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The Important Concept of "Fraudulent Transfers" Explored in a New Local Appeals Court Ruling

On April 30, 2013, the federal Ninth Circuit Court of Appeals-which hears appeals of bankruptcy court decisions throughout the greater West Coast region including California-published an opinion ( In re Fitness Holdings Int'l, Inc. ) which gives me the opportunity to explain "fraudulent transfers." This is a bankruptcy concept that is widely misunderstood. There are at least two reasons for this-the term "fraudulent transfer" is confusing because these transfers are in fact often not fraudulent, and the rules about them are complicated.  I hope with today's blog to touch on some of the complications, but mostly to cut through the confusion and make sense of it.

The Crucial Role of "Fraudulent Transfers" in Bankruptcy

Bankruptcy, especially in the business context, is about the fair distribution of assets to creditors. (In most consumer Chapter 7 "straight bankruptcy cases, there is no such distribution because all the assets are "exempt," protected for the consumer.)

Usually the assets to be distributed are owned by the individual or business at the time of its bankruptcy filing. But in some circumstances the bankruptcy system has jurisdiction over assets previously owned by that person or business and sold or given away during a period of time before the date of the filing. The reason for this is very practical: to discourage debtors from disposing of assets before filing bankruptcy. So the law provides that if assets are transferred away under certain circumstances in the two years before the bankruptcy filing, that transfer can be undone-"avoided." As a result, the transferred assets revert back to the individual or business filing bankruptcy, so that the bankruptcy trustee can sell them and distribute the proceeds to the creditors.

This makes sense when an individual or business transfers assets "with actual intent to hinder, delay, or defraud" its creditors. The debtor is purposely hiding assets from its creditors. That's called an intentionally fraudulent transfer.

Why Does a "Fraudulent" Transfer Not Actually Need to Be Fraudulent?

So-called "fraudulent transfers" include transfers which were either not at all fraudulent, or at least don't need to be proved to be. These are called constructively fraudulent transfers.

A constructively fraudulent transfer occurs when the debtor filing bankruptcy simply gets 'less than a reasonably equivalent value in exchange for such transfer or obligation" in one of four circumstances. (See Section 548(a)(1)(B)(i) of the Bankruptcy Code.)

What the above quoted statutory language means is that if a debtor sells or transfers an asset in the two years before filing bankruptcy, and does not get money or something else of value in return worth about what the asset is worth, that transfer could be a constructively fraudulent one. No fraudulent intent is needed.

The idea is that under certain special circumstances of financial exposure, if a debtor transfers an asset without getting paid adequately for it-in money or some other fair exchange-and files bankruptcy within two years thereafter, its creditors (through the bankruptcy trustee acting for them) should in fairness be able to undo that transfer and get the benefits of that asset.

The Special Circumstances of Non-Fraudulent "Fraudulent Transfers"

The four different circumstances in which constructively fraudulent transfers can occur are not important for the purposes of this Fitness Holdings court opinion, and are beyond the scope of this blog. But to give you an idea about this, one of the circumstances is if the debtor is insolvent when the transfer was made, or the transfer itself made the debtor insolvent. The point is that businesses and individuals should generally be able to sell or gift away their assets without worrying about those sales or gifts being undone in the future. But doing so when it is insolvent, and then ends up filing bankruptcy, is understandably seen as "constructively" defrauding the business or individual's creditors of the value of that asset.

The Fitness Holdings Opinion's Focus

The recent Fitness Holdings opinion hones in what "reasonably equivalent value" in the above-quoted statutory language means. The Ninth Circuit addressed whether a business which paid about $12 million to its sole shareholder seemingly to pay off a loan 16 months before filing bankruptcy received "reasonably equivalent value" for that payment. If it did, then there was no "fraudulent transfer." If the business did not receive "reasonably equivalent value" for that payment, then the business' shareholder would have to disgorge that $12 million and pay it to the bankruptcy trustee for distribution to the business' creditors.

