Carlos J. Cuevas ()
Bankruptcy Code §548(a)(1) contains the Bankruptcy Code fraudulent conveyance statute. 11 U.S.C. §548(a)(1). Bankruptcy Code §548(a)(1)(A) governs intentional fraudulent conveyances: those transfers made by a transferor with actual intent to hinder, delay, or defraud creditors. 11 U.S.C. §548(a)(1)(A). Bankruptcy Code §548(a)(1)(B) governs constructive fraudulent conveyances: those transfers made by a transferor for which the estate was not provided with reasonably equivalent value and left the estate without sufficient assets to pay its creditors. 11 U.S.C. §548(a)(1)(B). Bankruptcy trustees frequently commence fraudulent conveyance actions. Bankruptcy Code §548 is a heavily litigated Bankruptcy Code provision.
Bankruptcy Code §548(c) provides a transferee, the recipient of an alleged fraudulent conveyance, with an affirmative defense to the fraudulent conveyance action. Bankruptcy Code §548(c) states:
Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.
11 U.S.C. §548(c).
The good faith defense is an important affirmative defense in a fraudulent conveyance proceeding. In order to prevail on a Bankruptcy Code §548(c) affirmative defense a transferee must establish both that it gave value and has acted in good faith. See Hayes v. Palm Seedlings Partners-A (In re Agricultural Research and Technology Group), 916 F.2d 528, 535 (9th Cir. 1990). The burden of proof is on the transferee to establish the “good faith” defense. Doeling v. Grueneich (In re Grueneich), 400 B.R. 688, 693 (8th Cir. 2009). The purpose of this article is to discuss what constitutes “good faith” under Bankruptcy Code §548(c).
The phrase “in good faith” is not defined in Bankruptcy Code §548(c). Collins v. Sellis (In re Lake State Commodities), 253 B.R. 866, 878 (Bankr. N.D. Ill. 2000). A transferee’s good faith is determined on a case by case basis. Meeks v. Red River Entertainment of Shreveport (In re Armstrong), 285 F.3d 1092, 1096 (8th Cir. 2002).
The U.S. Court of Appeals for the Eighth Circuit has made the following observations the nature of the “good faith” component of Bankruptcy Code §548(c):
To determine whether a transferee acts in good faith, “courts look to what the transferee objectively ‘knew or should have known’” instead of examining the transferee’s actual knowledge from a subjective standpoint. In re Agricultural Research & Technology Group, Inc., 916 F.2d 528, 535-36 (9th Cir. 1990); cf. Bonded Fin. Servs. v. European Am. Bank, 838 F.2d 890, 897-98 (7th Cir. 1988) (analyzing good faith under §550(b)). In other words, a transferee does not act in good faith when he has sufficient knowledge to place him on inquiry notice of the debtor’s possible insolvency.
Brown v. Third National Bank (In re Sherman), 67 F.3d 1348, 1355 (8th Cir. 1995).
Another court has made the following observations concerning the “good faith” requirement of Bankruptcy Code §548(c) in the context of a constructive fraudulent conveyance action:
In the context of a transfer that is avoided as constructively fraudulent, courts have held that the transferee acts in good faith only where it has an honest belief in the propriety of the activities in question, no intent to take unconscionable advantage of others, no actual intent to defraud others, and no knowledge that the transaction would operate to defraud others. See Hirsch v. Cahill (In re Colonial Realty Co.), 210 B.R. 921, 923 (Bankr. D. Conn. 1997). A transferee’s knowledge, moreover, is determined by an objective rather than a subjective standard.
Breeden v. L.I. Bridge Fund (In re The Bennett Funding Group), 232 B.R. 565 (Bankr. N.D.N.Y. 1999).
Facts sufficient to warrant a finding of inquiry notice will generally negate the good faith that is essential to raise the good faith defense. Plotkin v. Pomona Valley Imports (In re Cohen), 199 B.R. 709, 720 (Bankr. 9th Cir. 1996). The U.S. Court of Appeals for the Tenth Circuit has stated:
Significantly, the majority of bankruptcy courts construing “good faith,” as it is used in §548(c), have followed the Eighth and Ninth Circuits, holding that a transferee who reasonably should have known of a debtor’s insolvency or of the fraudulent intent underlying the transfer is not entitled to the §548(c) good faith defense.
