Key Creditors' Rights Decision

State fraudulent transfer law is governed by either the Uniform Fraudulent Conveyance Act (UFCA), or the Uniform Fraudulent Transfer Act (UFTA), depending on where the assets were transferred. Maryland, New York, Tennessee, the Virgin Islands and Wyoming still use the older UFTA. At least 39 other states (eg, California, Texas, Illinois) have adopted the newer UFTA since its enactment in 1984.

Substantive Difference Between 'Fair Consideration' and 'Reasonably Equivalent Value'

When describing the adequacy of the property exchanged in the fraudulent transfer context, Code ' 548 replaces the old Bankruptcy Act's “fair consideration,” with “reasonably equivalent value,” as does the UFTA. In contrast, under ' 3 of the UFCA, applicable to the Sharp case, “fair consideration” is given for property or an obligation:

• When in exchange for such property, or obligation, as a fair equivalent therefor, and in good faith, property is conveyed or an antecedent debt is satisfied, or
• When such property, or obligation is received in good faith to secure a present advance or antecedent debt in amount not disproportionately small as compared with the value of the property, or obligation obtained. (Emphasis added.)

The substantive difference between the two statutory standards, therefore, is the UFTA's elimination of the “good faith” requirement. Of course, the “good faith” requirement still exists in the New York version of the UFCA. (N.Y. Debt. & Cred. L. '' 272-275 (McKinney 1945 & Supp. 1990)). Thus, when a trustee or creditor attacks a transfer under state law, the applicable test in New York will turn on “fair consideration” and “good faith.” The “good faith” requirement has thus been crucial. See, e.g., Seligson v. N.Y. Prod. Exch., 394 F. Supp 125, 133 (S.D.N.Y. 1975) (defendants' summary judgment motion denied when trustee “raised a general issue of material fact as to [defendants'] good faith”); Southern Indus., Inc. v. Jeremias, 411 N.Y.S.2d 945, 949 (2d Dep't 1978) (transfer made by corporation with intent to obtain advantage for insider over creditors voidable for his lack of good faith). But as the First Circuit noted in Boston Trading Group Inc. v. Burnazos, 835 F. 2d 1504, 1511 (1st Cir. 1987), “[c]ourts and commentators [still] have had difficulty determining the meaning of 'good faith' in ' 3's definition of 'fair consideration.'” See generally Note, “Good Faith And Fraudulent Conveyances, 97 Harv. L. Rev. 495 (1983).

Sharp: The Facts

The bank had approved a $20 million demand line of credit to Sharp International Corp. (Sharp) in 1996. Beginning in the summer of 1998, the bank began to suspect fraud at the company. Sharp was growing at an alarmingly rapid pace and was consuming a large amount of cash. Sharp at *4. In the fall of 1998, the bank twice took the “'unusual step' of contacting Sharp's customers directly to verify that they were, in fact, purchasing Sharp products.” Id. at *5. Ultimately, the bank undertook a full-scale investigation, learning that Sharp had fraudulently created fictitious customers and accounts receivable. Id. at *6. “The nub of the complaint is that the bank then arranged quietly for [management] to repay [the bank's] loan from the proceeds of new loans from unsuspecting lenders.” Id. The bank “demanded and obtained Sharp's agreement to secure new financing — presumably from investors unaware of the fraud — and to use that financing to pay off the [$15 million] debt to [the bank].” Id. at *7. In March 1999, Sharp raised $25 million through the issuance of subordinated notes, and repaid the bank approximately $12.25 million. The bank then released Sharp from its debt. Id. Between the fall of 1998, when the bank's suspicions began, and October 1999, Sharp officers had looted the company of more than $19 million. Id. at *8.

