Under certain situations, a bankruptcy trustee may try to recover transfers made by a debtor to creditors before the filing of his case.  These types of conveyances are termed “fraudulent conveyances.”  But does an innocent transferee, who had no knowledge of a debtor’s coming bankruptcy, have any way to prevent a trustee from recovering this kind of a transfer?  Under Section 548( c) of the Bankruptcy Code, a transferee can have an affirmative defense in such a situation.

The transferee (who bears the burden of proof in this situation) would have to demonstrate that he received the transfer “for value” and “in good faith.”  When cash payments are involved, the “for value” element is easily met.  But what does “good faith” mean for a transferee?   Case law over the years has laid down some broad principles for ascertaining “good faith” in the context of Section 548(c ).  To simplify things, courts will essentially ask if the transferee (the person who received the money) knew or should have known that the transfer was made to them (1) when the debtor was insolvent; or (2) with a fraudulent purpose.

When probing into the issue of whether a transferee “should have known” about a debtor’s fraudulent plans, the Court will basically look to the existence of any “badges of fraud” or “red flags” that might have given some indication of something being amiss.  A transferee cannot simply close his eyes to what simple inquiry might have revealed.

In a recent Fourth Circuit case, In Re Taneja (4^th Circuit, Feb. 21, 2014), the court held that the appropriate standard of good faith in the section 548(c) context is whether the “transferee actually was aware or should have been aware, at the time of the transfers and in accordance with routine business practices, that the transferor-debtor intended to hinder, delay, or defraud any entity to which the debtor was or became . . . indebted.”

In the Taneja case, there were very large transfers that had been made by an insolvent mortgage company to a Tennessee bank before the mortgage company filed for bankruptcy.  The trustee for the mortgage company sought to avoid some of the large transfers made to the Tennessee bank as fraudulent transfers under Section 548( a) of the Bankruptcy Code.

The bankruptcy court in the Taneja case found that the transfers made to the Tennessee bank were made for value and in good faith, and so could not be avoided by a trustee under Section 548 (a).  The court essentially applied a subjective test to evaluate whether the bank should have known that the mortgage company’s payments were fraudulent.

The bank’s witnesses offered testimony that the bank had acted reasonably and properly based on the information they received.  A truly objective test would have been for the court to ask whether the bank’s actions were reasonable based on a comparison with all other types of similar lenders.  In other words, the court applied a subjective standard, rather than an objective one.

And a subjective standard is much more lenient.  All the bank had to show was that it had acted “reasonably” based on the information it was getting.  The bank never really had to prove that its practices conformed to good industry standards, or that its responses to the mortgage company’s communications were truly reasonable considering prevailing industry practices.

This ruling is not in keeping with the usual objective test used to evaluate Section 548 transfer issues.  However, it does seem to follow the depressingly familiar pattern that has been observed since the onset of the financial crisis in 2009:  big institutional lenders and mortgage companies are, in practice, not being held accountable for much of the conduct that created the financial crisis in the first place.

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