Enhancing the Estate

• Author: Gregory Germain
• Pages: 152-212

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Chapter 8: Enhancing the Estate

8.1. Fraudulent Transfers (11 U.S.C. § 548)

The Bankruptcy Code contains its own provision allowing the trustee to avoid fraudulent

transfers made by the debtor prepetition. It is quite similar in its operation to the Uniform

Fraudulent Transfers Act, but gives the recovery to the bankruptcy estate rather than to the creditor

seeking to avoid the transfer. It also contains a different limitations period, creating the possibility

that the state law period for avoiding fraudulent transfers would be longer than the bankruptcy law

period for avoiding fraudulent transfers.

In order for the Trustee to avoid a transfer or obligation under Section 548, the transfer

must have taken place, or the obligation must have been incurred, within two years before the

filing of the petition. 11 U.S.C. § 548(a)(1).

There is one special exception covering transfers to self-settled trusts within 10 years

before bankruptcy. 11 U.S.C. § 548(e)(1). A self-settled trust is a spendthrift trust funded by the

debtor and for the benefit of the debtor for the purpose of shielding assets from the claims of the

debtor’s existing or future creditors. Because of the restriction on the debtor’s ability to withdraw

or transfer the funds in the trust, the corpus would not constitute property of the estate in the

absence of avoidance. See 11 U.S.C. § 541(c)(2). For many years, self-settled spendthrift trusts

were invalid under state law, but after Alaska led the states by creating this legal mechanism for

hiding assets from creditors, other states followed, and it was necessary to add an additional

avoiding power to the trustee’s arsenal.

The Bankruptcy Code’s fraudulent conveyance provisions contain the same basic two-

ground test for fraudulent conveyances: either (1) actual intent to hinder, delay or defraud

creditors, or (2) received less than reasonably equivalent value, and was or became insolvent (or

in an insolvent like condition). 11 U.S.C. § 548(a)(1)(A) and (B). As under the UFTA, value is

given when an existing creditor’s claim is secured or paid. 11 U.S.C. § 548(d)(2)(A).

8.2. The Trustee’s State Law Powers (11 U.S.C. § 544(b))

Section 544(b) allows the trustee to step into the shoes of a creditor who could avoid a pre-

petition transfer under state law. The claim which previously belonged to the creditor now belongs

to the estate. This rule is commonly used to allow the trustee to avoid fraudulent transfers under

the UFTA that would not be avoidable under Section 548 because of the two year limitations

period. It also applies to other state avoidance rules, such as Article 6 of the Uniform Commercial

Code enacted in only some states that allows the avoidance of bulk transfers made without

following the notice provisions of the UCC.

Hidden from the statutory language is the doctrine of Moore v. Bay, 284 U.S. 4 (1931),

which allows the trustee to assert the full rights of the estate against the recipient rather than the

limited rights of the creditor in whose shoes the trustee has stepped.

Section 544(b) does not give the trustee the power to assert state law claims directly – the

trustee must find an actual unpaid creditor on the petition date who could have avoided the transfer

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under state law. Unless there is an existing creditor on the petition date with standing to avoid the

transfer, the trustee has no one’s shoes to step into.

8.3. Practice Problems – Fraudulent Transfers

Problem 1. When Doctor Debtor was sued for medical malpractice, he immediately

transferred title to his only asset – a house worth $1 million – to his girlfriend as a gift. The plaintiff

in the malpractice case knew nothing about the transfer. Two years and one day later, on the eve

of trial, Doctor Debtor filed a Chapter 7 bankruptcy proceeding. Can the trustee avoid the transfer

of the house to the girlfriend under Section 548?

Problem 2. Suppose the plaintiff’s malpractice claim in Problem (1) is determined to be

worth $400,000. Dr. Debtor also owed other creditors (credit cards, personal loans, investment

guarantees) $350,000. Assume that only the Plaintiff in Problem (1) could avoid the transfer of the

home under the UFTA. If the trustee is able to avoid the transfer, how much of the transfer can the

trustee avoid? See 11 U.S.C. § 544(b), Moore v. Bay, 284 U.S. 4 (1931).

Problem 3. The day before filing bankruptcy, Dr. Debtor entered into a five year

employment contract with his girlfriend, promising to pay her $250,000 per year to work as a

receptionist in his medical office. Ignoring any claim limitations that we have yet to study, does

the trustee have any way to avoid the girlfriend’s unsecured claim for the present value of

$1,250,000? See 11 U.S.C. § 548(a)(1)(B)(ii)(IV).