Procedural Posture

Sharp, as Chapter 11 debtor-in-possession, sued the bank in the bankruptcy court during 2001, 1.5 years after Sharp's noteholders had filed an involuntary Chapter 11 petition against it. Sharp claimed the bank had aided the company's former officers in looting the company, and that Sharp's $12.25 million loan repayment to the bank was a fraudulent transfer. Significantly, Sharp could not challenge the loan repayment as a preference, because the payment was made more than 90 days prior to Sharp's bankruptcy filing. See Code ' 547(b)(4)(A). The bankruptcy court found, however, and the district court affirmed, that despite the bank's well-documented suspicions, it: 1) had not participated in the fraud; 2) had advanced the funds in good faith; and 3) thus could not be held liable for aiding and abetting the management's breach of fiduciary duty, nor could it be compelled to return the $12.25 million payment on a fraudulent transfer theory. Sharp appealed.

A Lender Has No Fiduciary Duty to Its Borrower or to Other Creditors

The bankruptcy court found Sharp's complaint had failed to show the bank's knowledge of the fraud, but the district court disagreed. The Second Circuit never reached the issue because it “agreed with both judges that the complaint insufficiently alleged knowing inducement or participation on the part of [the bank]” Id. at *13: “ [S]ince Sharp does not contend that [the bank] owed Sharp a fiduciary duty, Sharp must allege [the bank] committed affirmative acts that furthered [management's] breaches of fiduciary duty to Sharp. The complaint cites five acts by [the bank] that are alleged to satisfy these standards; we consider these acts in turn. Ultimately, we conclude that the complaint says no more than that [the bank] relied on its own wits and resources to extricate itself from peril, without warning those it had no duty to warn.” Id., at *16, *17. According to the court, “[t]he nub of the complaint is that [the bank] knew that there would likely be victims of [management's] fraud, and arranged not to be among them; … [o]ne could say that [the bank] failed to tell someone that his coat was on fire; or one could say that it simply grabbed a seat when the music stopped. The moral analysis contributes little. Whatever [the bank] knew about [management's] fraud, [it came] by that information through diligent inquiries that any other lender could have made. Sharp fails to identify any duty on [the bank's] part to precipitate its own loss in order to protect lenders that were less diligent.” Id. at *22.

Lender's Knowledge Of Borrower Fraud Insufficient Fraudulent Transfer Liability

Sharp brought its fraudulent transfer claim under the New York version of the UFCA. Sharp acknowledged “the payment at issue discharged an antecedent debt and was made for a 'fair equivalent,'” but argued that “fair consideration is lacking because [the bank] did not receive the payment in 'good faith.'” Id. at *25, *26. Reasoning that “[g]ood faith is an elusive concept in New York's constructive fraud statute,” and that “bad faith does not appear to be an articulable exception to the broad principle that 'the satisfaction of a preexisting debt qualifies as fair consideration for a transfer of property [citing cases],'” the court stressed that “[the bank's] loan was made in good faith long before the purportedly fraudulent transfer (Id. at *26) … New York fraudulent conveyance law … is primarily concerned with transactions that shield company assets from creditors, not the manner in which specific debts were created. [The bank's] knowledge of the [management] fraud, without more, does not allow the inference that [the bank] received the $12.25 million payment in bad faith.” Id. at *32.

Implications of Decision

Pre-Existing Debt Was Legitimate

The bank advanced funds for a proper purpose, long before the purportedly fraudulent transfer; under New York law repayment of a legitimate antecedent debt constitutes fair consideration “'unless the transferee is an officer, director or major shareholder of the transferor.'” Sharp at *27, citing Atlanta Shipping Corp., Inc. v. Chem. Bank, 818 F.2d. 240, 249 (2d Cir. 1987). See also HBE Leasing Corp. v. Frank, 48 F.3d 623 (2d Cir. 1995) (same).

When Pre-Existing Debt is Legitimate, Creditor's Subjective Bad Faith Is Not Enough

The court or the parties found only one case where “an (allegedly) antecedent debt paid to an outsider was found lacking in fair consideration … [In that case] the debtor affirmatively swore that the transaction was intended to evade his creditors.” Id., citing Ede v. Ede, 193 A.D.2d 940, 942 (3d Dep't 1993) (fair consideration lacking in face of evidence “which can admit of no finding other than … bad faith.”). “[A] case such as Ede does not furnish a rule of decision for detecting what constitutes bad faith … Here … there is no admission of subjective bad faith, if indeed that would matter.” Sharp, at *27. (Emphasis added).

