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Positive Health Of The Fraudulent Transferee's Good Faith Defense

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Positive Health Management Inc., operated pain management clinics in Texas. The company's president and sole owner also personally owned a second company, which owned a building that Positive Health was using for office space.

To this second company, First National Bank extended a loan. Although Positive Health had no obligations on the loan, it made payments to First National totaling $367,681.34 and claimed them as "rent" on Positive Health's tax returns.

Eventually, Positive Health became a financial negative, and filed for bankruptcy. A Bankruptcy Trustee (which I will shorten to just "Trustee") was appointed to administer Positive Health's bankruptcy estate.

The Trustee brought an adversary actions against First National. The Trustee alleged that because Positive Health owed no obligations to First National on the loan, the $367,681.34 amounted to a fraudulent transfer to First National, and should be set aside under the Bankruptcy Code's fraudulent transfer provision, 11 U.S.C. sec. 548, as both actual and constructive fraudulent transfers.

First National asserted two defenses. First, the moneys paid by Positive Health kept First National from foreclosing on the building, and thus Positive Health received a substantial benefit in that it had for several years the office space necessary to run its operations. Second, Positive Health's payments were in the nature of rent paid for the office space.

The Bankruptcy Court conducted a three-day trial on the Trustee's claims. The Bankruptcy Court found that Positive Health was in deep financial distress when it made the payments, and had the actual intent to cheat its own creditors by making payments to First National instead of paying off its own debts. Thus, the Bankruptcy Court held that the Trustee had made a good case for Positive Health having made a fraudulent transfer.

However, the Bankruptcy Court also found that First National's two defenses were sound, and that a reasonable amount of the rent was $253,333.33. Therefore, the Bankruptcy Court went on to hold, Positive Health had received "reasonably equivalent value" for the moneys that it paid to First National, which knocked out the Trustee's constructive fraudulent transfer claim (which only has two elements: (1) the debtor was insolvent, and (2) the transfer lacked "reasonable equivalent value").

That left the Trustee's actual fraudulent transfer case (which looks only to the debtor's intent in making the transfer) to be resolved, and, as noted, the Bankruptcy Court had already found that Positive Health acted with the intent to cheat its creditors.

But although the actual fraudulent transfer was established, that didn't take into account First National's defense as a "good faith transferee" under section 548(c). That defense has but two elements: First, the transferee was in good faith, and, second, the transferee gave value back to the debtor for the transfer (here, the payments) received.

The Bankruptcy Court found that First National acted in good faith, and that left only the question of whether First National gave value back to Positive Health to be determined. Here, the Bankruptcy Court adopted a similar analysis to what it had just held in relation to the Trustee's constructive fraudulent transfer claim, holding that because Positive Health realized $253,333.33 in value from the rent payments, that such amounted to "reasonably equivalent value". First National could then keep the entire $367,681.34 that it received, despite the disparity in the amounts.

Not happy with the result, the Trustee appealed the decision to the U.S. Court of Appeals, which framed the issue this way:

 The unresolved question we must now decide is what happens when a transferee gave less value to the debtor than it received. Is the transferee allowed to keep all that it received so long as it gave "reasonably equivalent" value in exchange? Or is netting required so that the transferee keeps only the value that it gave to the Debtor?

In answering this question, the Fifth Circuit gives us a very good opinion on the interpretation of reasonably equivalent value and the operation of the transferee's good faith defense.

Section 548(c) provides in relevant part:

[A] transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.

Since it was not disputed that First National was in good faith, the Fifth Circuit could focus squarely on the concept of "value".

The Fifth Circuit noted that "value" is always determined from the creditor's perspective -- the debtor's perspective being irrelevant. It simply doesn't matter how the debtor views "value".

Further, for purposes of the good faith defense, it doesn't matter what the debtor received, since that is irrelevant as well. The salient inquiry is instead on what the transferee gave in exchange for what the transferee received. In other words, the good faith defense looks at the transferee in utter isolation away from the debtor.

First National creatively argued that its forbearance in foreclosing on the building allowed Positive Health to maintain its operations and ultimately generate over $4 million in revenue, thus making the $367,681.35 that was received by First National look like a pittance.

But of course that was the wrong analysis, since the good faith defense looks only at what First National gave up, not the benefit to Positive Health. So, Positive Health's opportunity to earn $4 million in revenue was irrelevant.

