Imputation of Agent's Knowledge to Transferee in Bankruptcy Avoidance Litigation Defeats Good-Faith Defense
In situations where a bankruptcy court avoids a fraudulent transfer or similar transaction, subsequent transferees who received proceeds of the avoided transaction from the initial transferee can avoid liability in certain circumstances. Specifically, section 550(b)(1) of the Bankruptcy Code provides that the plaintiff in an avoidance action "may not recover" from a subsequent transferee who received proceeds of an avoided transaction "for value …, in good faith, and without knowledge of the voidability of the transfer." 11 U.S.C. § 550(b)(1). What constitutes "knowledge" under the statute is sometimes murky, however, particularly where the subsequent transferee, such as an investor, relied on an agent to make investment-related decisions on the investor's behalf.
The U.S. Court of Appeals for the Fifth Circuit recently examined this question in In re Black Elk Energy Offshore Operations, LLC, 114 F.4th 343 (5th Cir. 2024). The court affirmed lower court rulings that certain investors who received proceeds of an avoided fraudulent transfer from the initial transferee were not protected by the good-faith defense in section 550(b)(1), because the investors' agent was aware of, and participated in, the fraud. The agent's knowledge of the fraud was imputed to the investors, the court determined, even though the agent's conduct was criminal, and even though the investors maintained they had no personal knowledge of the fraud at the time of the transaction.
Good-Faith Defense to Avoidance of Transfers
The Bankruptcy Code gives a bankruptcy trustee or a chapter 11 debtor-in-possession ("DIP") the power to avoid (i.e., invalidate) certain pre- and post-bankruptcy transfers of, or incumbrances on, a debtor's property and to recover such property for the benefit of the debtor's estate and creditors. For example, section 548(a)(1) of the Bankruptcy Code authorizes a trustee or DIP to avoid a "fraudulent transfer," defined as any transfer of an interest of the debtor in property or any obligation incurred by the debtor "on or within 2 years before the date of the filing of the petition" if: (i) the transfer was made, or the obligation was incurred, "with actual intent to hinder, delay, or defraud" any creditor; or (ii) the debtor received "less than a reasonably equivalent value in exchange for such transfer or obligation" and was, among other things, insolvent, undercapitalized, or unable to pay its debts as they come due. 11 U.S.C. § 548(a)(1).
Fraudulent transfers also may be avoided by a trustee or DIP under section 544(b) of the Bankruptcy Code, which provides that "the trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law," i.e., under state law. 11 U.S.C. § 544(b)(1). Section 550(a) of the Bankruptcy Code provides that, after avoidance of a transfer, the trustee may recover the property transferred or its value from the initial transferee (or the entity for whose benefit such transfer was made) or any "immediate or mediate transferee" of the initial transferee (i.e., a subsequent transferee). 11 U.S.C. § 550(a).
However, the Bankruptcy Code includes certain statutory defenses that, in some circumstances, allow an initial or subsequent transferee who received the proceeds of an avoided transfer "in good faith" to avoid or limit the transferee's liability. Section 548(c) of the Bankruptcy Code provides a defense to avoidance of a fraudulent transfer for a "good faith" transferee or obligee who gives value in exchange for the transfer or obligation at issue:
Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.
11 U.S.C. § 548(c). Section 548(c) provides only a partial defense and is most often invoked by an initial transferee—i.e., one who received proceeds of an avoided transfer directly from the debtor—who cannot take advantage of the more robust defense in section 550(b) of the Bankruptcy Code applicable to subsequent transferees, discussed below.
Unlike an initial transferee, a subsequent transferee—i.e., one who received proceeds of an avoided transaction either from the initial transferee or thereafter from another transferee—may assert a complete, albeit narrow, statutory defense upon the avoidance of a fraudulent transfer or similar transaction. Section 550(b) of the Bankruptcy Code provides that the trustee "may not recover" from a subsequent transferee "that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided." 11 U.S.C. § 550(b)(1).