Mere Preference to One Creditor Does Not Constitute Bad Faith

Under New York law, a debtor's preference to one creditor, or a preferred creditor's knowledge that that a debtor is insolvent at the time it receives a transfer, is not evidence of bad faith. Id. at *27-*29, citing HBE Leasing, at 634 (quoting Boston Trading Group, Inc. v. Burnazos, 835 F. 2d 1504, 1509 (1st Cir. 1987); Ultramar Energy Ltd. v. Chase Manhattan Bank, N.A., 599 N.Y.S. 2d 816 (1st Dep't 1993) (same).

Transferee's Knowledge of Source of Funds Immaterial

Sharp alleged the bank's bad faith arose from its knowledge that the funds used to repay it had been fraudulently obtained. But “a lack of good faith does not ordinarily refer to the transferee's knowledge of the source of the debtor's monies.” Id. at *29, quoting Boston Trading at 1512.

Repayment of Bank's Loan Did Not Benefit Third Parties

“Transfers made to benefit third parties are not considered as made for 'fair' consideration” because of an asserted lack of “good faith.” Bullard v. Aluminum Company of America, 468 F.2d 11, 14 (7th Cir. 1972). Instead of deriving a benefit, however, Sharp insiders gave personal notes to repay the bank's loan in part. Sharp at *7.

Every Creditor for Itself

When Sharp raised new funds from its Noteholders to pay off its debt to the bank, the bank “gave no warnings and blew no whistles, ignored inquiring calls from the Noteholders, preserved Sharp's line of credit when it had the right to foreclose and pull the plug, and gave Sharp its needed consent to the new indebtedness.” Id. at *7. Neither the Second Circuit nor the New York courts in a separate action brought against the bank by the Noteholders (Albion Alliance Mezzanine Fund, L.P. v. State Street Bank & Trust Co., 767 N.Y.S. 2d 619 (1st Dep't 2003) (affirming grant of motion to dismiss)), found anything actionable in the bank's conduct. Indeed, 4 days after the Second Circuit's Sharp decision, the Seventh Circuit reached the same result in B.E.L.T., Inc. v. Wachovia Corp., 2005 U.S. App. LEXIS 5375, *3 (7th Cir. April 5, 2005), (“Illinois, like most other states, does not require business ventures to do good turns for their rivals.”).

No Discussion of Public Policy

In dicta, the district court suggested that as a matter of public policy there might be a benefit to imposing an affirmative duty on a bank to act when it learns that its borrower is committing fraud. The Second Circuit apparently does not share this view.

Michael L. Cook, a member of this newsletter's Board of Editors, is a partner and Alix Pustilnik is an associate at Schulte Roth & Zabel LLP in New York.

The Second Circuit handed down a key creditors' rights decision on April 1 in Sharp Int'l Corp. v. State Street Bank & Trust Co. (In re Sharp Int'l Corp. & Sharp Sales Corp.), 2005 U.S. App. LEXIS 5241(2d Cir. Apr. 1, 2005). The court affirmed the lower courts' finding that a secured lender was not liable for aiding and abetting management's breach of fiduciary duty, and not liable for receiving a $12.25 million loan repayment from a closely held borrower it correctly suspected of engaging in massive fraud. The decision limits the scope of a lender's duties to its borrower and other creditors. Absent the lender's participation in its borrower's fraud, the lender should have no liability on a fraudulent transfer theory or on any other basis, at least in New York, where Sharp arose.

