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Payment of a Debt Prior to Bankruptcy is Not a Fraudulent Transfer, According to Ninth Circuit

2businessbayIn a bankruptcy proceeding, a trustee may avoid transfers made, or obligations incurred, by the debtor during the two years prior to the filing date, if the transfer or obligation was actually or constructively fraudulent. 11 U.S.C. § 548(a). The Ninth Circuit recently considered whether a transfer made to pay a purported debt was constructively fraudulent, finding that the Bankruptcy Code requires courts to apply state law. In re Fitness Holdings International, Inc., No. 11-56677, slip op. (9th Cir., Apr. 30, 2013). The court articulated a procedure for evaluating a purported debt, and it held that courts have the authority to recharacterize a debt under certain circumstances.

The debtor, Fitness Holdings International (FHI), signed multiple promissory notes to its sole shareholder, Hancock Park (HP), in exchange for over $24 million in funding from 2003 to 2006. The company also received about $12 million in loans from Pacific Western Bank (PWB) in 2004, secured by FHI’s assets and guaranteed by HP. In June 2007, FHI refinanced its loans with PWB, which included favorable repayment terms and a release of HP from its guarantee. From the funds received in the refinance, FHI made a $12 million payment to HP to pay off its unsecured promissory notes. Despite these efforts, FHI filed for Chapter 11 bankruptcy in October 2008.

Several of FHI’s unsecured creditors filed suit against HP, PWB, and two FHI directors, seeking to avoid the $12 million payment to HP. The creditors alleged that it was a constructively fraudulent transfer under 11 U.S.C. § 548(a)(1)(B), which states that a transfer is fraudulent if the debtor “received less than a reasonably equivalent value” from the transfer. They asked the court to recharacterize HP’s financing of FHI as an “equity investment” instead of “extensions of credit.” Fitness Holdings, slip op. at 5. The bankruptcy court dismissed all of the claims with prejudice, and the case was later converted from a Chapter 11 to a Chapter 7. The trustee appealed the dismissal.

The Ninth Circuit analyzed the meaning of “reasonably equivalent value” under the Bankruptcy Code. It found that the Code has a clear definition of “value,” essentially as payment of a debt. Id. at 9. It further found that “debt” is defined as “liability on a claim,” and that a “claim” is a “right to payment.” Id. at 10. The court therefore held that a payment made to satisfy a lawful “claim,” or a right to payment, is not constructively fraudulent.

To determine whether the recipient of a transfer has a “right to payment,” the court applied the “Butner principle,” which holds that a court must apply state law. Butner v. United States, 448 U.S. 48, 55 (1979). If a court finds that a transfer does not repay a lawful debt, the court may determine whether it “constituted a right to payment under state law.” Fitness Holdings, slip op. at 12. If it does not, the court can declare the transfer or obligation to be constructively fraudulent and recharacterize it, using state law. Id. at 12-13. Because the lower courts did not apply this legal analysis, the court remanded the case for further proceedings to consider whether HP had a lawful debt or a right to payment.

Bankruptcy offers a way for many individuals in financial distress to restructure their bills, or even discharge debts entirely. Bankruptcy attorney Devin Sawdayi has helped clients navigate the bankruptcy process in the Los Angeles area since 1997. To schedule a free and confidential consultation, contact us today online or at (310) 475-9399.

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