Giving Back a Fraudulent Transfer: A Defense to Liability?

• Author: Carlson, David Gray

Suppose a debtor (D) is insolvent and owns a gold brick. Seeking to hinder creditors, D fraudulently transfers the brick to X. D will soon file for bankruptcy, but, just prior to D's bankruptcy petition, X is stricken with conscience, the blushing shame-faced spirit that mutinies in a man's bosom. X contacts D and says, "I want to give back the gold brick. The gift was a fraudulent transfer, and you should have kept the brick in consideration of your creditors." (1) It is hornbook law that D may not compel X to convey the brick back. (2) D has alienated all right, title and interest in the brick. X does not violate any right of D to retain the brick when D demands its return. (3) Only creditors of D may avoid the transfer. (4) Nevertheless, X, slave to conscience, actually gives the brick back to D. D then buries the gold brick (a crime) (5) and files for bankruptcy. The gold brick is never found. May D's bankruptcy trustee (T) sue X for the value of the brick? X is definitely the initial transferee of a fraudulent transfer. (6) Can X assert a non-statutory defense: "I gave it back!"?

In Whitlock v. Lowe (In re DeBerry), (7) the Fifth Circuit Court of Appeals ruled that if X gives back the fraudulent transfer to D and D dissipates the asset, X has a defense. The court treated this as obvious (8) and insinuated that there is no contrary authority. Yet in two circuits, the give-back has proven to be no defense. (9)

Which of these views is correct? Is giving back a fraudulent transfer a defense, even though the statutes do not expressly say so? The matter is far more complex than is dreamt of in Fifth Circuit philosophy. In this Article, I propose to revive a nineteenth century doctrine of the good faith innocent donee. According to this forgotten doctrine, where X receives a fraudulent transfer without knowledge of the fraud, the transferred gold brick may be reached by D's creditors or, if D is bankrupt, the brick is property of the bankruptcy estate. Beyond that, X is not personally liable for any disposition (including a give-back to the debtor). In contrast, if X had knowledge that the transfer was fraudulent, then X is personally liable to D's creditors (or to D's bankruptcy trustee), despite of the give-back.

The analysis is complicated by difficulties in distinguishing between a fraudulent transfer and its very close cousin, the resulting trust. (10) Suppose D gives her gold brick to X and says, "Sell this for me." D has transferred the brick in trust. Trust creation is not a fraudulent transfer. The brick or proceeds of the brick are quite accessible to the creditors of D. (11) They can levy D directly or bring a supplemental proceeding (i.e., a creditor's bill in equity) to obtain turnover of the proceeds that X holds in trust for D. The creditors need not avoid anything. They can achieve what they want by judicial process against X. (12) Resulting trust and fraudulent transfer are mutually exclusive theories. (13)

If X, as resulting trustee, gives the brick back to D or sells the brick and transmits the proceeds to D, X does nothing wrong. Where D has appointed X as trustee of the brick for the benefit of D, X's fiduciary duty is to D alone, not to the creditors of D. Thus, a give-back is not problematic if we have a resulting trust rather than a fraudulent transfer.

Where D fraudulently alienates both legal and equitable title to the brick, X takes title in trust for the creditors of D. X has a fiduciary duty to these creditors (not to D). Returning the proceeds to D (instead of D's creditors) might conceivably violate X's duty to the creditors.

The line between resulting trust and fraudulent transfer is treacherous and highly technical. The innocent donee doctrine renders the line partly irrelevant. Under either theory, the creditors can get the gold brick. If, however, X has given back the brick to D, X has an absolute give-back defense under the resulting trust theory. X has a give-back defense under the fraudulent transfer theory if X is a good faith donee. In these cases, it does not matter whether we have a fraudulent transfer or a resulting trust before us. The give-back defense is problematic only where D fraudulently transfers to X, X is in bad faith, X reconveys to D, and D dissipates the give-back.

Therefore, in reviewing the fraudulent transfer cases that recognize or disregard a give-back defense, I will often pause to consider whether the case involves a fraudulent transfer at all. Perhaps what we have is a resulting trust. If we do, there can be no question of holding X liable after giving back to D.

The Article proceeds as follows. Part I identifies what a fraudulent transfer is. Part I(A) then describes the forgotten defense of good faith donation. Under this defense, the creditors may always obtain X's fraudulently received gold brick, but X owes no fiduciary duty to the creditors if X disposes of the brick (whether by giving it back to D or to anyone else). Part I(B) considers the bad faith donee who gives back the brick to D, suggesting that give-back is not a defense if the brick disappears. Part II compares the resulting trust and shows that D has not made a fraudulent transfer where D retains the equitable title of the gold brick and conveys only legal title to X.