The Role of State Fraudulent Transfer Law in Federal Bankruptcy Cases

A trustee or Chapter 11 debtor-in-possession may attack a fraudulent transfer either under Bankruptcy Code (Code) ' 548 or under state law, made available to the trustee by Code ' 544(b) (trustee may avoid any pre-bankruptcy transfer voidable by unsecured creditors). See, e.g., In re Image Worldwide, Ltd., 139 F.3d 574, 577 (7th Cir. 1998) (bankruptcy case construing UFTA and applying state law); In re Leonard, 125 F. 3d 543, 544 (7th Cir. 1997) (“if any unsecured creditor could reach an asset of the debtor outside bankruptcy, the Trustee can use ' 544(b) to obtain that asset for the estate[,] … Trustee need not name a specific creditor.”). Because of generally longer reach-back recovery periods, state fraudulent transfer law is more frequently relied on in this kind of bankruptcy litigation. When, for example, a debtor fraudulently transfers assets in New York 3 years prior to bankruptcy, the trustee cannot rely on Code ' 548, but must rely on state fraudulent transfer law to challenge the transfer. New York's statute of limitations for fraud suits — 6 years — will govern. See, e.g., Buncher Co. v. Official Comm. Of Unsecured Creditors of Genfarm LP IV , 229 F.3d 245, 250-51 (3d Cir. 2000) (“When recovery is sought under section 544(b) … [t]he remedy … adopts the longer 'reach-back' provisions of state law.”); Seligson v. N.Y. Prod. Exch. , 378 F. Supp 1076 1106-1107(S.D.N.Y. 1974) (pre-code case; if fraudulent transfer claim is brought under state law, that state's statute of limitations applies.).

State fraudulent transfer law is governed by either the Uniform Fraudulent Conveyance Act (UFCA), or the Uniform Fraudulent Transfer Act (UFTA), depending on where the assets were transferred. Maryland, New York, Tennessee, the Virgin Islands and Wyoming still use the older UFTA. At least 39 other states (eg, California, Texas, Illinois) have adopted the newer UFTA since its enactment in 1984.

Substantive Difference Between 'Fair Consideration' and 'Reasonably Equivalent Value'

When describing the adequacy of the property exchanged in the fraudulent transfer context, Code ' 548 replaces the old Bankruptcy Act's “fair consideration,” with “reasonably equivalent value,” as does the UFTA. In contrast, under ' 3 of the UFCA, applicable to the Sharp case, “fair consideration” is given for property or an obligation:

• When in exchange for such property, or obligation, as a fair equivalent therefor, and in good faith, property is conveyed or an antecedent debt is satisfied, or
• When such property, or obligation is received in good faith to secure a present advance or antecedent debt in amount not disproportionately small as compared with the value of the property, or obligation obtained. (Emphasis added.)

The substantive difference between the two statutory standards, therefore, is the UFTA's elimination of the “good faith” requirement. Of course, the “good faith” requirement still exists in the New York version of the UFCA. (N.Y. Debt. & Cred. L. '' 272-275 (McKinney 1945 & Supp. 1990)). Thus, when a trustee or creditor attacks a transfer under state law, the applicable test in New York will turn on “fair consideration” and “good faith.” The “good faith” requirement has thus been crucial. See, e.g., Seligson v. N.Y. Prod. Exch. , 394 F. Supp 125, 133 (S.D.N.Y. 1975) (defendants' summary judgment motion denied when trustee “raised a general issue of material fact as to [defendants'] good faith”); Southern Indus., Inc. v. Jeremias , 411 N.Y.S.2d 945, 949 (2d Dep't 1978) (transfer made by corporation with intent to obtain advantage for insider over creditors voidable for his lack of good faith). But as the First Circuit noted in Boston Trading Group Inc. v. Burnazos , 835 F. 2d 1504, 1511 (1st Cir. 1987), “[c]ourts and commentators [still] have had difficulty determining the meaning of 'good faith' in ' 3's definition of 'fair consideration.'” See generally Note, “Good Faith And Fraudulent Conveyances, 97 Harv. L. Rev. 495 (1983).

