Tenth Circuit Protects Subsequent Recipients of Fraudulent Transfer with a New Defense

The Tenth Circuit handed down an opinion on July 10 that will be cited for the controversial proposition that a subsequent recipient of proceeds from fraudulently transferred property cannot be held liable under Section 550(a)(2), even if the subsequent transferee was aware of the fraud.

The Denver-based appeals court reasoned that a trustee cannot recover cash proceeds from fraudulently transferred property because the proceeds were not the “property transferred” under Section 550(a). The appeals court cited no caselaw authority for its interpretation of the statute.

The initial transferee took a contract claim in a fraudulent transfer. The initial transferee converted the contract claim to cash and transferred the cash to a subsequent transferee. The Tenth Circuit held that the subsequent transferee had not received a “transfer” because the property that it received was cash, not the contract claim.

The Complex Facts

In her 17-page opinion for the appeals court, Circuit Judge Carolyn B. McHugh needed nine pages to lay out the highly complex facts. We hope the following summary is a fair representation.

A company had rights to develop a wind-power project. The builder was obligated to pay the developer a fee and the developer’s costs when the project was completed and sold. The developer became insolvent but did not file bankruptcy. Instead, the insolvent developer transferred its rights as developer to a new company that we will refer to as the transferee. As part of the transfer, the transferee received the developer’s rights to be paid the developer’s costs and fees.

When the project was completed and sold, the builder paid the transferee some $5 million, but the transferee retained counsel to sue, claiming more was owed on account of the developer’s costs and fees. Eventually, a federal court in Pennsylvania entered a $9 million judgment against the builder and in favor of the transferee.

After receiving the $9 million, the transferee paid two law firms a total of about $2 million in fees for prosecuting the lawsuit against the builder.

Along the way, the original, insolvent developer filed a chapter 7 petition. Later, the chapter 7 trustee sued the transferee for receipt of a fraudulent transfer, namely, the right to be paid when the project was sold. The trustee ultimately obtained a $10.5 million consent judgment against the transferee. The trustee was unable to collect anything from the transferee on account of the fraudulent transfer judgment.

So, the trustee sued the two law firms for $2 million as subsequent recipients of the fraudulent transfer under Section 550(a). The bankruptcy court denied the law firms’ motion to dismiss, but the Tenth Circuit granted permission for a direct, interlocutory appeal.

Proceeds of the Fraudulent Transfer Weren’t Recoverable

Judge McHugh reversed, directing the bankruptcy court to dismiss the suit against the two firms. She held that the firms were not transferees of the fraudulently transferred property (the developer’s rights to payment) and therefore had no liability under Section 550(a).

Judge McHugh based her decision on the plain language of Section 550(a). She said that the “firms are not subsequent transferees because they never received the property transferred, i.e., the contractual right to the . . . sales proceeds.” She said there was no evidence that the transferee transferred the right to receive sale proceeds to the two firms. In other words, “neither firm is a transferee of the property that was set aside as fraudulently transferred.”

The trustee argued, however, that Section 550(a) permits recovery of “the transferred property, or if the court so orders, the value of such property.” In other words, the trustee was contending that he had the right to recover proceeds from the fraudulent transfer as the “value” of the fraudulently transferred property.

Judge McHugh rejected the argument. Even if there had been an order to recover the value of the transferred property, she said the trustee could not recover under Section 550 because “the firms are not transferees” of the property that was fraudulently transferred — that is, the contract right to receive payments on sale.

Judge McHugh also rejected the trustee’s contention that the payments to the firms were “proceeds” of estate property under Section 541(a)(6). Even if the payments were proceeds of estate property, she said that nothing in Section 541(a)(6) “expands the trustee’s powers under § 550 to recover from persons who are not transferees.”

With regard to the trustee’s argument under Section 541, Judge McHugh said that if Congress had intended “to provide the trustee with power to trace proceeds . . . , it could have [written Section 550 to say] so.”

The Tenth Circuit appears to have held: If a debtor fraudulently transfers a contract claim, and if the initial transferee converts the contract claim to cash, a subsequent transferee of the cash did not receive a transfer of the fraudulently transferred property (the contract claim) and therefore cannot be held liable under Section 550(a).

Observations

Respectfully, the Tenth Circuit gutted fraudulent transfer law and blessed a process allowing a fraudster to immunize proceeds from recovery. Take the following example.

A fraudster fraudulently transfers real property to the initial transferee. The initial transferee sells the property for cash and transfers the cash to a subsequent transferee. Under the Tenth Circuit’s holding, the subsequent transferee has a complete defense, even if the subsequent transferee was aware of the initial fraud. If the initial transferee is judgment-proof, creditors would have no recovery.

The holding is a startling development in fraudulent transfer law, and particularly so because the circuit only cited the statute for authority. When a court is issuing a significant opinion with profound implications for fraudulent transfer law, one ordinarily would expect the court to cite and discuss authority from caselaw and treatises.

Granted, the Tenth Circuit reached a result that might seem equitable to some. However, fraudulent transfer law can bring results that don’t seem equitable to everyone, particularly when dealing with subsequent recipients unaware of the fraud.

