Mitigating Lender Risk in Constructive Fraudulent Transfer Litigation

Lenders to a debtor sometimes view constructive fraudulent transfer claims against equity holders and other non-lender third parties as an estate asset that may boost their recovery. Proceeds from these claims are often shared pari passu with the general unsecured creditors, which in certain cases will include under-secured creditors on account of the portion of their total claim that is not secured by collateral (i.e., the "deficiency claim").

However, a lender may also be the target of constructive fraudulent transfer claims if: 1) the borrower and/or guarantor obligor was insolvent at the time of the loan transaction or was rendered insolvent upon consummation thereof; and (2) the obligor did not receive "reasonably equivalent value" because it did not obtain a benefit from the loan. If a loan transaction is avoided as a constructive fraudulent transfer: (1) the lender's claim against the obligor in bankruptcy may be disallowed or subordinated; and 2) the lender may also have to disgorge any debt service payments it received, plus prejudgment interest thereon.

Collapsing a Multi-Staged Lending Transaction

Although there is no provision in the Bankruptcy Code or binding Supreme Court case law so stating, many courts, including the U.S. Courts of Appeals for the Second and Third Circuits, have held that multi-staged lending transactions, which are typically found in an LBO or dividend recapitalization, may be collapsed and treated as integrated phases of a single transaction for purposes of evaluating whether a transferor or obligor received reasonably equivalent value. See, HBE Leasing v. Frank, 48 F.3d 623, 635 (2d Cir. 1995). The "paradigmatic scheme" justifying collapsing is where "one transferee gives fair value to the debtor in exchange for the debtor's property, and the debtor then gratuitously transfers the proceeds of the first exchange to a second transferee." As a result, the "first transferee receives the debtor's [repayment obligation], and the second transferee receives the consideration, while the debtor retains nothing." Where collapsing occurs, the lenders are viewed as having remitted the consideration directly to stockholders, with no corresponding value to the debtor. Prior to collapsing a multi-staged lending transaction, both the Second and Third Circuits require that the lender have knowledge of the multiple interdependent transactions — i.e., in an LBO, knowledge that the loan proceeds would be used to redeem the stock of the seller. See, HBE Leasing, 48 F.3d at 635 (holding that the initial transferee "must have actual or constructive knowledge of the entire scheme that renders her exchange with the debtor fraudulent"); In re Mervyn's Holdings, 426 B.R. 488, 497 (Bankr. D. Del. 2010) (holding that the Third Circuit's decision in United States v. Tabor Court Realty, 803 F.2d 1288, 1302 (3d Cir. 1986) supports a three-pronged test concerning the propriety of collapsing multiple individual transfers when determining whether a transaction constitutes a fraudulent transfer: 1) "whether all of the parties involved had knowledge of the multiple transactions"; 2) "whether each transaction would have occurred on its own"; and 3) whether each transaction was dependent or conditioned on other transactions).