Fraudulently Conveyed Property: Part of the Bankruptcy Estate and Subject to the Automatic Stay (Or Not)?

Rajala v. Gardner, 709 F.3d 1031 (10th Cir. 2013) –

A bankruptcy trustee claimed that $9 million held in escrow was fraudulently transferred property that could be recovered through an avoidance action in bankruptcy, and consequently constituted property of the bankruptcy estate that was subject to the automatic stay.  The district court disagreed, holding that fraudulently transferred property was not part of the estate until it was recovered, so that the stay did not apply.  The trustee appealed to the 10th Circuit.

The debtor (GRHC) was formed to develop wind power projects, and employed FreeScreen Capital, LLC (FreeScreen) to provide advisory services.  GRHC entered into a memorandum of understanding with Edison Capital (Edison) for the purchase of three wind power projects, including the “Lookout” project.

Several insiders subsequently formed another company (LWHC) that entered into a deal with Edison for sale of the wind power projects.  The trustee alleged that the insiders fraudulently transferred GRHC’s business opportunities to insider owned companies.

Under the LWHC contract for the Lookout project, once the project was commercial (at which point Edison would become the 100% owner), a final installment of the purchase price was to be paid 25% to FreeScreen and 75% to LWHC.   LWHC and FreeScreen sued Edison for payment of the final installment in a Pennsylvania federal court.

Eventually the Pennsylvania court entered a judgment for ~$9 million in favor of LWHC (75%) and FreeScreen (25%).  Although that court declined the trustee’s motion to stay the Pennsylvania case, it did order that the judgment funds be deposited with the GRHC bankruptcy court in Kansas.

LWHC and FreeScreen filed motions in Kansas for distribution of the $9 million, arguing that the funds were not property of the bankruptcy estate.  The Kansas district court agreed, holding that fraudulently transferred property does not become part of the estate until it is recovered, and directing that the funds be distributed.  Because the district court order was in essence a grant of relief from the automatic stay, the 10th Circuit accepted the trustee’s appeal.

The trustee’s claim that the funds were fraudulently transferred property, and therefore were subject to the automatic stay, turned on whether the estate has an interest in the property prior to recovery.

  • Section 541(a)(1) of the Bankruptcy Code defines the bankruptcy estate to include “all legal or equitable interests of the debtor in property as of the commencement of the case.”
  • Under Section 541(a)(3) the estate also includes “[a]ny interest in property that the trustee recovers under Section… 550… of this title.”  (Section 550 provides that when a transfer is avoided under various sections, including the sections providing for avoidance of fraudulent transfers, the property transferred can be recovered for the benefit of the estate.)

On the one hand, it can be argued that there is an equitable interest in property subject to recovery that is sufficient to bring the property within the estate under subsection  (1).  On the other hand, the specific treatment of avoided transfers in subsection (3) suggests that it becomes property of the estate only after it is recovered.

The 10th Circuit noted that there is a split among the circuits:  The 5th Circuit concluded that fraudulently transferred property belongs to the estate under Section 541(a)(1), explaining that “it makes the most sense to consider the debtor as continuing to have a ‘legal or equitable interest’ in the property fraudulently transferred.”  In contrast the 2nd Circuit adopted a narrower reading, holding that Section 541(a)(3) governs so that the property does not become part of the estate until it is recovered.

In the 10th Circuit’s view, under the “plain meaning” of Section 541, fraudulently transferred property is not part of the estate until it is recovered.  The court rejected the trustee’s argument that there is an equitable title or claim because including property in the estate based on a mere allegation would violate equity concepts.  In addition, the court agreed with the 2nd Circuit that including an interest in fraudulently transferred property under Section 541(a)(1) would make Section 541(a)(3) superfluous.

The court closed its analysis by raising the specter of a constitutional issue.  In the 10th Circuit’s view, “a broad reading could potentially violate the Due Process Clause by allowing a trustee to enjoin another party’s property rights based only on the allegation of fraud.”  Since the bankruptcy stay is automatic:  “Mere filing of a fraudulent transfer claim could deprive a bona fide purchaser of his property without judicial supervision, a finding of probable cause, the posting of a bond, or a showing of exigent circumstances – let alone a pre-deprivation opportunity to be heard.”

The consequence of the court’s ruling is that fraudulently transferred property that has not yet been recovered is not subject to the stay that comes into effect automatically upon the filing of a bankruptcy.  However, as the court notes, there are alternative ways to protect the estate’s interests in the fraudulently conveyed assets.

Among other things, a trustee or debtor could seek injunctive relief to prevent further disposition of the assets in question.  It is certainly more burdensome than simply notifying someone that the automatic stay prevents them from doing anything with the assets, but at least there are some options.  This does put pressure on a debtor or trustee to pursue avoidance actions sooner rather than later in order to reduce the likelihood it will have to chase assets that have already been dissipated.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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