Tangible Possession Not Required for § 550 Transfer Avoidance

A debtor who obtained a recovery order for fraudulently transferred funds had sufficiently “recovered” those funds for the benefit of the estate, held the U.S. Court of Appeals for the Third Circuit, reversing a district court ruling that actual possession of the funds was required for a “recovery” within the meaning of Bankruptcy Code Sec. 550.

The transferee was a founder, former shareholder and employee of the debtor. The debtor company terminated the transferee’s employment, and the transferee sued the debtor. The debtor and the transferee settled the lawsuit. Several years after the settlement, the debtor company filed for bankruptcy and sought to recover the settlement payment. According to the debtor, the settlement payment was fraudulent because the debtor did not receive reasonably equivalent value in exchange for the payment. The bankruptcy court ultimately entered an order avoiding the transfer and directed the transferee to return the settlement funds to the debtor. The transferee failed to comply with the bankruptcy court’s order, moved the funds to an offshore account and filed for bankruptcy himself.

Competing Estates

The debtor company argued that it was not prevented by the automatic stay in the transferee debtor’s bankruptcy case from pursuing recovery of the settlement payment because the funds were property of its bankruptcy estate and not that of the transferee debtor. The bankruptcy court disagreed, holding that, because the debtor company never actually had tangible possession of the settlement payment, the funds were never “recovered” for the benefit of the debtor’s bankruptcy estate pursuant to Sec. 550 despite entry of the recovery order. In other words, the transferee debtor’s estate had a superior claim to the settlement funds. On appeal, the district court affirmed.

The court of appeals disagreed with the lower courts’ narrow interpretation of “recovery.” The lower courts based their interpretation of “recovery” on holdings by the Second and Tenth Circuits that property is “recovered” only if a debtor or trustee has actual possession of the property. The Second and Tenth Circuits were concerned that absent actual recovery, an allegation of fraud would be enough to bring property into a bankruptcy estate “without any showing of merit.”

However, the Second and Tenth Circuits did not address the meaning of “recover” under Sec. 550. The Second and Tenth Circuits addressed the question of what it means to “recover” fraudulently transferred property for purposes of Sec. 541(a), which identifies “property of the estate” and provides that property of the estate includes property “recovered” by the trustee under Sec. 550.

The court of appeals determined that the earlier circuit court opinions centered on the meaning of “recovery” for purposes of Sec. 541(a) and, therefore, they were not helpful because the debtor company in this case had an actual order of recovery under Sec. 550. The debtor company had done more than simply allege a fraudulent transfer of assets. In a legal sense, the debtor had already recovered the funds for the benefit of its bankruptcy estate by obtaining the recovery order. The only impediment to actual possession was the transferee debtor’s refusal to hand the settlement funds over to the debtor company despite the bankruptcy court’s recovery order.

The appellate court also observed that requiring actual recovery would render Sec. 541 internally inconsistent. Section 541(a) provides that property of the estate includes property “wherever located and by whomever held.” If “recover” is interpreted to require actual possession, the phrase “wherever located and by whomever held” would be rendered superfluous since actual possession would mean that only the trustee could ever possess estate property.

In re Allen, 2014 WL 4783085 (3rd Cir. Sept. 26, 2014)

About the Author:

George Basharis, JD

George Basharis, J.D. is a practicing bankruptcy attorney in the Northern District of Illinois. He has represented dozens of individuals and small businesses in federal bankruptcy proceedings and related matters. George also advises the CINgroup on a variety of aspects regarding bankruptcy law. He has authored books, white papers, customer newsletters and conducted speaking engagements regarding bankruptcy.