A Trustee’s Dilemma: Charity Avoidance Actions in §§ 548 and 550

By Richard Arrowsmith and Brittany B. Falabella

Many recent cases of fraud have ended up in bankruptcy court as the primary source of adjudication of claims. The unfortunate consequence of some of these matters is that the tortfeasors, while consuming the majority of their ill-gotten proceeds for their personal enjoyment, may have also directed funds to eleemosynary organizations. A trustee of any such estate owes a fiduciary obligation to creditors (often the trust beneficiaries) to use reasonable efforts to recover the fraudulently transferred funds. Many of these organizations from which a trustee is seeking to recover are of the highest regard among the charitable-giving public. Thus, the trustee’s dilemma is whether to pursue clawback actions against presumably “innocent” recipients of ill-gotten monies that have no real defenses, rely on donations for operating expenses, and provide goods and services ultimately to beneficiaries with limited resources.

A bankruptcy trustee’s decision in this regard is evaluated using the business-judgment standard. Assuming that such a decision is reasonable (i.e., justified), discretionary and within the scope of the trustee’s duties, it will almost always be upheld as being within the exercise of the trustee’s business judgment. However, justifying the decision not to bring a claim when the potential recovery is substantial and defenses are limited is difficult, if not impossible. After all, a trustee has a fiduciary obligation to maximize the recovery and distribution to creditors. Nevertheless, when a church or charitable organization is the potential defendant, the perceived calculus or business judgment to be employed is more nuanced.

While the defendant’s identity may indirectly impact justifications for action or inaction taken, the Bankruptcy Code strictly defines “liability.” Although the Code’s language was amended in 1998 to carve out churches and charities from some liability under certain facts, the amendments do nothing to protect them from liability arising out of fraudulent schemes perpetrated through insolvent entities that later file for bankruptcy. This article covers three parts: (1) the limited protections for churches and charities in § 548 of the Bankruptcy Code enacted pursuant to the Religious Liberty and Charitable Donation Protection Act of 1998 (RLCDPA);1 (2) two decisions arising out of the In re Health Diagnostic Laboratory Inc. cases finding churches liable under the express language of § 550 of the Code; and (3) the proposition that neither the trustee’s business judgment, the statutory language nor the congressional record supports an expansive interpretation of the protection to churches in § 548.

The RLCDPA

The RLCDPA was passed by Congress, at least in part, in response to the threat that the Religious Freedom Restoration Act (RFRA)2 would be held to be unconstitutional as applied to federal law, and there was a perceived increase in chapter 7 trustees seeking to claw back a debtor’s prebankruptcy tithing as fraudulent conveyances under § 548(a)(1)(B) based on the theory that the transfers that were not made in exchange for reasonably equivalent value.3 The RLCDPA created a safe harbor for certain charitable contributions in § 548(a)(2), which states:

A transfer of a charitable contribution to a qualified religious or charitable entity or organization shall not be considered to be a transfer covered under paragraph (1)(B) in any case in which —

(A) the amount of that contribution does not exceed 15 percent of the gross annual income of the debtor for the year in which the transfer of the contribution is made; or

(B) the contribution made by a debtor exceeded the percentage amount of gross annual income specified in subparagraph (A), if the transfer was consistent with the practices of the debtor in making charitable contributions.4

Section 548 was also amended to add the definition of “charitable contribution”5 and “qualified religious or charitable entity or organization.”6 For purposes of § 548, a charitable contribution must (1) be made by a natural person, (2) consist of a financial instrument or cash, and (3) otherwise meet the qualifications set forth in § 170(c) of the Internal Revenue Code of 1986 (IRC).7 A qualified religious or charitable entity or organization for purposes of § 548 of the Bankruptcy Code is defined to include two of the six categories of covered entities in § 170(c) of the IRC.8

Far from being a carte blanche exclusion of liability for all charitable donations, the RLCDPA exception in § 548(a)(2) was narrowly tailored in its terms. It does not apply when the transfers exceed 15 percent of the debtor’s gross income or are inconsistent with past practice.9 It does not apply to actually fraudulent transfers under § 548(a)(1)(A).10 It also does not apply to transfers made by debtors that are not natural persons.11 And as the bankruptcy court found in Arrowsmith v. Christian Life Assembly of Columbia, South Carolina, Inc. (In re Health Diagnostic Laboratory Inc.) (the “CLC adversary proceeding”) and the jointly decided Arrowsmith v. Lake Murray Baptist Church (In re Health Diagnostic Laboratory Inc.) (the “LMBC adversary proceeding”), it does not apply to protect a church that is a subsequent transferee under § 550 of the Bankruptcy Code.

