Volume 2, Number 4
Third
Circuit Says Trustee Gets
to Start With Clean Slate
Under §548
Written
by Michael M. Parker*
In McNamara, The Personal & Business Insurance Agency (“PBI” or “Debtor”) made payments totaling $580,000 to Premium Finance Specialists (“PFS”) in putative repayment of loans that Emil Kesselring (“Kesselring”), the CEO and sole shareholder of PBI, had fraudulently obtained from PFS through PBI. PBI was an insurance brokerage firm for trucking companies. “As a standard part of its business, PBI would sometimes obtain for its clients financing for the insurance premium payments necessary to secure coverage.” Id. at ____. In 1997 Kesselring, through PBI, began submitting false financing applications to PFS allegedly on behalf of clients and pocketing the money. To avoid detection, Kesselring caused PBI to make payments on the “fraudulent loans,” 2 using PBI funds. When the fraudulent scheme fell apart and PBI filed for bankruptcy protection, PBI’s chapter 7 trustee sued PFS to recover the $580,000 in payments PBI made to PFS on the “fraudulent loans,” asserting that the payments were fraudulent conveyances under §548 and the Pennsylvania Uniform Fraudulent Conveyance Act because PBI did not receive “reasonably equivalent value” or “fair consideration” in exchange for them, notwithstanding the fact that the money PFS paid went to a PBI operating account before it was removed by Kesselring.
The bankruptcy court and the district court both dismissed the fraudulent conveyance action on the grounds that the payments from PBI to PFS were loan repayments, and therefore constituted adequate consideration. The Third Circuit reversed, finding that Kesselring’s fraudulent conduct in obtaining financing from PFS through PBI could not be imputed to PBI such that Kesselring’s use of funds received by PBI constituted a loan from PFS to PBI.
To be fair, the Third Circuit’s decision declining to impute Kesselring’s fraudulent acts to PBI attempts to be substantially more narrow in its holding than announced in the opening of this article, but the reasoning the Third Circuit used to arrive that holding leaves the door open much wider than the holding suggests, or perhaps than the Third Circuit intended. The Third Circuit held:
In sum, nothing in the language of §548 precludes us from considering the replacement of Kesselring by the Trustee and the concomitant removal of the taint of Kesselring’s fraud from PBI,3 and we hold that Kesselring’s conduct will not be imputed to the Trustee.McNamara, ___ F.3d at ____.
To arrive at this holding the Third Circuit had to dance around precedent both in its own circuit and in the Supreme Court. Only two years earlier, in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., a divided panel of the Third Circuit had found that actions that could be commenced (by a creditors’ committee or presumably a trustee) fell into two categories: (1) those brought by the trustee as successor to debtor’s interest included in the estate under Section 541, and (2) those brought under one or more of the trustee’s avoiding powers.” 267 F.3d 340, 356-58 (3d Cir. 2001)(citing 3 COLLIER ON BANKRUPTCY 323.03[2] (15th rev. ed. 2001)). In Lafferty, two lease financing companies that were being operated, as Ponzi schemes filed for bankruptcy protection and the creditors committee for the debtors was authorized to pursue a “deepening insolvency” action against the debtor’s professionals, including Lafferty, which had served as an underwriter. The Lafferty court concluded that the committee was proceeding under §541 and rejected the creditors’ committee’s argument that its status as an “innocent successor” to the debtor should be considered when weighing “equities” and should foreclose application of the in pari delecto equitable defense asserted by the defendant. The Court found that the “plain language of §541 . . . prevents courts from taking into account events that occur after the commencement of the bankruptcy case.” 267 F.3d at 356-57 (citing Bank of Marin v. England, 385 U.S. 99, 101 (“The trustee succeeds only to such rights as the bankrupt possessed; and the trustee is subject to all claims and defenses which might have been asserted against the bankrupt but for the filing of the petition.”).