Sharp: The Facts

The bank had approved a $20 million demand line of credit to Sharp International Corp. (Sharp) in 1996. Beginning in the summer of 1998, the bank began to suspect fraud at the company. Sharp was growing at an alarmingly rapid pace and was consuming a large amount of cash. Sharp at *4. In the fall of 1998, the bank twice took the “'unusual step' of contacting Sharp's customers directly to verify that they were, in fact, purchasing Sharp products.” Id. at *5. Ultimately, the bank undertook a full-scale investigation, learning that Sharp had fraudulently created fictitious customers and accounts receivable. Id. at *6. “The nub of the complaint is that the bank then arranged quietly for [management] to repay [the bank's] loan from the proceeds of new loans from unsuspecting lenders.” Id. The bank “demanded and obtained Sharp's agreement to secure new financing — presumably from investors unaware of the fraud — and to use that financing to pay off the [$15 million] debt to [the bank].” Id. at *7. In March 1999, Sharp raised $25 million through the issuance of subordinated notes, and repaid the bank approximately $12.25 million. The bank then released Sharp from its debt. Id. Between the fall of 1998, when the bank's suspicions began, and October 1999, Sharp officers had looted the company of more than $19 million. Id. at *8.

Procedural Posture

Sharp, as Chapter 11 debtor-in-possession, sued the bank in the bankruptcy court during 2001, 1.5 years after Sharp's noteholders had filed an involuntary Chapter 11 petition against it. Sharp claimed the bank had aided the company's former officers in looting the company, and that Sharp's $12.25 million loan repayment to the bank was a fraudulent transfer. Significantly, Sharp could not challenge the loan repayment as a preference, because the payment was made more than 90 days prior to Sharp's bankruptcy filing. See Code ' 547(b)(4)(A). The bankruptcy court found, however, and the district court affirmed, that despite the bank's well-documented suspicions, it: 1) had not participated in the fraud; 2) had advanced the funds in good faith; and 3) thus could not be held liable for aiding and abetting the management's breach of fiduciary duty, nor could it be compelled to return the $12.25 million payment on a fraudulent transfer theory. Sharp appealed.

A Lender Has No Fiduciary Duty to Its Borrower or to Other Creditors

The bankruptcy court found Sharp's complaint had failed to show the bank's knowledge of the fraud, but the district court disagreed. The Second Circuit never reached the issue because it “agreed with both judges that the complaint insufficiently alleged knowing inducement or participation on the part of [the bank]” Id. at *13: “ [S]ince Sharp does not contend that [the bank] owed Sharp a fiduciary duty, Sharp must allege [the bank] committed affirmative acts that furthered [management's] breaches of fiduciary duty to Sharp. The complaint cites five acts by [the bank] that are alleged to satisfy these standards; we consider these acts in turn. Ultimately, we conclude that the complaint says no more than that [the bank] relied on its own wits and resources to extricate itself from peril, without warning those it had no duty to warn.” Id., at *16, *17. According to the court, “[t]he nub of the complaint is that [the bank] knew that there would likely be victims of [management's] fraud, and arranged not to be among them; … [o]ne could say that [the bank] failed to tell someone that his coat was on fire; or one could say that it simply grabbed a seat when the music stopped. The moral analysis contributes little. Whatever [the bank] knew about [management's] fraud, [it came] by that information through diligent inquiries that any other lender could have made. Sharp fails to identify any duty on [the bank's] part to precipitate its own loss in order to protect lenders that were less diligent.” Id. at *22.

Lender's Knowledge Of Borrower Fraud Insufficient Fraudulent Transfer Liability

Sharp brought its fraudulent transfer claim under the New York version of the UFCA. Sharp acknowledged “the payment at issue discharged an antecedent debt and was made for a 'fair equivalent,'” but argued that “fair consideration is lacking because [the bank] did not receive the payment in 'good faith.'” Id. at *25, *26. Reasoning that “[g]ood faith is an elusive concept in New York's constructive fraud statute,” and that “bad faith does not appear to be an articulable exception to the broad principle that 'the satisfaction of a preexisting debt qualifies as fair consideration for a transfer of property [citing cases],'” the court stressed that “[the bank's] loan was made in good faith long before the purportedly fraudulent transfer (Id. at *26) … New York fraudulent conveyance law … is primarily concerned with transactions that shield company assets from creditors, not the manner in which specific debts were created. [The bank's] knowledge of the [management] fraud, without more, does not allow the inference that [the bank] received the $12.25 million payment in bad faith.” Id. at *32.