The Adversary Proceedings

The adversary proceedings arose out of a fraudulent agreement entered into in 2010 between the debtor, Health Diagnostic Laboratory Inc., and its medical sales agent, BlueWave Healthcare Consultants Inc. BlueWave was partly owned and operated by Floyd Calhoun Dent, III.12

The agreement was ultimately found by the Fourth Circuit to have violated the False Claims Act13 and was thus void ab initio.14 On the basis of the illegality of the agreement and the lack of reasonably equivalent value, the district court adopted the bankruptcy court’s findings and conclusions and entered summary judgment against BlueWave, Dent and others in the amount of the transfers made by the debtor on account of the agreement pursuant to §§ 548(a)(1)(B) and 544(b).15 Collectively, more than $221 million was avoided as constructively fraudulent transfers between 2010-15.

Based on the summary judgment, the liquidating trustee, who was appointed pursuant to the debtor’s confirmed plan to administer the liquidating trust for the benefit of allowed unsecured claimants, began investigating the transfers of the $221 million. Dent received more than $720,000 directly from the debtor, and he received more than $38 million from the debtor via BlueWave.16 In addition to the multiple properties, businesses, gold and trust funds purchased and funded by this money, Dent also gave away millions to friends, family, churches and charities. Two such churches were the defendants in the adversary proceedings (collectively, the “defendants”). The defendant in the CLC adversary proceeding received more than $1.35 million in donations, and the defendant in the LMBC adversary proceeding received donations exceeding $375,000.17

The liquidating trustee sought to recover from the defendants as subsequent transferees the amount of the donations that were traceable to the avoided $221 million in transfers from the debtor. The defendants moved to dismiss on the grounds that the donations were protected by the RLCDPA.18 In denying the motion to dismiss, the bankruptcy court analyzed the language of § 550 and noted that the RLCDPA did not amend that Code section.19 Moreover, because § 550 contains its own list of applicable defenses, it would violate the Code20 and U.S. Supreme Court precedent21 to apply a defense that is not contained in the statute.

In reaching this conclusion, the bankruptcy court acknowledged that the language of § 550 “may put a charitable or religious institution in a difficult position,” but noted that Congress is the proper party to address those concerns.22 Finding the language of §§ 548 and 550 unambiguous as to whether the RLCDPA created a defense under the facts of the adversary proceedings, the court did not address its legislative history. The authors (admittedly the liquidating trustee and his counsel in the adversary proceedings) submit that review of the legislative history would not have changed the outcome.

The RLCDPA’s Purpose

The RLCDPA accomplished its objective. First, the legislative record suggests that the concern was protection of the debtor’s right to practice religion through tithing rather than the protection of the recipient church or charity from recovery actions.23 As mentioned, the impetus for the RLCDPA was the threat that the RFRA would be declared unconstitutional as applied to federal law and the Bankruptcy Code. The Supreme Court had declared the RFRA unconstitutional as it related to state law in City of Boerne v. Flores,24 and Congress feared that determination also would extend to the Bankruptcy Code.25 The RLCDPA’s goal was protection of the right to practice religion. As stated in hearings considering the RLCDPA:

It is difficult to imagine a more intrusive burden on the religious conduct of a member of our church than the confiscation in bankruptcy of a member’s tithing, thereby placing in possible jeopardy his or her good standing in the Church and denying the future opportunity to obtain these singularly important blessings that can only be received in our Temples.26

To the extent that it can even be argued that a goal of the RLCDPA was the protection of the church or charity itself, this protection was never absolute, and the innocence of the recipient was not the relevant qualification. The protection was from the perceived impending tidal wave of de minimis clawback actions against churches being the primary source of funding for the average consumer bankruptcy case. Prof. Douglas Laycock, during the congressional hearings on the RLCDPA, said:

In 97 percent of consumer cases today, there are no assets to distribute to creditors. Only 3 percent have assets, but many more than 3 percent give to their churches. What this emerging body of law means is that churches will become the primary source of funds for distribution to the consumer credit industry in American bankruptcy courts, and suits by trustees against churches will become the most common form of adversary proceeding in American bankruptcy courts. I am quite confident that is not what Congress intended when it passed § 548(a)[(1)(B)].27

Congress specifically knew and accounted for cases like the adversary proceedings where innocent churches and charities would be liable to return donations pursuant to § 550 or when avoidance was based on actual fraud, but Congress did not intend to address these “rare cases” with the RLCDPA amendments.28 The RLCDPA has accomplished what it was intended to protect and prevent.

Conclusion

Nevertheless, pursuing a church or charity to return donations that were made with fraudulently obtained funds is still often met with a visceral response. When faced with the task of pursuing an “innocent” party, trustees and their counsel must resolve an internal psychological struggle as a result of a conflict between values and duties.

Similarly, bankruptcy courts also may face a similar dilemma in deciding such cases when two “innocent” parties claim entitlement to the same property. However, fulsome consideration of the issues, law and fiduciary obligations require the pursuit of claims against parties that actively did nothing wrong just as the bankruptcy court did in the adversary proceedings, and just as Congress contemplated.

Rick Arrowsmith is a partner in Alastar Partners’ Capital Solutions Business, based in Boyds, Md. Britt Falabella is a partner in Hirschler’s Litigation Group in Richmond, Va. She is a chapter 7 panel trustee for the Western District of Virginia and was named a 2024 ABI “40 Under 40” honoree.