Ninth Circuit authorizes trustees to avoid intentional fraudulent transfers without need to demonstrate creditor harm

In a case of first impression in the Ninth Circuit, the US Court of Appeals recently handed bankruptcy trustees a significant power by ruling in The Lovering Tubbs Trust v. Hoffman (In re O’Gorman) that a trustee can avoid intentionally fraudulent transfers under the Federal Bankruptcy Code, even if no creditor suffered harm as a result.

In so doing, the Ninth Circuit held that a trustee’s standing arose from the harm that the bankruptcy estate, created under Title 11 of the US Code, Section 541(a), suffered as a result of the diminution in value of the estate caused by the fraudulent transfer.

Consequently, the Ninth Circuit held that the trustee – as representative of that estate – can remedy that harm regardless of actual creditor injury.

Background

O’Gorman (the Debtor) owned a 30-acre parcel of land in Calistoga, California. As a result of nonpayment of legal services, the Debtor pledged that land as collateral for ultimate repayment.

However, the Debtor defaulted on her payments and faced foreclosure. On the eve of foreclosure, the Debtor transferred the land to the Lovering Tubbs Trust (the Transfer). The Transfer occurred without consideration, although the Debtor obtained a 20 percent beneficial interest in the trust and continued to reside on the property.

Eventually, the Debtor filed for Chapter 7 bankruptcy. The Chapter 7 trustee (the Trustee) sued the Lovering Tubbs Trust and two affiliated trusts created to facilitate the Transfer (collectively, the Defendants) and sought to avoid the Transfer under Title 11 of the US Code, Section 548(a)(1)(A) and California Civil Code Section 3439.04(b)(1)-(11) as an intentional fraudulent transfer.

The Trustee presented evidence including the Debtor's declaration stating her intent to prevent or delay the lender from foreclosing on his deed of trust. Additionally, the Trustee pointed to several "badges of fraud" under California Civil Code Section 3439.04(b)(1)-(11), such as the Transfer to an insider, the Debtor retaining control of the property, and no consideration paid for the Transfer.

The Defendants contended that because the lender did not have a valid claim to the property at the time of the Transfer and unsecured creditors could be paid in full from the Debtor's anticipated $235,000 priority distribution, an actionable injury did not exist.

Summary of defendants’ arguments

The Defendants made two primary arguments in defense of the fraudulent transfer claims.

First, they contended that the Trustee lacked standing to bring the claims because none of the Debtor's creditors were harmed by the Transfer.

Second, the Defendants argued that the claims must fail because the Trustee could not demonstrate that the Transfer harmed any creditor – and that such harm constituted a necessary element of an intentional fraudulent transfer claim.

The Ninth Circuit rejected both of these arguments.

The Trustee has Article III standing

The Defendants argued that the Trustee lacked standing to bring an action to set aside the Transfer as fraudulent because no creditors were harmed. In support of their argument, Defendants presented evidence that the estate had sufficient value to pay allowed claims in full.

The Defendants also relied upon case law from the Ninth Circuit and the Southern District of New York, which found that a creditor and a recovery trust lacked Article III standing to bring fraudulent transfer claims because the alleged injuries in those cases were too conjectural to establish an injury-in-fact, since the bankruptcy plans in those cases guaranteed that the parties would be paid in full.

The Ninth Circuit distinguished those cases as “inapposite” because in the instant case the Trustee – as representative of the estate and not an individual creditor or creditor trust – brought the action.

The Ninth Circuit reasoned that when a trustee brings an action for an intentional fraudulent transfer on behalf of the estate, the existence of an injury to the estate itself is sufficient to establish Article III standing.

The Ninth Circuit relied on decisions from the appellate courts in the Second, Third, and Eleventh Circuits that also found trustee standing to pursue remedies for harm to the estate.

Actual harm to a creditor is not a necessary element of the claim

The Defendants also argued that the Trustee’s complaint should fail because the Trustee could not identify any creditor harmed by the Transfer. The Ninth Circuit rejected this argument and held that actual harm does not represent an element required under Section 548(a)(1)(A) of the Bankruptcy Code or California Civil Code Section 3439.04.

According to the Ninth Circuit, Section 548 focuses on whether the intent to hinder, delay, or defraud creditors existed at the time of transfer, not whether creditors suffered harm as a result.

The Ninth Circuit reasoned that this interpretation of Section 548 “upholds the goals of efficiency and finality in bankruptcy,” while the Defendants’ interpretation would “risk upending the work trustees perform at the outset of bankruptcy proceedings to marshal the assets available to pay creditors’ claims.”

The Ninth Circuit’s ruling follows the Fourth and Eighth Circuit Courts in affirming trustees’ ability to challenge transfers made with fraudulent intent without a showing of actual harm to creditors.

Furthermore, the Ninth Circuit’s finding that an avoidance action can pursue a claim without a cap on recovery, regardless of whether it will pay creditors in full, is “virtually universal among courts that have substantively considered the issue.”

Key takeaways

This ruling reinforces trustees' ability to challenge transfers made with fraudulent intent and clarifies Article III standing requirements in bankruptcy cases involving asset transfers.

In summary, the Ninth Circuit ruled that:

• The Trustee had Article III standing due to an injury-in-fact caused by depletion of estate assets notwithstanding the fact that no creditors were directly harmed by the Transfer.
  
  
• Actual harm to creditors does not constitute a required element of fraudulent transfer claims under Section 548 of the Bankruptcy Code or California Civil Code Section 3439.04.

For more information

If you have any questions about this ruling or any restructuring-related matter, please reach out to the authors, Robert Klyman and Rod Kazempour, or your usual DLA Piper contact.