"Good faith" is not defined by the Bankruptcy Code. In determining whether it exists, some courts have applied a two-part analysis, examining: (i) whether the transferee was on "inquiry notice" of suspicious facts amounting to "red flags"; and (ii) if so, whether the transferee reasonably followed up with due diligence to determine whether a transaction may not have been bona fide. See, e.g., Horton v. O'Cheskey (In re Am. Hous. Found.), 544 F. App'x 516, 520 (5th Cir. 2013); Christian Bros. High School Endowment v. Bayou No Leverage Fund LLC (In re Bayou Grp., LLC), 439 B.R. 284, 310-13 (S.D.N.Y. 2010).
In a more recent, and frequently cited, case, the U.S. Court of Appeals for the Second Circuit announced a slightly different standard for analyzing whether good faith was present. In Picard v. Citibank, N.A. (In re Bernard L. Madoff Investment Securities LLC), 12 F.4th 171 (2d Cir. 2021), the Second Circuit articulated a three-step inquiry for reviewing a good-faith defense at the pleading stage under both sections 548(c) and 550(b)(1) of the Bankruptcy Code:
First, a court must examine what facts the defendant knew; this is a subjective inquiry and not "a theory of constructive notice." … Second, a court determines whether these facts put the transferee on inquiry notice of the fraudulent purpose behind a transaction—that is, whether the facts the transferee knew would have led a reasonable person in the transferee's position to conduct further inquiry into a debtor-transferor's possible fraud …. Third, once the court has determined that a transferee had been put on inquiry notice, the court must inquire whether "diligent inquiry [by the transferee] would have discovered the fraudulent purpose" of the transfer.
Id. at 191–92 (citations omitted).
Black Elk Energy
Mark Nordlicht was the founder and chief investment officer of the hedge fund Platinum Partners ("Platinum"). Black Elk, 114 F.4th at 348. Platinum, in turn, was the controlling shareholder of Black Elk Energy Offshore Operations, LLC ("Black Elk"), a Houston-based oil and gas company. Id. Facing a liquidity crisis, in 2013, Black Elk issued preferred equity shares, created a special-purpose entity—Platinum Partners Black Elk Opportunities Fund LLC ("PPBEO")—to purchase them, and solicited Platinum's investors to participate. Id. Two of those investors were Shlomo and Tamar Rechnitz (the "Rechnitzes"), who already held significant equity interests in Platinum. Id. at 349. Platinum offered them a 16% return on their investment, which was more than double the usual return on Platinum funds, and promised to guarantee their principal. Id.
The Rechnitzes invested $10 million in PPBEO. Black Elk, 114 F.3d at 349. In accordance with PPBEO's subscription and operating agreements, another Platinum affiliate—PPBE Holdings—managed by Nordlicht acted as the Rechnitzes' agent. Id. In PPBEO's operating agreement, the Rechnitzes and other investors gave Nordlicht "full power and discretionary authority to act in [PPBEO's] name, place and stead, to make [PPBEO's] investments and execute any trades ancillary to such investments." Id.
Black Elk was insolvent by 2014, prompting Nordlicht, anticipating a Black Elk bankruptcy filing, to set in motion a plan to pay back PPBEO's investors—including the Rechnitzes—rather than paying Black Elk's creditors. Id. As part of that scheme, Platinum installed a new Black Elk chief financial officer, who sold the company's most valuable assets for $125 million. Id. The proceeds were to be used to redeem the preferred stock rather than to pay creditors, including senior bondholders and trade creditors. Id. Nordlicht recognized that, to do so, the bonds would first have to be subordinated to the preferred stock, which would require the consent of a majority of Black Elk's bondholders. Id. To "rig the vote," Nordlicht acquired bonds through affiliates covertly controlled by Platinum, shifted PPBEO's investments from preferred stock to bonds, and convinced the Rechnitzes to do the same. Id. In this way, the necessary threshold for approval of subordination of the bonds to the preferred stock was satisfied. Id.