Part III discusses court of appeals cases in which the give-back is no defense. Part IV discusses two appellate cases in which the give-back defense is intuited as correct but is deeply disguised in other doctrines.

Finally, Part V returns to the Fifth Circuit opinion in DeBerry. This part of the Article shows that the result reached in DeBerry is certainly not obvious and was arguably wrong.

1. FRAUDULENT TRANSFERS

   Suppose D has an unsecured creditor (whom I shall call C). D owns a gold brick (the "fee simple absolute" of it), and C has no interest in it. To obtain a property interest in the brick, C must obtain a judicial lien on it. (14) This requires C to obtain a money judgment against D, or a prejudgment attachment of the brick. In ancient parlance, these events augur passage from C's status as a creditor at large to a specific creditor. (15) If C has received a money judgment, either C has become a judicial lien creditor or equity is prepared to help C obtain the all-important judicial lien on the gold brick.

   Suppose D, however, still owning the fee simple of the brick, conveys it to a third party X. D intends to enrich X and intends also to keep the brick out of the hands of C. Suppose further that X gives no value to D in return for this transfer. To invoke the language of Uniform Fraudulent Transfer Act (UFTA) [section] 4(a), D has made a fraudulent transfer to X:

   A transfer made ... by a debtor is fraudulent as to a creditor, whether the creditor's claim arose before or after the transfer was made ... if the debtor made the transfer ...:

   (1) with actual intent to hinder, delay, or defraud any creditor of the debtor ... (16)

   Because D transferred with intent to hinder, delay or defraud, the UFTA gives C a remedy: "avoidance of the transfer ... to the extent necessary to satisfy the creditor's claim.... (17)

   Under UFTA [section] 4(a)(1), D's insolvency is not strictly required. We need only D's bad intent to hinder, delay or defraud a creditor. (18) To be sure, D's insolvency was evidence (a "badge of fraud") from which D's bad intent might be inferred. (19) But strictly speaking, a transfer by a solvent D could conceivably be fraudulent. Nor does it matter whether X paid for the gold brick or received it for no value given back in return. If X paid for the brick, however, in good faith and without knowledge of D's bad intent, X has the bona fide transferee defense. According to the UFTA [section] 8(a):

   A transfer ... is not voidable under Section 4(a)(1) against a person who took in good faith and for a reasonably equivalent value .... (20) X paid a reasonably equivalent value for the transfer, the fraudulent transfer is what used to be called a "bulk sale" (21)--a liquidation out of the ordinary course of business which allows D to abscond with cash.

   It is worth dwelling on the bad faith bulk sale. In it, D sells the gold brick to X, in order to liquidate and abscond. If X is in on the scheme, C can levy on X's gold brick even though X gave a reasonably equivalent value for it. It does not matter that X's payment restores D's estate to its former position. Despite having paid for the brick, X must surrender the brick to C. X is not entitled to a refund. That right is reserved for the case in which X pays less than a reasonably equivalent value in good faith. (22)

   How does a bulk sale, where X is in bad faith, differ from a bad faith give' back? In the bulk sale, the payment to D was part of an exchange of brick for cash. In a give-back, X did not legally have to give the brick back. The gift is, by definition, not part of an exchange. Why should X be able to walk away from liability to C in the case of the give-back but not in the case of the bulk sale?

   In a bulk sale, bad faith X has in a sense given back an equivalent of the fraudulently transferred thing. Nevertheless, the bad faith exchange for value does not defend X from liability, (23) and so we would expect a subsequent bad faith gift (separate and apart from an "exchange") not to constitute a defense either. (24)

   By the early 20th century, in the case of gifts by D to X, legislators grew weary of D's claim that the gift was based on love for X, not on the strategy of hindering C. Therefore, in 1918, the Uniform Law Commission promulgated the Uniform Fraudulent Conveyance Act (UFCA) and dispensed with the requirement of intent when a gift by an insolvent D was at issue. (25) According to UFCA [section] 4:

   Every conveyance made ... by a person who is or will be thereby rendered insolvent is fraudulent as to creditors without regard to actual intent if the conveyance is made without a fair consideration. (26) In contrast, the UFCA...