This is the sixth and last post in a series in which I discuss fraudulent transfers. This one deals with defenses against fraudulent transfers avoidance actions.
F. Defenses To Fraudulent Conveyance Avoidance
Aside from the problem of collectability — the recipient of the fraudulent transfer may be an impecunious, judgment-proof person — the trustee may face an insurmountable impediment to a fraudulent transfer avoidance action if the transferee successfully applies the defenses provided in the Bankruptcy Code.
1. The Charitable Donation Defense
The first defense to an avoidance action is found in § 548(a)(2):
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.
Thus, the debtor who regular tithes will not hear that the trustee has filed an avoidance action against the church, provided that either the amount tithed is less than 15% of the debtor’s gross income, or if more, then at the level the debtor consistently makes donations. This comes up most frequently with Mormon clients who are required to contribute at least ten percent of their incomes to the church to remain in good standing. Not being a Mormon myself, I am basing this assertion on the sense I have gotten from Mormon clients, and from the text at http://mormon.org/faq/church-tithing. If you are a Mormon and have a different perspective, I mean no offense and have no axe to grind. In any event, § 548(a)(2) insulates the church from fraudulent transfer avoidance actions.
The types of contributions covered by this defense are just what you might expect, and are listed in §§ 548(d)(3) and (4):
(3) In this section, the term “charitable contribution” means a charitable contribution, as that term is defined in section 170(c) of the Internal Revenue Code of 1986, if that contribution —
(A) is made by a natural person; and
(B) consists of —
(i) a financial instrument (as that term is defined in section 731(c)(2)(C) of the Internal Revenue Code of 1986); or
(4) In this section, the term “qualified religious or charitable entity or organization” means —
(A) an entity described in section 170(c)(1) of the Internal Revenue Code of 1986; or
(B) an entity or organization described in section 170(c)(2) of the Internal Revenue Code of 1986.
This means that only legitimate charities qualify for the defense. “Charities” such as the American Society for the Elimination of the Cuticle will not qualify. And remember, it’s the recipient of the transfer, not the debtor, who must mount the defense.
2. The Good Faith For Value Transferee Defense
Subsection 548(c) has a special defense for certain good faith transferees:
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.
There are three key elements to this defense.
First, if part of the transfer could be avoided under any of sections 544 (this happens when the trustee steps into the shoes of either a hypothetical creditor, or an actual creditor), 545 (this happens when the trustee avoids certain statutory liens), or 547 (this happens when the trustee avoids preferences, as discussed in great detail in my posts about preferences), then to that extent the defense is not available.
Second, the transfer must have been for value. This is defined in § 548(d)(2)(A) as: “property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor.”
Third, the transferee must have acted in good faith.
The good faith prong has been the focus of much litigation because it is crucial:
Even if the transferee gave reasonably equivalent value in exchange for the transfer avoided on either of the alternate theories, the transferee may not recover such value if the exchange was not in good faith because good faith is “indispensable” for the transferee who would recover any value given pursuant to 11 U.S.C. § 548(c).
The party asserting the defense has the burden of establishing good faith. Id. I apologize for the extended quote you’re about to read, but it contains a very good summary of the way courts have attempted to apply the good faith prong. The writing mavens tell us that readers do not read extended quotes, so they should be avoided. But if you’ve read this far, I must assume that you’re actually interested in understanding the idea.
The Code does not define “good faith.” Courts, however, have defined it in various ways. Compare, e.g., Gilmer v. Woodson (In re Decker), 332 F.2d 541, 547 (4th Cir. 1964) (good faith not lacking “unless the transferee knowingly participated in the debtor-transferor’s purpose to defeat other creditors or lacked good faith in valuing the property exchanged”), with In re Windor Indus., Inc., 459 F. Supp. 270, 279 (N.D. Tex. 1978) (good faith under former 11 U.S.C. § 107 “is not present where the transferee at the time of the transaction had knowledge of facts sufficient to put him on inquiry as to the insolvency or possible insolvency of the debtor”). . . see also Seligson v. New York Produce Exch., 394 F. Supp. 125, 133 (S.D.N.Y.1975) (“if the transferee had knowledge of the unfavorable financial condition of the transferor at the time of the transfer, it could not meet the good faith requirement” of former 11 U.S.C. § 107(d)(2)); Consumers Credit Union v. Widett (In re Health Gourmet, Inc.), 29 B.R. 673, 677 (Bankr. D. Mass.1983) (transferee’s knowledge of the debtor’s insolvency “is equivalent to lack of good faith” under § 548(c)). “Indeed, the presence of any circumstance placing the transferee on inquiry as to the financial condition of the transferor may be a contributing factor in depriving the former of any claim to good faith unless investigation actually disclosed no reason to suspect financial embarrassment.” . . . The test is whether the transaction in question bears the earmarks of an arm’s length bargain.
