Authors: Andrew M. Thaler & Spiros Avramidis
Disgorgement often arises in bankruptcy proceedings. Bankruptcy law is designed to achieve two primary goals: (1) “obtaining a maximum and equitable distribution for creditors” and (2) “ensuring a fresh start for individual debtors.” In furthering the first goal, the law is designed to preserve and recover assets to pay creditors. To achieve that goal, debtors’ financial histories, including bank transactions, are inspected by creditors, bankruptcy trustees and the court. This scrutiny is, in part, designed to uncover and “claw back” assets from third parties for distribution to creditors.
Fraudulent conveyances can either be made with actual intent to hinder, delay or defraud creditors or be constructively fraudulent.  Unlike actual fraud, constructive fraud does not require intent. The conveyance need only be made for less than “fair consideration” or “reasonably equivalent value”. Constructive fraud is often less difficult to prove than actual fraud because it is easier to establish the value of a transferred asset by use of appraisals and the like than intent; additionally, pleading a constructive fraud cause of action is not subject to the heightened pleading standard of Federal Rule 9(b). Documentary evidence of actual intent to defraud rarely exists and is usually established by circumstantial evidence.
Constructive fraud can be illustrated by example: “Bank A” loans money to “Owner B”. Owner B solely owns “Corp C.” If Bank A accepts a check drawn from Corp C, which is insolvent or rendered insolvent by the transfer, on account of the loan to Owner B, then Bank A can potentially be liable to the creditors of Corp C under a constructive fraudulent conveyance theory. Assuming Corp C did not receive or benefit from any part of the loan, Corp C has paid a debt for which it received no consideration in return.
When a third party check is received, an alarm should go off. The recipient needs be aware of the potential consequences of negotiating the check and then make an informed decision on how to proceed. Systems should be established to identify when checks or other payments are received from a non-obligated party. Even checks received by guarantors of the primary obligor must be scrutinized because guarantors do not necessarily receive consideration. The check could be returned to the maker and the actual obligor asked to make payment with a check of their own. Alternatively, because insolvency is a necessary element of a fraudulent conveyance action, an investigation could be undertaken to determine if the payer is insolvent or having financial problems. These measures are good in theory, but, in reality, they may not be practical. Banks process thousands of checks daily. Monitoring voluminous payments is time consuming and difficult. Creditors may be a reluctant to offend or risk loss of a valued customer that for its own reasons arranged third party payment. Certain defenses exist which may lessen the likelihood of having to return the payment, either in whole or in part. However the efficacies of some of the defenses are open to debate.
The payee may be able to establish fair consideration even though the party paying had no obligation to the payee of the check. Under well-established law, a “debtor may sometimes receive fair consideration even though the consideration given for his property or obligation goes initially to a third person…. If the consideration given to the third person has ultimately landed in the debtor's hands, or if the giving of the consideration to the third person otherwise confers an economic benefit upon the debtor, then the debtor's net worth has been preserved, and [the bankruptcy statute] has been satisfied-provided, of course, that the value of the benefit received by the debtor approximates the value of the property or obligation he has given up.”
Following the prior example, if Bank A could establish that Owner B used the loan proceeds to improve, buy supplies, inventory, etc. for Corp C, then Corp C received an indirect benefit from Bank A. Accordingly, a creditor should not be successful in avoiding payments made from Corp C to Bank A because Bank A provided fair consideration (indirect benefit) to Corp C.
If the bank had no prior relationship with the debtor it may be difficult to establish the economic benefit the debtor indirectly received in comparison to the value of the property the debtor transferred. Time consuming and expensive discovery might be required to elicit facts to establish an “economic benefit” to the debtor. The fact that the debtor merely received a “benefit” is insufficient to find fair consideration. The debtor must receive a benefit of fair equivalence. This does not mean that the benefits have to be of exact equivalent value..
The key is to try and establish no diminution of the debtor’s assets that would otherwise be available to pay creditors. This is the central issue the court will focus upon..
Although not raised often, the holder in due course defense has been used as a defense to fraudulent transfers to varying degrees of success. Under N.Y. U.C.C. Law § 3-302(1), a holder in due course “is a holder who takes an instrument (a) for value; and (b) in good faith and (c) without notice that it is overdue or has been dishonored or of any defense against or claim to it on the part of any person.” Good faith turns on what the holder actually knew of the transaction in question.. Further, “[h]olders in due course are to be determined by the simple test of what they actually knew, not by speculation as to what they had reason to know, or what would have aroused the suspicion of a reasonable person in their circumstances.” This is sensible because the UCC’s underlying policy is to foster commerce and not burden the banking system with expensive and time consuming due diligence prior to cashing a check. To do otherwise would bring check cashing processes to a grinding halt.
