A federal bankruptcy court recently awarded the bankruptcy trustee a $569,435 judgment against a church for fraudulent transfers from a bankruptcy estate. This article highlights several key issues, including recovery of avoidable transfers from secondary transferees, methods used by forensic accountants to trace disbursed funds, and the meaning of “value received” in determining whether a secondary transferee was liable.

Arrowsmith v. First United Methodist Church Centre, Alabama (In re Health Diagnostic Laboratory, Inc.), 2023 Bankr. LEXIS 2721 (Bankr. E.D. Va. November 9, 2023).

Fraudulent transfers?

The debtor operated a health care laboratory. The bankruptcy trustee had obtained a judgment for more than $220 million against the debtor’s exclusive sales agent for receipt of fraudulent transfers from the debtor (the “avoided transfers”). The trustee also sought to recover transfers that had been received by one of the debtor’s shareholders, a principal and insider of the sales agent. However, because the shareholder and several of his business entities filed for bankruptcy protection, the trustee’s action against him was stayed.

The church stipulated that transfers of just over $1.7 million from the debtor to the shareholder were avoidable under the Bankruptcy Code’s fraudulent transfer provisions (the “avoidable transfers”). (See “Recovering fraudulent transfers in bankruptcy” below.) The instant action involved $1,085,000 in donations the shareholder made to the church. These donations came from bank accounts containing funds that had been commingled with the avoided and avoidable transfers. The trustee sought to recover the portion of the donations traceable to the debtor.

Tracing methodology

The trustee’s expert witness, a forensic accountant, traced the money flow in and out of the bank accounts to determine the amount of the debtor’s funds that went to the church. Although several tracing methods are available, the expert applied the following two techniques:

1. The lowest intermediate balance rule (LIBR) method. This assumes “trust or secured funds deposited into a commingled bank account are the last funds disbursed from that account, and any disbursements made from the account are taken first from funds other than the trust or secured funds until the balance in the account dips below the amount of those trust or secured funds.” In simpler terms, “clean” funds are assumed to exit the account before the “dirty” funds until no clean funds are remaining, then withdrawals are made from dirty funds. Using this method, the expert estimated that the amount traceable to the debtor was $569,435.
2. The restated tracing rules (RTR) method. This technique assumes that withdrawals are made from the trustee’s funds provided they don’t exceed the account’s lowest balance between when the debtor’s funds were deposited and when they were withdrawn. Using this method, the expert found that the amount traceable to the debtor was $845,015.

The court determined that the LIBR method was best suited to trace the funds and awarded the trustee $569,435.

Court’s reasoning

The court rejected three key arguments the church raised in its defense. First, the court found the trustee wasn’t obligated to present his case in the light most favorable to the church. If the church believed a different tracing method was appropriate, it could have offered a rebuttal expert — but chose not to.

Second, the church failed to show that it provided value in exchange for the donations, which could have precluded the trustee’s recovery. The church provided no goods or services in exchange for the donations, and neither the “intangible and emotional benefits of charitable giving” nor charitable acts performed by its congregation in the community were sufficient. The donor must receive a tangible, quantifiable economic benefit.

Finally, the fact that the church had already spent more than half of the donations wasn’t a valid defense. The Bankruptcy Code’s fraudulent transfer provision doesn’t consider “the potential hardship to . . . a subsequent transferee.”

Lessons learned

This case highlights the need for forensic experts to establish the source of funds in fraudulent transfer cases. It also demonstrates that fairness to the transferee, regardless of how innocent, isn’t a consideration when seeking the return of fraudulently transferred funds.

Sidebar:  Recovering fraudulent transfers in bankruptcy

The U.S. Bankruptcy Code’s fraudulent transfer rules are designed to prevent debtors from depleting their assets to place them beyond creditors’ reach. Bankruptcy trustees have the power to prevent fraudulent transfers and bring the assets back into the bankruptcy estate.

Under Bankruptcy Code Section 548, trustees can avoid transfers made within two years before a bankruptcy filing if they involve actual or constructive fraud. Actual fraud means a transfer was made with actual intent to hinder, delay or defraud creditors. Constructive fraud happens when a debtor transfers assets without receiving “reasonably equivalent value” under certain conditions. Examples include insolvent debtors, transfers that render debtors insolvent and transfers to insiders.

Section 550 permits trustees to recover the value of fraudulent transfers from 1) an initial transferee (or the entity for whose benefit the transfer was made), or 2) any immediate or mediate transferee of such initial transferee, such as the church in Arrowsmith (see main article). However, a trustee may not recover from a mediate transferee that “takes for value … in good faith, and without knowledge of the voidability of the transfer avoided.”

Contact our team today if you have any questions about Fraudulent transfers.