On October 16, 2014, the US Court of Appeals for the Fifth Circuit, in Williams v. Federal Deposit Insurance Corp. (In re Positive Health Management), held that, where a debtor's payments to a lender acting in good faith constituted actual fraudulent transfers, the lender could retain the payments under the affirmative defense of section 548(c) of the Bankruptcy Code only to the extent that these payments were netted against the value that the lender gave to the debtor in exchange (769 F.3d 899 (5th Cir. 2014)).

Ronald Ziegler (Ziegler) was the president and sole shareholder of Positive Health Management, Inc. (Debtor). In 2005, First National Bank (Lender) made a refinance loan to a separate corporate entity owned by Ziegler. The loan was secured by a building that the Debtor used for office space. Despite having no direct obligations under the loan, the Debtor made a series of payments to the Lender totalling $367,681.35. The Debtor listed these payments on its tax returns as rent.

After the Debtor filed a bankruptcy petition, the Debtor's trustee (Trustee) filed an adversary proceeding to recover the payments to the Lender as either actual or constructive fraudulent transfers under section 548(a) of the Bankruptcy Code. The Bankruptcy Court found that the Debtor received at least reasonably equivalent value in exchange for the $367,681.35 in payments made to the Lender, because:

Therefore, the Bankruptcy Court held there was no constructive fraudulent transfer. However, since the Debtor made the transfers "with actual intent to hinder, delay or defraud," its creditors, the Trustee had established actual fraud under section 548(a)(1)(A) of the Bankruptcy Code.

Section 548(c) of the Bankruptcy Code contains an affirmative defense to fraudulent transfer liability which entitles a good faith transferee that takes for value to retain or receive a lien on any property transferred, or to enforce any obligation incurred, to the extent of any value given by the transferee to the debtor. The Bankruptcy Court held that the Lender could assert this defense and retain the funds in their entirety because it:

Ultimately, the District Court adopted the Bankruptcy Court's proposed order, and the Trustee appealed to the Fifth Circuit.

The Fifth Circuit affirmed the District Court's decision that the Lender was entitled to assert the section 548(c) defense, but that the estate should recover the $114,348.02 difference between the payments the Lender received and the value related to the Debtor's continued use of the property.

On appeal, the Trustee argued that section 548(c) of the Bankruptcy Code provides the transferee a defense for good faith only to the extent that the transferee gave value to the debtor in exchange for the transfer. Therefore, the Trustee argued that, even if the affirmative defense applied, section 548(c) of the Bankruptcy Code required the Court to reduce the value of the fraudulent transfers by the value of the market rent, and to award the estate the difference.

While acknowledging that some courts have concluded that "value" for purposes of section 548(c) means "reasonably equivalent value," the Fifth Circuit agreed with the Trustee and adopted the "netting" approach on the grounds that the clause of the statute, "beginning with 'to the extent,' makes it clear that a transferee is entitled to keep only the amount of a fraudulent transfer that equals the amount it gave up in exchange." The Fifth Circuit rejected the Lender's argument that a "rigid netting approach" was inappropriate because the good faith and value defense merely required "good consideration" rather than a precise mathematical equivalence of value. It reasoned that because consideration may be "disproportionately small," allowing a transferee who merely gives "good consideration" in exchange for a fraudulent transfer to keep the entire amount would benefit the transferee at the expense of the debtor's creditors "based on the fortuity that it received a fraudulent transfer."

This case serves as a reminder that lenders should be mindful of the source of the debt payments they receive and take note of any payments received from a party other than the borrower. As this case demonstrates, even if a lender acts in good faith and gives the debtor value in exchange, the lender may still face fraudulent transfer liability for amounts that exceed the value it gave to the debtor. Here, if the Debtor had made its "rent" payments to Ziegler, and then Ziegler used those funds to pay the Lender, the Lender would not have had any fraudulent transfer liability.

For more information on fraudulent transfers, see Practice Notes, Fraudulent Conveyances in Bankruptcy: Overview and Fraudulent Conveyances: Issues and Strategies for Lenders and Private Equity Sponsors.