Implications of Decision

Pre-Existing Debt Was Legitimate

The bank advanced funds for a proper purpose, long before the purportedly fraudulent transfer; under New York law repayment of a legitimate antecedent debt constitutes fair consideration “'unless the transferee is an officer, director or major shareholder of the transferor.'” Sharp at *27, citing Atlanta Shipping Corp., Inc. v. Chem. Bank , 818 F.2d. 240, 249 (2d Cir. 1987). See also HBE Leasing Corp. v. Frank , 48 F.3d 623 (2d Cir. 1995) (same).

When Pre-Existing Debt is Legitimate, Creditor's Subjective Bad Faith Is Not Enough

The court or the parties found only one case where “an (allegedly) antecedent debt paid to an outsider was found lacking in fair consideration … [In that case] the debtor affirmatively swore that the transaction was intended to evade his creditors.” Id., citing Ede v. Ede , 193 A.D.2d 940, 942 (3d Dep't 1993) (fair consideration lacking in face of evidence “which can admit of no finding other than … bad faith.”). “[A] case such as Ede does not furnish a rule of decision for detecting what constitutes bad faith … Here … there is no admission of subjective bad faith, if indeed that would matter .” Sharp , at *27. (Emphasis added).

Mere Preference to One Creditor Does Not Constitute Bad Faith

Under New York law, a debtor's preference to one creditor, or a preferred creditor's knowledge that that a debtor is insolvent at the time it receives a transfer, is not evidence of bad faith. Id. at *27-*29, citing HBE Leasing , at 634 (quoting Boston Trading Group, Inc. v. Burnazos , 835 F. 2d 1504, 1509 (1st Cir. 1987); Ultramar Energy Ltd. v. Chase Manhattan Bank, N.A. , 599 N.Y.S. 2d 816 (1st Dep't 1993) (same).

Transferee's Knowledge of Source of Funds Immaterial

Sharp alleged the bank's bad faith arose from its knowledge that the funds used to repay it had been fraudulently obtained. But “a lack of good faith does not ordinarily refer to the transferee's knowledge of the source of the debtor's monies.” Id. at *29, quoting Boston Trading at 1512.

Repayment of Bank's Loan Did Not Benefit Third Parties

“Transfers made to benefit third parties are not considered as made for 'fair' consideration” because of an asserted lack of “good faith.” Bullard v. Aluminum Company of America , 468 F.2d 11, 14 (7th Cir. 1972). Instead of deriving a benefit, however, Sharp insiders gave personal notes to repay the bank's loan in part. Sharp at *7.

Every Creditor for Itself

When Sharp raised new funds from its Noteholders to pay off its debt to the bank, the bank “gave no warnings and blew no whistles, ignored inquiring calls from the Noteholders, preserved Sharp's line of credit when it had the right to foreclose and pull the plug, and gave Sharp its needed consent to the new indebtedness.” Id. at *7. Neither the Second Circuit nor the New York courts in a separate action brought against the bank by the Noteholders (Albion Alliance Mezzanine Fund, L.P. v. State Street Bank & Trust Co. , 767 N.Y.S. 2d 619 (1st Dep't 2003) (affirming grant of motion to dismiss)), found anything actionable in the bank's conduct. Indeed, 4 days after the Second Circuit's Sharp decision, the Seventh Circuit reached the same result in B.E.L.T., Inc. v. Wachovia Corp., 2005 U.S. App. LEXIS 5375, *3 (7th Cir. April 5, 2005), (“Illinois, like most other states, does not require business ventures to do good turns for their rivals.”).

No Discussion of Public Policy

In dicta, the district court suggested that as a matter of public policy there might be a benefit to imposing an affirmative duty on a bank to act when it learns that its borrower is committing fraud. The Second Circuit apparently does not share this view.

Michael L. Cook, a member of this newsletter's Board of Editors, is a partner and Alix Pustilnik is an associate at Schulte Roth & Zabel LLP in New York.