The two law firms generated value by converting a contract claim to a judgment and a monetary recovery. As subsequent recipients, the two firms might therefore have had “good faith” defenses under Sections 550(b)(2) and (e).

Still, the law firms might not have qualified for good faith defenses had they been aware of the manner in which the transferee came into possession of the contract claim.

Scholarly Commentary

ABI received commentary on the opinion from two law professors: Bruce A. Markell, Professor of Bankruptcy Law and Practice at the Northwestern Univ. Pritzker School of Law, and Jack F. Williams, Professor of Law at the Georgia State Univ. College of Law.

Commentary from Prof. Markell:

“The opinion will cause great mischief,” Prof. Markell said. He told ABI that the opinion “is so wrong that I don’t know exactly where to begin. 

“It ignores that, under the avoidance statutes such as Sections 548 and 547, the phrase ‘an interest of the debtor in property’ has generally been held to be the equivalent of ‘property of the estate.’ See Begier v. IRS, 496 U.S. 53, 59 (1990) (“Although not defined by the Code, ‘property of the debtor’ is best understood to mean property that would have been part of the estate had it not been transferred.”).

“Section 550 just deals with property subject to avoidance under Section 548, so ‘property transferred’ under 550 would be the ‘property of the debtor’ subject to avoidance under Section 548, and thus would include the proceeds concept under Section 541(a)(6), therefore giving the estate an interest in proceeds.

“The court’s analysis seems clouded by the intangible nature of the property involved. Yes, a payment obligation is discharged and does not exist after payment. But the payment persists, and is clearly subject to the ‘property or value’ language in Section 550. 

“In short, I had always thought that, if a proceeds concept wasn’t imported from the various avoidance sections (the ‘property of the debtor’ argument above), then the ‘or value’ language allowed courts to pursue proceeds. 

“Otherwise, by the court’s logic, even the initial transferee could claim it no longer held the intangible property, and thus would not have to disgorge. A transferee might say with a straight face, ‘I don’t have the property you seek,’ but they can’t say, ‘I don’t have the value of the property you seek.’ 

“Making distinctions between those two statements is a short path to chaos.”

Commentary from Prof. Williams:

Prof. Williams told ABI that the opinion is “quite questionable.” He said that the “point about no citation of authority is a good one but expected. Because there isn’t any.”

Prof. Williams believes the opinion “is an unprecedented departure from fraudulent transfer law and from its cousin, restitution. It also does not square with the statute. 

“Section 548’s focus, for these purposes, is on an ‘interest in property’ and not the ‘thing’ itself. Equity has long recognized, and so too fraudulent transfer law, that interests in property can carry forward even if the underlying property changes its character. 

“Think of the ability to trace identifiable proceeds of property for purposes of the imposition of an equitable lien or constructive trust. But it is the court’s treatment of section 541 that is most troubling. 

“Section 541 is silent on the meaning of ‘property’; rather, it speaks to property ‘of the estate.’ Sections 541(a)(3), (a)(6) and (a)(7) focus on when property becomes something more, when it transforms from property to property of the estate. 

“I am reminded of Twains’ observation that the difference between the ‘right word’ and the ‘almost right word’ is similar to the difference between lightning and a lightning bug. 

“Although the Supreme Court reminds us, in Chicago Bd. of Trade v. Johnson, 264 U.S. 1 (1924), that property under bankruptcy law is a federal question, we do not hesitate to consult state law for guidance. But just because it is property does not make it property of the estate. This is especially the case where the definition of property of the estate contains that temporal element — that is, all of the debtor’s legal or equitable interest in property at the time of the petition date.  Section 541(a)(1). 

“So now to how this plays out. Once a debtor transfers property prepetition, it is no longer property of the estate. However, at the time of the prepetition transfer, it is a transfer of an interest in property (including the right to convert property to cash and grant good title). Section 550 allows the recovery of the property transferred or the value of property transferred that is subject to avoidance under section 548 from the initial transferee, the immediate transferee and any mediate transferee. 

“Each transferee has its own potential defense, some of which appear to be applicable in the case, including good faith under Section 550(b). The court’s holding and analysis simply does not square with the statutory regime or the language of Sections 541 and 550.

“Now the ‘Choctaw’ Test: How would this holding apply to a run-of-the mill case? If the result is silly, try again. A transfers Greenacre to A’s brother as a gift while A is insolvent. A’s brother sells Greenacre to Joe, who takes it in good faith and for fair value. A’s brother then transfers the cash proceeds of the sale to A’s daughter. How would the Tenth Circuit resolve this issue if A then files a bankruptcy petition and his trustee commences a section 548/550 action against A’s brother, Joe and A’s daughter? Assume A’s brother is hopelessly insolvent. The trustee avoids the transfer to A’s brother; insolvents can’t make gifts. But A’s brother no longer has the property or the proceeds and is insolvent — so no luck. Worse, the property is in the hands of a protected BFP, so no recovery of the property here, either. That leaves A’s daughter. But she does not have the ‘property transferred,’ so she is not subject to Section 550, according to the Tenth Circuit. And she gets to keep the cash. That is a silly result. Silly amplifies the fallacy in the Tenth Circuit’s opinion. This is, and should be, a ‘good faith’ case.”