What was relevant was the rent for Positive Health's office space, since it was this that First National really gave up:

The alternative form of value found by the bankruptcy court, market rent, does analyze value from the correct perspective. [A]llowing Positive Health to stay in the Garland property was costly to First National. By giving up the chance to foreclose and find a new tenant, First National incurred an opportunity cost in the form of foregone market rent.

First National had given up $253,333.33 in rent, by not foreclosing on the building and finding a new tenant. Thus, First National was at least entitled to assert the good faith defense as to the $253,333.33 in rental value.

But was First National entitled to more than the $253,333.33? The Bankruptcy Court had thought so, and held that because the $253,333.33 constituted "value", then First National had a complete defense to the entire $367,681.35 that it received from Positive Health. In other words, the Bankruptcy Court had ruled that because First National had given some substantial value, albeit not the full amount, First National had a complete defense to the Trustee's fraudulent transfer action and could pocket the extra $114,348.02.

In defending the Bankruptcy Court's decision, First National argued that the $253,333.33 amounted to "reasonably equivalent value", and that such gave First National a complete defense under 548(c).

The obvious fly in First National's ointment was that 548(c) doesn't use the phrase "reasonably equivalent value" at all -- that is a phase used to determine whether a fraudulent transfer occurred, not whether the transferee (here, First National) had a defense, or the amount of that defense. Instead, 548(c) simply uses the term "value".

What happened is that the Bankruptcy Court improperly conflated "reasonably equivalent value" with "value", even though they mean two entirely different things.

In the fraudulent transfer context, the phrase "reasonably equivalent value" means what the transferee gave the debtor was more-or-less close in value to what the debtor gave the transferee. Close counts in horseshoes, hand grenades and nuclear weapons -- and for "reasonably equivalent value".

If the debtor gives the transferee a diamond ring worth $10,000 and the transferee only $9,999 for it, that is "reasonably equivalent value". If the transferee pays only $8,000 for it, that still might be "reasonably equivalent value", if you can convince the judge so. Only $2,000 would not be "reasonably equivalent value", however.

Conversely, "value" means "exact value" in the 548(c) context. If the transferee paid $9,999 for the $10,000 diamond ring, the transferee would get a credit for $9,999 and not the whole $10,000. Close doesn't count with 548(c).

The Fifth Circuit noted that the result might be different outside of bankruptcy, under state law applying the Uniform Fraudulent Transfer Act (UFTA, since renamed the Uniform Voidable Transaction Act, or UVTA), where a transferee who gives the debtor "reasonably equivalent value" might have a complete defense.

Thus, the Fifth Circuit held, First National would only get credit for the $253,333.33 in rental income, and would have to cough up the difference of $114,348.02 to the Trustee:

The language of the Bankruptcy Code and the policies it embodies therefore lead us to the following conclusion: A good faith transferee is entitled to the protections of section 548(c) when it gives any value in return, but only to the extent of that value. When a transferee receives a fraudulent transfer the value of which exceeds the consideration it gave up in return, section 548(c) requires netting.

And with that, the Fifth Circuit entered judgment in favor of the Trustee for $114,348.02.

ANALYSIS

For planners, the important take away of this Opinion is that the transferee's good faith defense looks at what the transferee gives up in exact number. There is no blanket defense to a fraudulent transfer case under 548(c) simply by the transferee being in the general ballpark of value.

But in a broader sense, the Fifth Circuit's admonition that value is always measured from the viewpoint of creditors, not debtors, has the most significant implications for planners. If a planner exchanges cash or a piece of property for an interest in an LLC, the LLC interest does not inherently have the same value to creditors, because of the charging order limitation, as cash or property interests.

Indeed, a number of sophisticated asset protection transactions have the potential to run aground on the shoals of the "utility to creditors" rule. One should not presume that just because the book values of two assets are the same, that they ipso facto must have the same value to creditors -- that just isn't necessarily true.

A planner must instead look at the completed transaction from the viewpoint of creditors. If creditors are potentially disadvantaged by the result, then the transaction has the same potential to be set aside as an avoidable transaction. This has dramatic implications for planning, but it can't be ignored.

CITE AS

Matter of Positive Health Management, 769 F.3d 899 (5th Cir., Oct 16, 2014). Full Opinion at http://goo.gl/uvzbZv

This article at http://onforb.es/1zBInah and http://goo.gl/rG4S5t