Under the Bankruptcy Code, not only can the initial recipient of a fraudulent conveyance be held liable, but so too can a subsequent transferee. However, there can be important nuances in the challenged transaction that may provide a subsequent transferee with a substantial defense. One of those nuances was recently identified by the U.S. Court of Appeals for the Tenth Circuit, which highlighted the difference between the receipt of the asset which was fraudulently conveyed and the proceeds of such asset. See Rajala v. Spencer Fane (In re Generation Resources Holding), 2020 U.S. App. LEXIS 21454 (10th Cir. July 10, 2020).

Pre-petition, debtor Generation Resources Holding Co., LLC entered into development agreements for three wind power projects with Edison Capital, under which agreements Generation was the sole developer. Several months later, insiders of Generation created two new LLCs—LWHC and FWHC—and revised the development agreements so that the project developers were changed from Generation to LWHC and FWHC, respectively.  The revised development agreements had the effect of transferring Generation's right to receive substantial payments under the agreements to LWHC and FWHC.

Years later, but after Generation filed for Chapter 7 bankruptcy, LWHC demanded payment from Edison. Although Edison paid, it unilaterally reduced the amount from $10.5 million to $5.5 million. In response, LWHC hired Husch Blackwell to bring suit against Edison for the remaining balance. Although LWHC prevailed in its action against Edison, the court ordered Edison to pay the $9 million judgment into the court pending judgment from the bankruptcy court as to whether the $9 million was property of LWHC or of the bankrupt Generation estate.

Back in the bankruptcy court, the law firm of Spencer Fane (collectively with Husch Blackwell, the firms) was retained to represent LWHC, FWHC, and insiders of Generation. The bankruptcy court ultimately held that the $9 million judgment was not estate property because the chapter 7 trustee had not yet prevailed on a fraudulent transfer claim. The bankruptcy court determined that if the trustee later prevailed on a fraudulent transfer claim, then the trustee's remedy would be to avoid the fraudulent transfer. Based on this ruling, the $9 million was released from the court into a LWHC bank account and, from there, amounts were paid to the firms.

Generation's Chapter 7 trustee then filed fraudulent transfer suits against Generation's insiders, LWHC, and FWHC. The parties ultimately negotiated a settlement that was formalized through a consent judgment, whereby the transfers of Generation's contractual property interests in the projects to LWHC and FWHC were avoided and the trustee was authorized, among other things, to recover over $9 million from LWHC. The trustee was unable to recover any funds from LWHC and, thus, filed suit against the firms under Section 550 of the Bankruptcy Code to recover over $2 million in proceeds of the LWHC fraudulent transfer. The bankruptcy court denied the firms' motions to dismiss, finding that the firms were transferees of the proceeds from LWHC's fraudulent transfer as provided for in the consent judgment. The bankruptcy court certified its order denying the motions to dismiss, and the Tenth Circuit agreed to hear the interlocutory appeal.

The question on appeal was whether, under Section 550 of the Bankruptcy Code, the trustee could recover proceeds of the avoided fraudulent transfer from the firms. The Tenth Circuit ultimately held that the firms were not "transferees" as used in Section 550, such that the trustee could not recover any amounts from the firms.

To state a claim under Section 550, the Tenth Circuit provided that three requirements must be satisfied: the claim must relate to a transfer avoided under the Bankruptcy Code; the claim must plausibly allege that the recovery is of "the property transferred" or "the value of such property" as required by the plain language of Section 550(a); and the claim must plausibly allege that the defendant is the "the initial transferee," "the entity for whose benefit such transfer was made," or "any immediate or mediate transferee of such initial transferee" as required by Section 550(a).

The Tenth Circuit first evaluated "the property transferred" with respect to the avoided fraudulent transfer at issue, which was the transfer between the debtor Generation and LWHC as set forth in the consent judgement. The Tenth Circuit determined that the property transferred (as set forth in the trustee's complaint against LWHC) was the debtor Generation's "right and interest to be paid the project sales proceeds."

Next, to determine whether the firms were "immediate or mediate transferees," the Tenth Circuit noted that it first needed to determine the initial transferee.  The Tenth Circuit found that the initial transferee was LWHC when the insiders substituted LWHC for Generation as the project developer and LWHC became the designated recipient of the project proceeds. Thus, the Firms could only be "immediate or mediate transferees" of the "property transferred" under Section 550 if the firms received the same property transferred to LWHC. Importantly, the Tenth Circuit held that the firms were not subsequent transferees under Section 550 because the firms never received the "property transferred," which was the contractual right to receive the project sales proceeds.

The trustee argued that LWHC was paid funds by Edison in satisfaction of its contractual right to the project sales proceeds and that some of those funds were transferred to the firms. The Tenth Circuit, however, determined that the funds paid to the firms were distinct from the "property transferred" as part of the avoided transfer—which was solely the contractual rights to the sales proceeds, not proceeds from the contractual rights. Because the firms never received the contractual rights to the project sale proceeds, they were not transferees who could be recovered from under Section 550.

Additionally, to the extent the trustee's argument was that cash proceeds of avoided transfers are always part of the "property transferred" under Section 550 because "proceeds" are part of the bankruptcy estate under Section 541, the Tenth Circuit determined that Section 541 does not expand which parties may be recovered against by the trustee under Section 550; Section 541, in describing estate property, separately lists "any interest in property … recovered under Section … 550" from "proceeds … of or from property of the estate," indicating that these types of property are separate and distinct; and Section 541 shows that Congress knew how to include proceeds when it wanted to, such that the exclusion of proceeds from Section 550 was purposeful. Thus, the Tenth Circuit held that "property transferred" as related to an avoided transfer under Section 550 of the Bankruptcy Code does not include "proceeds of the property transferred."

The Tenth Circuit's decision highlights the critical need to parse out code language carefully as the court did in highlighting the difference between Sections 541 and 550. Undoubtedly, this decision may surprise practitioners at first glance, but upon reflection makes sense. It may also be instructional for those filing fraudulent conveyance actions to make sure that if there are subsequent transferees that the transfer initially sought to be clawed back is defined as broadly as possible to pick up subsequent transfers that might involve proceeds.

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States.

Marcy J. McLaughlin Smith is an associate in the corporate restructuring and bankruptcy practice group of the firm, resident in the Wilmington office.