PREFERENCES AND FRAUDULENT TRANSFERS David B. Young [email protected] McGINNIS, LOCHRIDGE & KILGORE, L.L.P. 1300 Capitol Center 919 Congress Avenue Austin, Texas 78701 (512) 495-6000 (512) 505-6370 FAX Prepared for the Practising Law Institute 27th Annual Current Developments in Bankruptcy and Reorganization New York and San Francisco, 2005 Copyright © 2005 David B. Young All Rights Reserved © International Insolvency Institute - www.iiiglobal.org TABLE OF CONTENTS I. THE NATURE AND COMMON FEATURES OF PREFERENCE AND FRAUDULENT TRANSFER AVOIDANCE ACTIONS................................................1 A. Preferences and Fraudulent Transfers Compared..................................................1 B. The Debtor Must Have Had an Interest in the Property Transferred That Would Have Been Available to Creditors.....................................................9 1. Only a Prepetition Transfer of an Interest of the Debtor in Property Is Subject to Postpetition Avoidance. .........................................9 2. Assets That the Debtor Holds in Trust. ................................................... 10 3. Escrow Funds......................................................................................... 15 4. The Earmarking Doctrine. ...................................................................... 16 5. Prepetition Disclaimers of Bequests, Devises, or Inheritances. ............... 18 6. Interspousal Transfers of Property Held by the Entirety.......................... 27 7. Observing Corporate Forms: Property of the Corporation and Property of the Equity Owner................................................................. 33 C. There Must Have Been a Transfer...................................................................... 34 D. Standing to Bring a Fraudulent Transfer or Preference Action............................ 39 1. Trustees, Debtors-in-Possession, and Individual Debtors........................ 39 2. Granting Derivative Standing to a Committee or Individual Creditors. ............................................................................................... 41 3. Individual Creditors Seeking Avoidance on Their Own Behalf............... 44 4. Assignment of and Succession to Avoidance Actions. ............................ 45 5. Special Requirements for Standing under 11 U.S.C. § 544(b)................. 48 E. Time for Bringing a Preference or Fraudulent Transfer Claim............................ 49 1. A Split of Authority Resolved by the Bankruptcy Reform Act of 1994................................................................................................... 49 2. 11 U.S.C. § 546(a): Jurisdictional or a Mere Statute of Limitations? ........................................................................................... 52 i © International Insolvency Institute - www.iiiglobal.org F. The Nature of Recovery and the Parties Liable................................................... 54 1. The Distinction Between Avoidance and Recovery. ............................... 54 2. Parties Who May Be Liable for Recovery: 11 U.S.C. § 550(a)..................................................................................................... 55 3. The Right to Recovery Ends with a Subsequent Good Faith Transferee for Value: 11 U.S.C. § 550(b). ............................................. 59 4. Lien Protection for a Good Faith Transferee Who May Be Liable for Recovery: 11 U.S.C. § 550(e)................................................ 62 II. PREFERENCE ACTIONS UNDER 11 U.S.C. § 547 AND STATE LAW .................... 63 A. Elements of a Preference Claim under 11 U.S.C. § 547(b). ................................ 63 1. Transfer to or for the Benefit of a Creditor: 11 U.S.C. § 547(b)(1)............................................................................................. 64 2. Transfer for or on Account of an Antecedent Debt: 11 U.S.C. § 547(b)(2)............................................................................................. 66 3. Transfer Made While the Debtor Was Insolvent: 11 U.S.C. § 547(b)(3)............................................................................................. 68 4. Reachback Period for Preference Avoidance: 11 U.S.C. § 547(b)(4)............................................................................................. 71 5. The Creditor Must Have Received More Than It Would Have Received in a Chapter 7 Liquidation: 11 U.S.C. § 547(b)(5). ................. 75 B. Defenses to a Preference Claim under 11 U.S.C. § 547(c).................................. 78 1. Contemporaneous Exchange for New Value: 11 U.S.C. § 547(c)(1). ............................................................................................ 78 2. Ordinary Course of Business: 11 U.S.C. § 547(c)(2).............................. 