The Bankruptcy Code gives broad avoidance powers to debtors, allowing them to “unwind” transactions occurring relatively shortly before the bankruptcy filing in order to recover funds for the benefit of the debtor’s creditors. Indeed, debtors may in certain circumstances recover from subsequent transferees of the initial transferee. These broad avoidance and recovery powers are generally intended to preserve assets of the estate, but they are not unlimited. For example, no recovery is permissible against a subsequent transferee who took for “value” in good faith and with no knowledge of the avoidability of the initial transfer. In a decision last week, the Bankruptcy Court for the District of Kansas refused to require substantial equivalency of the amount transferred by the initial transferee and the amount tendered in exchange by the subsequent transferee. This is good news for subsequent transferees that transacted in good faith and without knowledge of the avoidability of the initial transfer.
Before filing for bankruptcy, the debtor, Brooke Corporation, transferred funds to its parent Brook Holdings, Inc. Certain of the transferred funds were used to repay a loan from the Parent and other transferred funds were in respect of dividend payments. After receiving the funds, the Parent transferred a portion of the funds to two of its stockholders, the Schmidts, in redemption of Parent stock each Schmidt held. The Schmidts apparently had no meaningful managerial roles with either the Parent or the Debtor.
After the Debtor filed for bankruptcy, its chapter 7 trustee commenced an avoidance action seeking to avoid both the loan repayment and dividend transfers made by the Debtor to its Parent. The court held that the funds transferred both in repayment of the loan and as dividend payments were avoidable, as a preferential transfer under Bankruptcy Code section 547(b) and as a constructively fraudulent transfer under Bankruptcy Code sections 544/548(a)(1)(B), respectively.
The chapter 7 trustee then sought to recover the funds transferred by the Parent to the Schmidts pursuant to Bankruptcy Code section 550(a)(2), which allows the trustee to recover from “any immediate or mediate transferee of such initial transferee.” With the funds received by the Schmidts clearly traceable to the avoided transfers the Parent received from the Debtor, the court found that the Schmidts were liable under section 550(a)(2), unless they could show they are protected by the “good faith” defense set out in Bankruptcy Code section 550(b).
Defense for Subsequent Transferees? Only if They Provide Value
While not available to the initial recipients of avoided transfers, Bankruptcy Code section 550(b) provides subsequent transferees with a defense to claims seeking recovery of funds transferred to them in connection with avoided transactions. In order to utilize this defense and avoid turning over funds they received from the initial avoided transfer recipient, the subsequent transferee must show that it provided value for the avoided transfers, in good faith, and without knowledge of the avoidability of the avoided transfer.
In asserting this defense, the Schmidts argued that they provided the Parent with value when they returned to it the Parent’s stock in exchange for the funds received as part of the stock redemption. There was no dispute that the Schmidts acted in good faith and with no knowledge of the avoidability of the transfers by the Debtor to the Parent. The sticking point? The Parent was insolvent at the time of the subsequent transfer with the consequence, so argued the trustee in his motion for summary judgment, that the stock tendered to the Parent by the Schmidts could not possibly constitute the requisite “value” under section 550(b).
The trustee contended that there must be some reasonable equivalency between what the initial transferee transferred to the subsequent transferee and what the initial transferee received from the subsequent transferee. The Schmidts countered, arguing that no equivalency is required.
How Much “Value” Does a Subsequent Transferee Need to Convey?
The court sided with the Schmidts, noting that section 550(b) does not require that the value provided by the subsequent transferee be equivalent to the value received by the subsequent transferee. The court compared section 550(b) to other sections of the Bankruptcy Code—section 549(c) and section 548(a)(1)(B)—which by contrast clearly define “value” for purposes of those sections as “present fair equivalent value” or “reasonably equivalent” value, respectively and further observed that if Congress intended to require equivalence in the section 550(b) context, it is reasonable to expect that it would have said so, as is did in sections 549(c) and 548(a)(1)(B).
The Kansas bankruptcy court acknowledged that other courts have held differently, requiring some level of equivalence between the value received and the value provided for a section 550(b) defense to succeed. The bankruptcy court noted, however, that those cases were inconsistent with the clear language of the statue as well as the legislative history, referring to a statement in the 1973 Report of the Commission on the Bankruptcy Laws of the United States: “If the subsequent transferee gives value in good faith, regardless of the amount or whether present or past consideration, he is protected.”
As to whether stock in an insolvent corporation could ever constitute any value, let alone equivalent value, the court observed that the stock of a clearly insolvent enterprise could nevertheless have value “because of control issues or because solvency is on the horizon.”
The court noted, however, that the trustee might ultimately prove that the Schmidts did not provide any value by tendering the insolvent Parent’s stock, but was unwilling to make such a determination at the summary judgment stage.
A good faith subsequent transferee without knowledge of avoidability of an initial transaction need not show that it conveyed equivalent value in exchange to prevail on a section 550(b) defense. Because trustees and debtors in possession may not succeed on motions for summary judgment in opposition to that defense even where, at least facially, the subsequent transferee appears to have conveyed no value in exchange, subsequent transferees may do well by advancing expansive arguments at to what constitutes “value” under section 550(b).