Clawbacks in Bankruptcy Courts

A “claw back” is a motion or petition that is filed with the appropriate court or regulatory agency that seeks a return of assets that were transferred from one entity to another, regardless of whether the entities are individual or corporate in nature, and such transfers fall under certain statutory definitions. Although claw back litigation has been employed in a number of administrative and judicial environments, such filings are most often made by a trustee in conjunction with bankruptcy proceedings.

The United States Bankruptcy Code (Title 11 USC) allows a trustee to pursue claw back measures when it can be determined that payment, or some other transfer of assets by the debtor, was made to a creditor in order to show that creditor some favoritism over others having a potential claim against the debtor. In bankruptcy cases, claw back claims may be filed by the trustee in one of three alleged circumstances: (1) the debtor made a preferential payment to a creditor; (2) the payment was made during the course of either an actual or constructively fraudulent activity, or (3) a transaction was made in violation of state laws.

(1) Preferential Transfers

Under the Bankruptcy Code the bankruptcy trustee may seek the return of any assets, such as money or property, paid or transferred to a creditor that were made within the ninety days immediately preceding the filing of the bankruptcy petition. If the recipient of a preferential transfer is a business associate or family member of the debtor, the recipient is considered an “insider” and any transfer made within one year of the filing of the bankruptcy petition is subject to claw back.

(2) Fraudulent Transfers

The Bankruptcy Code provides that a trustee may seek to claw back transfers that were made based on either actual or constructive fraud. Alleged fraudulent transfers made within two years prior to the filing of the debtor’s bankruptcy petition are subject to claw back by the trustee. Although the definition of ‘actual fraud” is narrowly established, the nature of “constructive fraud” is far more subjective.

The courts have consistently held that transfers made during the course of an activity that is illegal per se and falling within the prescribed time frames are subject to claw back even if the recipient of the transfer had no knowledge that the assets had been used in an illegal activity. As an example, the courts have ruled that since Ponzi Schemes are illegal then any transfers made by the operator of such a scheme are recoverable so long as they fall within the time limit of Section 548.

(3) Transfers that Violate State Financial and/or Securities Laws

In transfers or transactions that cannot be demonstrated to have fallen under the prohibitions of the Bankruptcy Code allows a trustee to seek claw back as may be applicable under state law.