In sum, an entity seeking to assert a § 548(c) defense will undoubtedly have to prove it engaged in due diligence prior to the transaction if it is to succeed in establishing the good faith prong.
3. The Defenses Of § 546
A final set of defenses is found in 11 U.S.C. § 546. Most of the defenses in § 546 are arcane, and unlikely to arise in all but a very few cases. Therefore, I will restrict my discussion to § 546(a), which puts time limits on when an avoidance action can be initiated:
An action or proceeding under section 544, 545, 547, 548, or 553 of this title may not be commenced after the earlier of —
(1) the later of —
(A) 2 years after the entry of the order for relief; or
(B) 1 year after the appointment or election of the first trustee under section 702, 1104, 1163, 1202, or 1302 of this title if such appointment or such election occurs before the expiration of the period specified in subparagraph (A); or
(2) the time the case is closed or dismissed.
Think of this as a statute of limitations. Therefore, if the trustee is dilatory, the transferee can use this torpor as a defense.
4. Transfer Of Exemptible Property
If the debtor transferred property that was exemptible, was the transfer fraudulent? The answer to this question is a little less certain than our previous discussion suggests.
On the one hand, the Court in Tavenner v. Smoot, 257 F. 3d 401 (4th Cir. 2001) answered in the affirmative because exemptible property is not the same as exempt property. Unless the debtor actually exempts the property it is not exempt. Thus, while the debtor can exempt wages garnished prepetition using § 522(g) and then recover them using § 522(h), an essential element is the actual exempting.
On the other hand, the Court in In re Treiber, 92 B.R. 930 (Bankr. N.D. Okla. 1988) followed the so-called “no harm, no foul” approach, holding that the trustee cannot avoid the transfer because, absent the transfer, creditors could not have reached the property, and thus the transfer did not harm them in any way.
The Tavenner Court’s approach is the majority one, and makes more sense if the debtor voluntarily transferred an asset prepetition. Indeed, the Bankruptcy Appellate Panel for the Ninth Circuit followed it rather than the Treiber Court’s approach in In re Pringle, 495 B.R. 447 (B.A.P. 9th Cir. 2013). The Tavenner approach is the better one because once the debtor transfers an asset, the asset no longer belongs to the debtor to exempt. 11 U.S.C. § 522(g) appears to have been added to cover the case where an asset of the debtor was involuntarily transferred, such as with a wage garnishment.
But what about a foreclosure sale? That is typically an involuntary transfer of the debtor’s asset. Suppose the debtor had presale equity that was exemptible. Could the transfer be avoided by the debtor? Unless unusual facts are present, the answer is probably, no. And even if such avoidance was possible, the victory would be pyrrhic because the creditor would undoubtedly seek relief from the automatic stay and then conduct another sale. After all, success in prosecuting the avoidance action would not cure the mortgage default. And finally, according to the Supreme Court’s holding BFP v. Resolution Trust Corp., 114 S. Ct. 1757 (1994), the sale of the property in a regularly conducted foreclosure sale conclusively establishes reasonably equivalent value. See also In re Tracht Gut, LLC, 503 B.R. 804 (B.A.P. 9th Cir. 2014) (properly conducted sale of tax-defaulted real property establishes reasonably equivalent value as a matter of UFTA law).
If you are facing overwhelming debt and are think fraudulent transfers might be an issue in your case, contact a highly knowledgeable and skilled bankruptcy attorney to guide you through the process.