83 (a) Introduction. ............................................................................... 83 (b) Debt Incurred in the Ordinary Course of Business or Financial Affairs: 11 U.S.C. § 547(c)(2)(A). .............................. 84 (c) Transfer Made in the Ordinary Course of Business or Financial Affairs: 11 U.S.C. § 547(c)(2)(B). .............................. 88 (d) Transfer Made According to Ordinary Business Terms: 11 U.S.C. § 547(c)(2)(C). ........................................................... 91 - ii - © International Insolvency Institute - www.iiiglobal.org (e) Proposed Changes in the Ordinary Course of Business Defense....................................................................................... 95 3. Purchase Money Security Interests and the Enabling Loan Defense: 11 U.S.C. § 547(c)(3).............................................................. 96 4. Subsequent Unsecured Advances: 11 U.S.C. § 547(c)(4)..................... 101 5. No Net Improvement for the Holder of a Floating Lien on Inventory and Receivables: 11 U.S.C. § 547(c)(5). .............................. 104 6. Fixing of a Statutory Lien: 11 U.S.C. § 547(c)(6). ............................... 107 7. Alimony, Maintenance, and Support: 11 U.S.C. § 547(c)(7). ............... 108 8. Small Transfers: 11 U.S.C. § 547(c)(8)................................................ 110 9. A Proposed Minimum for Nonconsumer Preference Actions. ............... 111 C. The Insider Preference Provisions of the Uniform Fraudulent Transfer Act................................................................................................................... 112 1. Nature and Elements of an Insider Preference Claim. ........................... 112 2. Reachback Period and Time to Sue....................................................... 115 3. Defenses to an Insider Preference Claim............................................... 116 D. The Deprizio Problem...................................................................................... 118 1. Deprizio and Its Progeny. ..................................................................... 118 2. Statutory and Contractual Solutions to Deprizio. .................................. 120 3. Continuing Problems and Proposed Legislation.................................... 123 III. FRAUDULENT TRANSFER AVOIDANCE.............................................................. 128 A. General Considerations.................................................................................... 128 1. Bases for Fraudulent Transfer Actions.................................................. 128 2. Reachback Period for Avoiding a Fraudulent Transfer.......................... 132 B. Transfers Made with Actual Intent to Hinder, Delay, or Defraud Creditors.......................................................................................................... 135 1. Standard of Proof. ................................................................................ 135 - iii - © International Insolvency Institute - www.iiiglobal.org 2. Determining Actual Intent: Badges of Fraud........................................ 137 C. Constructively Fraudulent Transfers. ............................................................... 142 1. Less Than Reasonably Equivalent Value: A Necessary, but Not a Sufficient, Condition for Avoidance: 11 U.S.C. § 548(a)(1)(B)(i). ................................................................................. 142 (a) The Importance of Reasonably Equivalent Value...................... 142 (b) Determining Whether the Debtor Received Value..................... 143 (c) Determining Reasonable Equivalence. ...................................... 146 2. Transfers by an Insolvent Debtor: 11 U.S.C. § 548(a)(1)(B)(ii)(I).............................................................................. 153 3. Transfers Leaving the Debtor With Unreasonably Small Capital: 11 U.S.C. § 548(a)(1)(B)(ii)(II). ............................................. 155 4. Transfers in Anticipation of Incurring Debts Beyond the Debtor’s Ability to Pay: 11 U.S.C. § 548(a)(1)(B)(ii)(III).................... 157 D. The Good Faith Purchaser Defense: 11 U.S.C. § 548(c). ................................. 158 E. Dealing With Conversions of Nonexempt to Exempt Property As Fraudulent Transfers. ....................................................................................... 162 F. Foreclosures and Similar Transactions As Constructively Fraudulent Transfers.......................................................................................................... 169 1. Reasonably Equivalent Value and Real Estate Foreclosures: Durrett and Its Progeny. ......................................................................