Problem 4. One week before the start of the trial in Problem (1), Dr. Debtor gave his last

$50,000 in cash to his lawyers as a retainer to represent him in the trial. The retainer agreement

provided that the $50,000 was a flat fee covering the lawyer’s services through trial regardless of

the length or amount of work required in the trial, and was to be deemed earned when paid . Can

the trustee recover the $50,000 as a fraudulent transfer?

Problem 5. Dr. Debtor’s mother loaned him $25,000 one month before bankruptcy. The

day before bankruptcy, Dr. Debtor secured his mother’s loan with a lien on his medical equipment

worth $35,000, by signing a security agreement, and filing a UCC-1 financing statement with the

secretary of state. Can the trustee avoid the security interest as a fraudulent transfer? See 11 U.S.C.

§ 548(d)(2)(A).

Problem 6. Big Corp owns 100% of the stock of Little Corp, as well as 100% of the stock

of other subsidiary corporations. Big Corp’s bankers require all of Big Corp’s subsidiaries to sign

guaranties of Big Corp’s $20,000,000 line of credit. This is known as an upstream guaranty.Can

Little Corp’s bankruptcy trustee avoid the guaranty as a fraudulent transfer?

Problem 7. What if Little Corp’s lender required Big Corp to guaranty Little Corp’s line

of credit, and Big Corp filed bankruptcy. This is known as a downstream guaranty. Could Big

Corp’s trustee avoid the guaranty as a fraudulent transfer?

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8.4. Cases on Fraudulent Transfers

8.4.1.1. BFP v. RESOLUTION TRUST CORPORATION,

511 U.S. 531 (1994)

Justice Scalia delivered the opinion of the Court.

Petitioner BFP is a partnership, formed by Wayne and Marlene Pedersen and Russell

Barton in 1987, for the purpose of buying a home in Newport Beach, California, from Sheldon and

Ann Foreman. Petitioner took title subject to a first deed of trust in favor of Imperial Savings

Association (Imperial) to secure payment of a loan of $356,250 made to the Pedersens in

connection with petitioner's acquisition of the home. Petitioner granted a second deed of trust to

the Foremans as security for a $200,000 promissory note. Subsequently, Imperial, whose loan was

not being serviced, entered a notice of default under the first deed of trust and scheduled a properly

noticed foreclosure sale. The foreclosure proceedings were temporarily delayed by the filing of an

involuntary bankruptcy petition on behalf of petitioner. After the dismissal of that petition in June

1989, Imperial's foreclosure proceeding was completed at a foreclosure sale on July 12, 1989. The

home was purchased by respondent Paul Osborne for $433,000.

In October 1989, petitioner filed for bankruptcy under Chapter 11 of the Bankruptcy Code.

Acting as a debtor in possession, petitioner filed a complaint in bankruptcy court seeking to set

aside the conveyance of the home to respondent Osborne on the grounds that the foreclosure sale

constituted a fraudulent transfer under § 548 of the Code. Petitioner alleged that the home was

actually worth over $725,000 at the time of the sale to Osborne.

The bankruptcy court found, inter alia, that the foreclosure sale had been conducted in

compliance with California law and was neither collusive nor fraudulent. The District Court

affirmed. A divided bankruptcy appellate panel affirmed. The Court of Appeals for the Ninth

Circuit affirmed.

Section 548 of the Bankruptcy Code sets forth the powers of a trustee in bankruptcy (or, in

a Chapter 11 case, a debtor in possession) to avoid fraudulent transfers. It permits to be set aside

not only transfers infected by actual fraud but certain other transfers as well--so called

constructively fraudulent transfers. The constructive fraud provision at issue in this case applies to

transfers by insolvent debtors. It permits avoidance if the trustee can establish (1) that the debtor

had an interest in property; (2) that a transfer of that interest occurred within one year of the filing

of the bankruptcy petition; (3) that the debtor was insolvent at the time of the transfer or be came

insolvent as a result thereof; and (4) that the debtor received "less than a reasonably equivalent

value in exchange for such transfer." 11 U.S.C. § 548(a)(2)(A). It is the last of these four elements

that presents the issue in the case before us.

The question presented here, therefore, is whether the amount of debt (to the first and

second lien holders) satisfied at the foreclosure sale (viz., a total of $433,000) is "reasonably

equivalent" to the worth of the real estate conveyed.

The Courts of Appeals have divided on the meaning of those undefined terms. In Durrett

v. Washington Nat. Ins. Co., 621 F.2d 201 (1980), the Fifth Circuit, interpreting a provision of the

old Bankruptcy Act analogous to § 548(a)(2), held that a foreclosure sale that yielded 57% of the

property's fair market value could be set aside, and indicated in dicta that any such sale for less