The McNamara court focused on the Lafferty court’s two categories of actions that might be raised by a trustee—those arising under §541 and those arising under a trustee’s avoiding powers. Assuming they were mutually exclusive provisions, the McNamara court then distinguished the Lafferty decision as one relating only a trustee’s rights arising under §541, and not a trustee’s rights arising under §548 (one of a trustee’s avoiding powers). Because in McNamara, the trustee only sought to invoke §548, the court reasoned, he was not burdened by the well-established law under §541 that a trustee steps into the shoes of the debtor and is subject to defenses that the debtor would be subject to. McNamara, ___ F.3d at ____. More importantly, the court concluded that the post-petition appointment of the trustee somehow extinguished the legal effect of Kesselring’s pre-petition conduct (i.e., “the concomitant removal of Kesselring’s fraud”). This erroneous conclusion is the Achilles’ heel of the opinion. While §548 does not prohibit “consideration” of a trustee’s appointment, it does not authorize that appointment to extinguish the legal effect of a debtor’s pre-petition conduct. Under the McNamara court’s result (refusal to impute Kesselring’s pre-petition acts to PBI), one must question how the trustee is “more innocent” than PFS, and question how, on the facts presented, PFS was supposed to know about Kesselring’s fraudulent conduct.
Carried to its logical conclusion, the McNamara court’s reasoning suggests that the appointment of a bankruptcy trustee (or a debtor in possession that has new management—like Enron) can alter the operative effect of a defendant’s pre-petition conduct and thereby alter pre-petition defenses. This makes little sense. The trustee’s avoidance powers, including §548, examine pre-petition conduct by a debtor and defendant and determine whether that conduct falls within the statute or within an exception to the statute. A trustee’s rights are all rooted in pre-petition conduct, even if the actual cause of action does not exist until a bankruptcy is filed. To be fair to all participants in a transaction, the trustee’s rights must be circumscribed by that conduct. The trustee’s appointment as a representative of the debtor’s estate should not erase the operative effect of that pre-petition conduct. For avoidance actions, the central question is not what the trustee did—because the trustee did not exist pre-petition—it is what the debtor and the defendant did.
Whether §541 is mentioned in a complaint or not is a red herring. Section 541 merely recognizes that a trustee gets no more and no less than the debtor had. Section 541 does not operate to alter pre-petition conduct by the debtor any more than §548 does. Section 548 does not negate §541. All that §548 does is grant a bankruptcy trustee an additional cause of action. Section 548 examines the pre-petition conduct of the debtor and the defendant and asks if reasonably equivalent value was exchanged. Section 548 conditions avoidance on the transfer of “an interest of the debtor in property” (emphasis added). State law defines that interest, and it often depends upon the debtor’s and defendant’s pre-petition conduct. See Butner v. United States, 440 U.S. 48, 54 (1979). To the point, §548 does not allow a trustee to eliminate, erase, or modify a debtor’s pre-petition conduct that may give rise to a defense to the trustee’s new cause of action. The trustee is a representative of the debtor’s bankruptcy estate and in that capacity, cannot escape the limits of the debtor’s pre-petition conduct or §541 by not mentioning §541 in his complaints or by arguing he is an “innocent successor.” The McNamara court’s failure to recognize this distinction may lead to an inequitable result in all future bankruptcy avoidance adversary proceedings.
*Michael Parker is Board Certified in Business Bankruptcy Law and in Consumer Bankruptcy Law by the Texas Board of Legal Specialization and is a Senior Associate with the law firm of Fulbright & Jaworski L.L.P. Mr. Parker is owned by five children, ages 2 to 10, and secured by a golden band.
Footnotes:
1 All section references herein shall be to title 11 of the United States Code unless otherwise identified. [back to text]2 From PFS’s perspective, there was nothing fraudulent about the loans. PFS had no apparent knowledge or notice of Kesselring’s fraudulent machinations. [back to text]
3 Kesselring’s fraud and the “taint” of that fraud attached pre-petition to the loan, fraudulent or not. The court fails to explain how the post petition appointment of a trustee somehow changes these operative pre-petition facts. [back to text]
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