I Hear Nothing, I See Nothing, I Know Nothing: Third Circuit Says Transferee’s Knowledge Not Relevant to Establishing Fraudulent Transfer Claims

Contributed by Katherine Doorley
The extent of a transferee’s knowledge in the context of fraudulent transfer claims under the Bankruptcy Code has been a frequent topic of discussion on the Weil Bankruptcy Blog. Recently, we examined the knowledge required to establish a transferee’s “good faith” defense under section 548(c) of the Bankruptcy Code. Now, the United States Court of Appeals for the Third Circuit in SB Liquidation Trust v. Preferred Bank, Nos. 13-1373 and 13-1959 (3rd Cir. Aug. 11, 2014) has provided more food for thought when it comes to the issue of a transferee’s knowledge, concluding that it is not necessary to plead the transferee’s knowledge of the fraudulent transfer to maintain a cause of action under section 548(a)(1) of the Bankruptcy Code.
In SB Liquidation Trust, prepetition, debtor Syntax-Brillian Corporation and Preferred Bank entered into a loan agreement and credit agreement, the proceeds of which were used by Syntax to acquire inventory from Taiwan Kolin Company. The loan agreement between Syntax and Preferred Bank was amended on a number of occasions. As it happened, several of Syntax’s officers and directors were also officers and directors of Kolin. Subsequently, the debtor sought bankruptcy protection in the United States Bankruptcy Court for the District of Delaware. The SB Liquidation Trust was established pursuant to the debtor’s liquidation plan, which transferred control over all of the debtor’s assets and causes of action to the Liquidation Trust. The Syntax-Brillian Liquidation Trust initiated an adversary proceeding against Preferred Bank under section 548(a) of the Bankruptcy Code and the corresponding provisions of the Delaware Code, attempting to avoid and recover alleged fraudulent transfers in the form of payments made by the debtor to Perferred Bank pursuant to the loan agreements. In its complaint, the Liquidation Trust alleged that several of Syntax’s officers and directors engaged in “a series of fraudulent activities” that led to the debtor’s insolvency and that such fraud was made possible through the involvement of Preferred Bank. The Liquidation Trust asserted that the debtor entered into financing with Preferred in order to “siphon” money to Kolin, Kolin overcharged Syntax for inventory, and that, as a result, the proceeds of Syntax’s sales of the inventory were insufficient to repay the debt to Preferred Bank. The Liquidation Trust further asserted that Preferred Bank was aware that Kolin priced its products above market, which would eventually make it impossible for the debtor to remain in business. At bottom, the crux of the complaint was that the financing, coupled with the purposeful overcharging, constituted a fraudulent transfer by the debtor under section 548(a)(1), and that Preferred Bank had culpable knowledge of the underlying scheme to defraud.
Legal Analysis:
Section 548(a)(1) of the Bankruptcy Code provides that “[t]he trustee may avoid any transfer . . . of an interest of the debtor in property, or any obligation . . . incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition if the debtor voluntarily or involuntarily (A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became . . . indebted . . . .”
The bankruptcy court analyzed the fraudulent transfer claims against Preferred Bank using the “collapsing” doctrine. The collapsing doctrine provides that a court may “collapse” several apparently innocuous transactions for purposes of fraudulent transfer analysis and consider the economic reality of the transactions together.
The bankruptcy court dismissed the claims at the pleading stage, concluding that the Liquidation Trust was required to show that Preferred Bank had knowledge of the alleged fraudulent acts and that the complaint had failed to allege facts from which such knowledge could be inferred. On direct appeal, the Third Circuit vacated the bankruptcy court’s dismissal.
As the Third Circuit noted, some courts applying the collapsing doctrine have required proof of knowledge of the fraudulent scheme on the part of both the debtor and the transferee. Adopting that interpretation, the bankruptcy court found that the transfers in question could not be collapsed because the Liquidation Trust failed to sufficiently allege that Preferred Bank had knowledge of the alleged scheme. The court stated that, without collapsing the transactions, the Liquidation Trust’s claims necessarily failed.
On appeal, the Third Circuit disagreed with the bankruptcy court’s interpretation and noted that Bankruptcy Code was “clear and unambiguous” that obligations are avoidable if the debtor incurred the obligations “with actual intent to hinder, delay or defraud” the debtor’s creditors. The Third Circuit noted that neither the Bankruptcy Code nor Delaware law refers to the intent of the transferee as being relevant to a determination of whether a specific transaction is fraudulent and avoidable, and, therefore, the transactions could be avoided without needing to resort to the collapsing doctrine. The Third Circuit concluded that the Liquidation Trust should not have been required to establish that Preferred Bank had knowledge of the debtor’s fraudulent intent to maintain a fraudulent transfer action. Accordingly, the Third Circuit vacated the bankruptcy court’s dismissal of the actual fraud claims against Preferred Bank.
Parties bringing fraudulent transfer actions under section 548(a)(1) in the Third Circuit may breathe a little easier knowing that the bar has not been raised – they do not need to establish the transferee’s knowledge of the fraudulent transfer to avoid a fraudulent transfer. That said, a transferee’s knowledge continues to be a factor in determining that the transferee acted in good faith.