what knowledge would be required for an immediate transferee to lose the protection of § 550(b)(1). Therefore, the Jackson court turns its attention to another case for guidance.

In Lifecare Technologies Inc. v. Berman Law Firm PA (In re Lifecare Technologies Inc.), 305 B.R. 88 (Bankr. M.D. Fla. 2003), the Chapter 11 debtor sought recovery of prepetition settlement payments the debtor made to a creditor and the payments the creditor had paid to its law firm for an attorney fee. The court held that the law firm defendant was an immediate transferee under 11 U.S.C. § 550(a)(1). However, the law firm defendant had filed an affidavit stating that it had no knowledge of a possible bankruptcy when it accepted a payment from the Chapter 11 debtor's creditor. The court was satisfied that the affidavit established that the law firm took funds from the initial transferee “without knowledge”. The court did not opine on whether knowledge of the bankruptcy would have been sufficient in of itself to constitute knowledge for purposes of avoiding the transfer to the immediate transferee.[17]

After a review of the statute itself and the applicable case law, the Jackson court concluded that the law firm defendant was “without knowledge of the avoidability of the transfer avoided,” notwithstanding the law firm's knowledge of the potential bankruptcy filing. However, the Jackson court does not address what would amount to “knowledge of the avoidability of the transfer [avoided]” in a preference action. Instead, it determined that there are only two circumstances in which an immediate transferee is liable under the Code:

Thus, as a general rule, an immediate transferee may not avail itself of the defense under…§ 550(b)(1) if the initial transferee is giving funds to the immediate transferee to hide or shield those funds from recovery, or if the transferee, through reasonable discovery, could determine that the initial transfer was tainted by fraud.[18]

The Jackson court seems to ignore the plain language in the Code, which explicitly allows a trustee to recover from an immediate transferee of a preferential transfer. [19] The issue arises because a preferential transfer, by its very nature, occurs prior to the filing of a bankruptcy petition. Therefore, no immediate transferee of a preferential transfer could ever have knowledge that the transfer is avoidable at the time the transfer is made, unless the immediate transferee accepts the transfer after a bankruptcy petition has been filed. This appears to be the situation that the Jackson court would look for in order to avoid such a transfer.

The Code does not require such a unique set of facts to avoid a preferential transfer to an immediate transferee. Rather, it provides that the immediate transferee must take the transfer “without knowledge of the avoidability of the transfer avoided.”[20] In the above example (and in Jackson for that matter), Law Firm took its contingent payment with knowledge that the judgment debtor may file for bankruptcy relief. Assuming then that Law Firm understands what a preference is and its implications, Law Firm is arguably taking its fees with knowledge that the original transfer (the collection on a judgment) is voidable if the judgment debtor files for bankruptcy relief within 90 days of such collection.

The issue for attorneys going forward is what constitutes knowledge in this completely common scenario. If a bankruptcy petition is prepared and served on the judgment creditor’s law firm, is that sufficient to provide notice of the avoidability? Does the judgment debtor need to employ bankruptcy counsel? Is the mere threat of a bankruptcy filing sufficient? If the mere threat of bankruptcy is sufficient all defendants could employ this tactic so that a law firms may refuse to take the case on a contingency basis? This becomes a very slippery slope. Law firms would not want to take any cases on a contingent fee basis and when cases are taken, the law firm may need to hold any contingent fee reward in escrow for 90 days from the date of the initial transfer if there is any sign that the judgment debtor may file for bankruptcy protection. Otherwise, it appears very possible, although maybe not probable based on the ruling in Jackson, that the law firm would have to disgorge its fees derived from its work on behalf of the judgment creditor.