United States: Ninth Circuit Upholds Harsh Remedy Imposed On Lender

In an issue of apparent first impression in the circuit, the U.S. Court of Appeals for the Ninth Circuit has found that the depletion or diminution of the debtor's estate is not a requirement for avoiding an unauthorized post-petition transaction under section 549 of the Bankruptcy Code.

The facts leading up to the decision in Aalfs v. Wirum (In re Straightline Invs.), 525 F.3d 870 (9th Cir. 2008), were as follows: chapter 11 debtor Straightline Investments obtained court authorization to borrow as much as $100,000, secured by a junior lien on its equipment and a senior lien on its inventory. The debtor's request for further borrowing, including loans secured by accounts receivable, was denied. Thereafter, in a series of transactions, the debtor sold accounts receivable that had a face value of $200,600 to the lender for payments totaling $186,455.

The lender also held a personal guarantee from the debtor's president covering any losses. The lender subsequently collected $163,007 from the accounts. After approximately one year, the case was converted to chapter 7 and the trustee filed a complaint to avoid the transactions that the lender contended were factoring transactions.

Post-Petition Transactions

The Ninth Circuit Court of Appeals found that the depletion or diminution of the debtor's estate is not a requirement for avoiding an unauthorized post-petition transaction under section 549 of the Bankruptcy Code. The Ninth Circuit also approved, as a measure of recovery under 11 U.S.C. § 550, the bankruptcy court's determination that the lender (1) must return all amounts collected on the accounts with interest; (2) must turn over the uncollected accounts; and (3) was precluded from recovering any portion of the amount paid for the purchase of the accounts.

In short, the lender lost both the amount paid for the accounts and the amounts collected on the accounts.

Under section 549, the trustee need only show that the transfer was not authorized by the court or the Bankruptcy Code. Acknowledging that the primary purpose of section 549 is to allow the recovery of transfers that deplete the estate, the Ninth Circuit with little discussion nevertheless refused to extend the diminution-of-estate theory to uphold a transaction where the explicit requirements of an avoidable post-petition transfer were met.

Although the depletion or diminution doctrine commonly is viewed as a prerequisite for avoiding pre-petition preferential transfers under section 547 and fraudulent transfers under section 548, only the Sixth Circuit had previously alluded to the doctrine in the context of an earmarking case involving the avoidance of a transfer under section 549. Peoples Bank & Trust Co. v. Burns (In re Shelton), 244 F. App. 634 (6th Cir. 2007). There, as dicta in an earlier decision in the same case, the appellate panel had indicated that earmarking might apply if the transaction did not result in a diminution of the estate.

When the matter came up on appeal for the second time, the issue was never reached because of a stipulation of the parties.

Avoidance Actions

Section 550 provides for recovery of the property transferred and avoided under section 549 for recovery of the value of that property. The bankruptcy court's choice of remedies is reviewed for "abuse of discretion." None was found in the bankruptcy court's refusal to account for the windfall received by the estate in the award of a monetary recovery for part of the value of the improperly transferred accounts, and the return of the remainder of the uncollected accounts for the balance.

The Ninth Circuit considered and ultimately rejected a number of arguments that equitable considerations should be included in fashioning the bankruptcy court's remedy under section 550.

Below, a dissenting Ninth Circuit BAP judge believed that the trustee should have been allowed to recover only the amount to which the debtor's estate was damaged—the difference between the $200,600 face value of the accounts receivable transferred to the debtor and the $186,455 the lender paid to the debtor. The dissenting judge further contended that if the recovery resulted in the estate being any better off financially than it was prior to the avoidable transfer, the recovery would be an improper "windfall." The Ninth Circuit noted, however, that the "Code contains no provision which would allow [the transferee] to set off the amount he paid for the [avoidably transferred property] against the value of the [property]." Walsh v. Alpha Fin. Group (In re Rice), 83 B.R. 8, 13 (BAP 9th Cir. 1987).

Equity Considerations

Acknowledging that the purpose of section 550(a) is, generally, to restore the estate to the financial condition it would have enjoyed if the transfer had not occurred and some case law supporting the dissenting judge's viewpoint, the court factually distinguished In re Cybridge Corp., 312 B.R. 262, 265-272 (D. N. J. 2004). In Cybridge, the New Jersey court found the transferee was entitled to a credit for property transferred, based on section 550(d)'s limitation of recovery to a "single satisfaction," and on the permission granted bankruptcy courts under 11 U.S.C. § 105(a) to issue equitable orders not violative of other Code provisions.

Central to the analysis under both subsections were considerations of equity. The court also expressed concern that permitting the debtor to recover the cash collected on the accounts receivable, in addition to the money paid by the transferee for the accounts, would encourage debtors to take advantage of "unsuspecting creditors" by continuing to enter into agreements after the filing of a bankruptcy petition, failing to tell the creditors about the bankruptcy petition, and later recovering the funds collected by the innocent creditors.

The Ninth Circuit also factually distinguished a recent decision from the Bankruptcy Court for the Southern District of Florida that was influenced by equitable concerns, Bakst v. Sawran (In re Sawran), 359 B.R. 348 (Bankr. S.D. Fla. 2007). There, the bankruptcy court held that the defendants were entitled to an equitable credit for the amount of the pre-petition cash transfers made to the debtor because the court found that they were "innocent of wrongdoing and deserved protection under the circumstances." Important to that decision was the court's finding that the defendants were not motivated by personal gain in the transaction.

In summary, lenders should take care that their transactions are approved by the bankruptcy court. Because the lender was aware that the debtor was in bankruptcy proceedings, and the court previously had denied the debtor's request to obtain loans secured by its receivables, the lender should not have engaged in the factoring arrangement, which the court viewed as a disguised loan in contravention of its earlier order.

This article is presented for informational purposes only and is not intended to constitute legal advice.