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Who Paid You? Chapter 7 Trustees are Asking and Creditors Should Know

Added by Brent Wilson in Articles & Publications, Banking Law, Business Law, News on June 2, 2016

In Idaho and beyond, Chapter 7 trustees are pursuing fraudulent transfer claims seeking to recover payments made on behalf of debtors by related entities of the debtors or other third parties (the “Other Party”) upon the Other Party’s bankruptcy filing. Creditors should take note and protect themselves by being cognizant of the source of payments they receive. 

To illustrate the issue: imagine you are a creditor to Bill. Bill is the sole shareholder in Bill, Inc. Bill, Inc. is insolvent but is receiving a source of funds. On behalf of Bill, and via a Bill, Inc. company check, Bill, Inc. pays you, as Bill’s creditor. Bill, Inc. owes no obligations to you in any capacity. You accept this payment and apply it to Bill’s debt because you know Bill, Inc. and Bill are “basically” one in the same and — let’s face it — you want to get paid. Bill, Inc. then files for bankruptcy under Chapter 7 of the Bankruptcy Code. For the reasons discussed below, creditors may have exposure in such a situation when faced with the Bill, Inc. Chapter 7 trustee’s demand to return the funds the company paid on behalf of Bill. This article identifies the basis for this risk and suggests ways to avoid it. 

In a case under Chapter 7 of the Bankruptcy Code, a trustee is assigned to the case and charged with, among other things, “collect[ing] and reduc[ing] to money the property of the estate for which such trustee serves[.]” 11 U.S.C. § 704(a)(1). Property of the estate is broadly defined in the Bankruptcy Code. See 11 U.S.C. § 541. A trustee has various tools to collect property of the estate, and can even recover money or property that was transferred away by the debtor before and after the debtor filed bankruptcy. The applicable provisions of the Bankruptcy Code that a trustee uses in this respect are found in chapter 5 of the Code and are frequently referred to as the trustee’s “avoidance powers.” See, e.g., Hopkins v. Suntrust Mortgage, Inc. (In re Ellis), 441 B.R. 656, 663 (Bankr. D. Idaho 2010). A common prepetition avoidance power Chapter 7 trustees utilize is referred to as a “fraudulent transfer” as provided in 11 U.S.C. § 548. While inclusion of the word “fraudulent” in the title of such an action suggests that the debtor engaged in fraud in making the transfer, that is not always the case. A transfer may be “fraudulent” even though no traditional fraud has occurred. See 11 U.S.C. § 548(a)(1)(B).

In addition to 11 U.S.C. § 548, 11 U.S.C. § 544(b) provides that a trustee can use other “applicable law” to avoid transfers of the debtor. The most common “applicable law” is state law known as the Uniform Fraudulent Transfer Act (UFTA), as enacted by the various states. The UFTA typically has a longer, four-year statute of limitations. By contrast, § 548 provides that a trustee can unwind a transfer that occurred within two years before the bankruptcy filing. Trustees have also advanced the argument, with varied success, under 28 U.S.C. § 3306, that they can recover payments made six years prior to the bankruptcy filing if the trustee is able to identify a specific type of creditor. See MC Assets Recovery LLC v. Commerzbank AG (In re Mirant Corp.), 675 F.3d 530 (5th Cir. 2012).

The UFTA and 11 U.S.C. § 548(a) are similar in the elements a trustee must prove in order to recover a fraudulent transfer. Applicable to the hypothetical situation above, and assuming no fraudulent intent by the debtor in the transfer, the applicable statute provides in relevant part: “[t]he trustee may avoid any transfer . . . of an interest of the debtor in property . . . that was made or incurred within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily— . . . (B)(i) received less than a reasonably equivalent value in exchange for such transfer . . . ; and (ii)(I) was insolvent on the date that such transfer was made . . . or became insolvent as a result of such transfer . . . .” 11 U.S.C. § 548(a)(1)(B).

“Reasonably equivalent value” is determined by asking: (1) whether the debtor received value in exchange for the transfer; and (2) whether the value received by the debtor is roughly the value the debtor gave up. Hopkins v. Crystal 2G Ranch, Inc. (In re Crystal), 513 B.R. 413, 419 (Bankr. D. Idaho 2014).

Applying this law to the facts of the hypothetical, the trustee would argue that Bill, Inc. did not receive “reasonably equivalent value” for its payment of Bill’s debt. In fact, according to the trustee, Bill, Inc. received nothing in exchange for making the payments to you, and simply paid a debt of another, of which Bill, Inc. had no contractual obligation. Moreover, Bill, Inc. was insolvent at the time of the transfer and thus, the trustee would argue, all the requirements of 11 U.S.C. § 548(a)(1)(B) are met. Although there are numerous defenses that may be raised depending on the particular facts of the case, the reality is that these disputes can be costly. Thus, to the extent the situation could be avoided, the better.

Creditors should monitor and know who is making the payment and ensure that the party making such payment is their debtor, guarantor, or otherwise an obligor for the debt at issue. In setting up automatic withdrawls from particular accounts, creditors should be mindful to make sure the automatic payment is being pulled from the account of their obligor as opposed to any related entity or party of the debtor, who has no contractual obligation to the creditor. By paying attention to the source of the funds received, creditors can mitigate the chances of being the subject of this type of fraudulent transfer action.