Few cases address the holder in due course defense vis-à-vis a fraudulent conveyance action. At least one court has held that holder in due course is a viable defense to a fraudulent conveyance claim, but, in contrast, another court has held that the holder in due course defense is inapplicable. Noteworthy, there is at least one recent determination by a bankruptcy judge that the defense is not applicable to fraudulent transfer claims because the purposes and policies underlying the respective statutes are similarly different. Whether the holder in due course defense will hold up in any particular case is unknown at this time based on the dearth of cases reaching that issue.
Another potential defense would be to try and establish that the payer and the obligor are alter egos of one another because corporate formalities were not followed. This might apply to small business owners that commingle personal affairs with that of the business.
One thing is for certain: care must be taken when accepting payments by parties not obligated to the payee or obligated in non-primary way, e.g. guarantees. Failure to do so may result in defense of a lengthy and costly fraudulent conveyance action.
 BFP v. Resolution Trust Corp., 511 U.S. 531, 563 (1994).
 See 11 U.S.C. §§ 341 and 343 (mandatory examination of a debtor at the meeting of creditors)
 11 U.S.C. §§ 547—48.
 11 U.S.C. § 544(b)(1).
 See N.Y. Debt. & Cred. Law §§ 270—281; N.Y. C.P.L.R. § 213(1), (8).
 Compare 11 U.S.C. § 548(a)(1)(A) and N.Y. Debt. & Cred. Law §§ 273—275, 277 (authorizing the avoidance of actual fraud) with 11 U.S.C. § 548(a)(1)(B) and N.Y. Debt. & Cred. Law § 276. (authorizing the avoidance of constructive fraud).
 See 11 U.S.C. § 548(a)(1)(B) (authorizing the avoidance of transfers made for “less than reasonably equivalent value); N.Y. Debt. & Cred. Law §§ 272—275, 277 (defining “fair consideration” and authorizing the avoidance of transfers made without “fair consideration”).
 In re Actrade Fin. Techs. Ltd., 337 B.R. 791, 801 (Bankr. S.D.N.Y. 2005) (because “constructive fraud does not require proof of fraud, the heightened pleading requirements of Rule 9(b) are not applicable”).
 Id. at 809 (listing and discussing the common badges of fraud).
 In re Image Worldwide, Ltd., 139 F.3d 574, 577-79 (7th Cir. 1998) (guarantor must receive a benefit to survive a fraudulent conveyance action).
 A word of warning: the bank may still be liable to return the money if the obligor merely borrows the money from the third-party that originally attempted to pay the bank. 11 U.S.C. § 550 authorizes a trustee to recover property from persons who received property of an avoided transfer. So, Corp C attempts to pay Bank A on account of Owner B’s loan, but Bank A wisely refuses. Therefore, Corp C gives Owner B the money who pays it to Bank A; Bank A may still be liable to return the money. Although good faith is a defense that can be raised by transferees, the initial refusal may have given cause for the Bank to launch an investigation into the subsequent payment.
 See e.g., Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979, 991-92 (2d Cir. 1981).
 Supra note 10 at 803 (“Whether fair consideration has been given in any circumstance is fact-driven, and not subject to any mathematical formula.”).
 Thaler v. Lee Servicing Corp. (In re Joe Sipala & Son Nursery Corp.), 214 B.R. 281 (Bankr. E.D.N.Y. 1997); Supra note 10.
 Countrywide Home Loans, Inc. v. St. Louis (In re AppOnline.Com, Inc.), 290 B.R. 1, 13 (Bankr. E.D.N.Y. 2003) (“Good faith turns on what the holder actually knew of the transaction in question.”)
 Hartford Acc. & Indem. Co. v. American Exp. Co., 74 N.Y.2d 153, 163 (1989)
 Compare supra note 10 at 807 with Sipala, 214 B.R. at 285-86.
 See Adversary Case No. 8-14-08245-ast currently pending in the Bankruptcy Court for the Eastern District of New York.
 In re KZK Livestock, Inc., 221 B.R. 471, 478 (Bankr. C.D. Ill. 1998)