11 USC 550: Liability of Transferee of Avoided Transfer

When a company or individual files for bankruptcy, a trustee is appointed to manage the debtor’s financial affairs and maximize the assets available to repay creditors. To achieve this, the U.S. Bankruptcy Code grants the trustee “avoidance powers,” allowing them to reverse certain transactions the debtor made before filing for bankruptcy. This process helps ensure a fair distribution of assets by preventing debtors from unfairly favoring certain creditors or hiding property.

After a trustee successfully “avoids” a transfer, a separate action is needed to reclaim the property or its value. This next step is governed by Section 550 of the Bankruptcy Code, which authorizes the trustee to recover the asset from whoever received it, creating a legal obligation for its return.

The Trustee’s Authority to Reclaim Assets

Before a trustee can recover property, they must first establish that a transfer is voidable under other parts of the Bankruptcy Code. Two common grounds for avoidance are preferential and fraudulent transfers.

A preferential transfer, governed by Section 547, occurs when a debtor pays a creditor shortly before filing for bankruptcy, giving that creditor more than they would have received in a Chapter 7 liquidation. The look-back period for these transfers is 90 days before the bankruptcy filing, but it extends to one year if the payment was made to an “insider,” such as a relative or director of the debtor. For example, if a struggling business pays a supplier’s old invoice in full just weeks before filing for bankruptcy while other suppliers remain unpaid, the trustee may seek to avoid that payment.

A fraudulent transfer, covered by Section 548, involves a transaction made within two years before the bankruptcy filing with the intent to deceive creditors or one where the debtor received less than reasonably equivalent value in return. An example would be a debtor selling valuable equipment to a relative for a fraction of its worth. Once a court agrees that a transfer was either preferential or fraudulent, the trustee has the legal authority to pursue the person who received the asset and compel its return.

Parties Subject to Recovery Actions

The Bankruptcy Code specifies the parties from whom a trustee can recover an avoided transfer. The law targets not only the first person to receive the property but also those who may have received it later. This structure is designed to prevent assets from being shielded simply by passing them through multiple hands.

Initial Transferees and Beneficiaries

The trustee’s first target for recovery is the “initial transferee,” which is the first party to receive the property directly from the debtor. For instance, if a debtor makes a $50,000 payment that is later deemed preferential, the company that received the check is the initial transferee. The law imposes strict liability on this party, meaning their good faith or lack of knowledge about the debtor’s financial situation is not a defense.

The trustee can also recover from the “entity for whose benefit such transfer was made.” This party may not have directly received the property but gained a financial advantage from the transaction. A common example involves a loan guarantee. If a company’s owner personally guarantees a corporate loan and the company pays off that loan just before bankruptcy, the owner benefits because their personal guarantee is extinguished. The trustee could seek recovery from the owner as the beneficiary, even though the bank was the initial transferee.

Subsequent Transferees

Recovery actions can extend beyond the initial transaction to “immediate or mediate transferees,” often called subsequent transferees. These are parties who receive the property from the initial transferee or from another subsequent transferee down the line. This provision allows the trustee to follow the asset as it changes hands.

Consider a situation where a debtor fraudulently transfers a classic car to Person A, the initial transferee. If Person A then sells the car to Person B, Person B becomes an immediate transferee. Should Person B later gift the car to Person C, Person C would be a mediate transferee. The trustee has the authority to pursue recovery from Person B or Person C, subject to certain defenses.

Statutory Protections for Transferees

While the trustee’s power to recover assets is broad, the law provides a safe harbor for certain subsequent transferees. This protection is not available to the initial transferee, who faces strict liability. To be shielded from a recovery action, a subsequent transferee must prove they meet three specific conditions.

The first condition is that the subsequent transferee must have taken the property “for value.” This means the transferee provided something of reasonably equivalent worth in exchange for the asset. The value can include the satisfaction of a pre-existing debt, but it must be a fair exchange. For example, paying $250,000 for a property with a fair market value of $260,000 would likely be considered “for value,” whereas paying only $50,000 for the same property would not.

The second requirement is that the transferee must have acted “in good faith.” Courts apply an objective standard of “inquiry notice,” which assesses whether a transferee knew or should have known that the original transfer was potentially improper based on the circumstances. If there were “red flags” that would lead a reasonable person to investigate, the transferee may be deemed to have lacked good faith.

The final condition is that the transferee must have been “without knowledge of the voidability of the transfer avoided.” This means the person receiving the property had no actual or constructive knowledge that the original transfer from the debtor was improper. A transferee who fails the “good faith” test by ignoring red flags would also fail this condition. A subsequent transferee must satisfy all three of these elements to prevent the trustee from reclaiming the asset.

Scope and Form of Recovery

When a trustee successfully pursues a recovery action, the law provides flexibility in what can be reclaimed for the bankruptcy estate to make it whole. A court can order the return of the specific property that was transferred or, alternatively, order the payment of its value. The choice between returning the property itself or its monetary equivalent is at the court’s discretion. If the value is recovered, it is assessed as of the date the transfer occurred, preventing the estate from being harmed by depreciation or benefiting from appreciation.

The code also enforces a “single satisfaction” rule. This means that even if multiple parties are liable for the same avoided transfer, the trustee is entitled to only one full recovery of the property’s value. For example, if a $100,000 fraudulent transfer was made, the trustee can sue both the initial and subsequent recipients, but the total amount collected for the estate cannot exceed $100,000.

Finally, a measure of protection is provided for a good-faith transferee who is nonetheless subject to a recovery action. If such a transferee made improvements to the property after receiving it, they are granted a lien on the property. The lien is for the lesser of the cost of the improvements or the increase in the property’s value. For instance, if a transferee unknowingly buys a house from a voidable transfer and spends $40,000 on a new kitchen that increases the home’s value by $35,000, they would be entitled to a $35,000 lien if the trustee recovers the property.