Jobin v. McKay (In re M & L Business Machine Co.), 84 F.3d 1330, 1338 (10th Cir. 1996).
Once a transferee is on inquiry notice, the “relevant question” is whether an “inquiry, if made with reasonable diligence, would have led to the discovery of the transferor’s fraudulent purpose.” Christian Brothers High School Endowment v. Bayou No Leverage Fund (In re Bayou Group), 439 B.R. 284, 316 (S.D.N.Y. 2010). Thus, “willful blindness,” when a defendant has a subjective belief that there is a high probability that a fact might be true and acts deliberately to avoid verifying the fact, negates the assertion of a §548(c) defense. Picard v. Merkin (In re Bernard L. Madoff Investment Securities), 515 B.R. 117, 139-40 (Bankr. S.D.N.Y. 2014).
A leading decision involving the application of Bankruptcy Code §548(c) is Brown v. Third National Bank (In re Sherman), 67 F.3d 1348, 1355 (8th Cir. 1995). There, the debtors, Larry and Karen Sherman, transferred 12 properties to Larry Sherman’s parents within a year of the debtors filing for bankruptcy. The consideration for the transfers was the outstanding mortgage indebtedness. In the year preceding the bankruptcy filing the debtors were in financial trouble. Some of the debtors’ properties were subject to tax foreclosure proceedings, and a supplier had commenced a state court collection action. The Chapter 7 trustee commenced a fraudulent conveyance action against Mr. Sherman’s parents. The bankruptcy court held that the 12 transfers were avoidable under Bankruptcy Code §548(a)(1), and that the parents did not have a good faith defense under 548(c). The district court affirmed the bankruptcy court.
The U.S. Court of Appeals for the Eighth Circuit affirmed the lower court rulings. The Eighth Circuit rejected the contention that the 12 transfers were subject to a good faith affirmative defense under Bankruptcy Code §548(c). The transferees were aware of sufficient facts concerning the debtors’ tenuous financial situation to place them on inquiry notice of the debtors’ insolvency and impending bankruptcy. The court stated:
Specifically, the bankruptcy court found that the Shermans were aware of the following facts: Karen Sherman’s recent illness caused the debtors to incur substantial medical debts; the Shermans knew about the debtors’ indebtedness to Benson and Benson’s impending lawsuit against the debtors; and the Shermans were aware that the debtors were behind in mortgage payments to the Bank and that the Bank was planning to commence foreclosure proceedings. We agree with the bankruptcy court’s conclusion that the combination of these factors places the Shermans on inquiry notice of the debtors’ insolvency. Thus, the Shermans did not take the transfer of the twelve properties in good faith.
Id. at 1355-56.
Another pertinent case involving the application of Bankruptcy Code §548(c) is Dobin v. Hill (In re Hill), 342 B.R. 183 (Bankr. D.N.J. 2006). There, the bankruptcy court held that a property settlement agreement that was incorporated into a divorce judgment was as an intentional fraudulent conveyance. The court also held that the ex-husband, the transferee, was not entitled to the benefit of Bankruptcy Code §548(c) because he had not acted in good faith. The court stated:
Here, Daniel has failed to meet his burden in establishing his good faith. Daniel knew, or should have known, that Phyllis’s transfer of assets through the divorce settlement agreement was done with fraudulent intent. Daniel was given no logical explanation as to why Phyllis suddenly changed her position and decided not to pursue the marital division of property she previously demanded. The significant change in position and grossly uneven distribution of marital assets was enough to put Daniel on notice that Phyllis was intending to divest herself of assets. As early as November, 2003, Daniel knew of the arbitration award entered against Phyllis.
Id. at 203.
Recently, Judge Stuart Bernstein denied a defendant’s motion for summary judgment because there were disputed issues of fact concerning whether the defendant had engaged in willful blindness. Picard v. Merkin (In re Bernard L. Madoff Investment Securities), 2017 WL 401191 (Bankr. S.D.N.Y. 2017). The trustee introduced evidence supporting the inference that the defendant was aware of the high probability that the debtor was a Ponzi scheme, and the defendant did nothing to confirm his suspicions. The defendant’s state of awareness and what he did present disputed issues of fact.