The Facts of the Case

Fitness Holdings International, Inc. was a home fitness business. Its sole shareholder was Hancock Park, which lent it or invested in it more than $24 million. Fitness Holdings also borrowed millions of dollars around the same time from Pacific Western Bank, secured by all of Fitness Holdings assets and guaranteed by Hancock Park. In June 2007 the loans with Pacific Western Bank were refinanced, with a portion used to pay off an earlier loan to the bank which had been guaranteed by Hancock Park, and the remaining $12 million used to finish paying off what Fitness Holdings owed to Hancock Park. 16 months later, in October 2008, Fitness Holdings filed a Chapter 11 business reorganization in the Central District of California (covering the greater Los Angeles area), which was converted into a Chapter 7 liquidation in April 2010.

The Decisions of the Bankruptcy Court and Federal District Court

A committee of unsecured creditors in the initial Chapter 11 case sued to recover the $12 million paid to Hancock Park in the June 2007 refinancing, so that this money would instead go to pay Fitness Holdings' unsecured creditors.

The issue was whether Fitness Holdings received "reasonably equivalent value" for the payment it made to Hancock Park.

In general, a debtor's payment of a preexisting debt, in which full credit is given for each dollar paid to reduce the debt, is considered "reasonably equivalent value." However, if the $12 million paid was not really payment on a debt but instead a new investment by Hancock Park in Fitness Holdings-on the rationale that their underlying agreements constituted equity investments in the business instead of debt-then Fitness Holdings transfer did not receive "reasonably equivalent value" for the $12 million it transferred to Hancock Park.

The bankruptcy court ruled against the committee of unsecured creditors, deciding that the $12 million payment was a payment on a debt, which could not be "recharacterized" as an equity investment. Therefore the debtor received "reasonably equivalent value" and the transfer of the money could not be undone, or "avoided."

After the case was converted to Chapter 7, the trustee assigned to the case appealed the bankruptcy court's decision to the federal District Court for the Central District of California. But the judge there agreed with the bankruptcy court judge, citing a longtime precedent disallowing recharacterization of loans as equity investments, In re Pacific Express , 69 B.R. 112, 115 (B.A.P. 9th Cir. 1986). The trustee then filed an appeal to the Ninth Circuit Court of Appeals.

The Ruling of the Ninth Circuit Court of Appeals

The Ninth Circuit disagreed with and overturned both the bankruptcy court and federal district court. It held that the Pacific Express opinion upon which these lower courts relied, and which did not allow recharacterization of a debt payment as an equity investment, was no longer good law because of subsequent U.S. Supreme Court opinions (Raleigh v. Illinois Dept. of Revenue, 530 U.S. 15 (2000) and Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443 (2007)). The Ninth Circuit held that these opinions effectively overturned Pacific Express and allowed recharacterization as follows:

. . . in an action to avoid a transfer as constructively fraudulent under § 548(a)(1)(B), if any party claims that the transfer constituted the repayment of a debt (and thus was a transfer for "reasonably equivalent value"), the court must determine whether the purported "debt" constituted a right to payment under state law. If it did not, the court may recharacterize the debtor's obligation to the transferee under state law principles.

The Ninth Circuit concluded:

Because the [district] court erroneously concluded that it was barred from considering whether the complaint plausibly alleged that the promissory notes could be recharacterized as creating equity interests rather than debt, it failed to apply the correct standard in considering whether the trustee's allegation that Fitness Holdings did not receive reasonably equivalent value for its transfer of $11,995,500 to Hancock Park plausibly gave rise to a claim for relief under § 548(a)(1)(B).

Analyzing the trustee's constructive fraudulent transfer claim under the proper legal framework requires the identification of the pertinent legal principles under applicable state law. Rather than ruling on these issues in the first instance . . . we vacate the district court's dismissal of the complaint's constructive fraudulent transfer claim and remand for further proceedings consistent with this opinion.

Conclusion

This summary of the "fraudulent transfer" law and of this recent local opinion about it makes (painfully!?) clear how complicated both the Bankruptcy Code and interpretations of it can get in this area. But hopefully this has also helped provide a basic understanding of this important and mostly misunderstood bankruptcy concept.

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