In August 2014, Black Elk used approximately $77 million of the asset sale proceeds to repurchase the preferred stock held by various Platinum entities. Black Elk, 114 F.4th at 349. Those entities then purchased the Black Elk bonds held by PPBEO, allowing PPBEO to pay its investors. Id. During this process, the sale proceeds were transferred between various Platinum accounts and commingled with $7.2 million of "untainted" funds. Id. In August and September 2014, Nordlicht began paying PPBEO's investors, including the Rechnitzes, who received more than $267,000 in interest payments as well as their $10 million principal. Id.
Black Elk filed for chapter 11 protection on July 25, 2016, in the Southern District of Texas. Id. at 350. It proposed a liquidating chapter 11 plan that established a litigation trust. Id. In 2019, the same year a federal jury convicted Nordlicht of securities fraud in connection with the PPBEO transactions, the litigation trustee commenced an adversary proceeding seeking avoidance and recovery of the asset sale proceeds paid to the Rechnitzes as a fraudulent transfer under sections 544, 548(a)(1), and 550(a) of the Bankruptcy Code. Id. Bankruptcy Judge Marvin Isgur ruled that Black Elk's transfer of approximately $77 million to various Platinum entities and, ultimately, to shareholders constituted an actual fraudulent transfer and granted summary judgment on the litigation trustee's claim to avoid the transaction as a whole. Schmidt v. Nordlicht (In re Black Elk Energy Offshore Ops., LLC), 649 B.R. 249, 254 (Bankr. S.D. Tex. 2023).
The bankruptcy court then considered the Rechnitzes' liability under section 550(a) of the Bankruptcy Code. It ultimately awarded the trustee partial summary judgment, ruling that the Rechnitzes could not rely on the good-faith transferee defense in section 550(b)(1) of the Bankruptcy Code because Nordlicht acted as the Rechnitzes' authorized sub-agent, and his knowledge of the fraudulent scheme was imputed to them. Id. at 263. Adopting its own tracing methodology, the bankruptcy court later held that the $10.3 million transferred by PPBEO to the Rechnitzes was traceable to the asset sale and related fraud, and thus was fully recoverable. Black Elk, 114 F.4th at 350.
The trustee and the Rechnitzes jointly sought a direct appeal of the ruling to the Fifth Circuit, which granted the request.
The Fifth Circuit's Ruling
A three-judge panel of the Fifth Circuit affirmed the bankruptcy court's decision.
On appeal, the Rechnitzes argued, among other things, that they should not be liable for the proceeds they received as a result of fraudulent transfer, because: (i) they were good-faith subsequent transferees within the meaning of section 550(b)(1) of the Bankruptcy Code and their agent Nordlicht's knowledge of the fraud should not be imputed to them; (ii) the trustee was required to, but did not, prove that they personally knew about Nordlicht's wrongdoing because section 550(b)(1) uses the word "knowledge" and does not mention imputed or constructive knowledge; and (iii) even if section 550(b)(1) allows such imputation, Nordlicht acted outside the scope of his authority as agent, and the Rechnitzes should consequently not be charged with his knowledge of the fraud. Black Elk, 114 F.4th at 353, 355. The Fifth Circuit rejected each of these arguments.
Judge Duncan explained that the Rechnitzes' arguments were flawed because they overlooked the basic premise that the Bankruptcy Code's provisions governing the avoidance and recovery of fraudulent transfers incorporate common law principles, including the common law tradition that a principal generally is liable for fraud committed by his or her agent acting within the scope of the agent's authority. Id. at 353.. According to Judge Duncan, "this traditional linkage between principal and agent is not severed" merely because section 550(b)(1) of the Bankruptcy Code uses the term "knowledge," as "Congress legislates against [the] backdrop of [such] common-law adjudicatory principles, and it expects those principles to apply except when a statutory purpose to the contrary is evident," which was not the case here. Id. (citations and internal quotation marks omitted). He also observed that "cases—concerning both fraudulent conveyance and bankruptcy—routinely treat principal-transferees as being on inquiry notice based on their agents' knowledge." Id. at 354 (footnote omitted).
The Fifth Circuit panel concluded that Nordlicht acted within the scope of the authority conferred upon him in PPBEO's operating agreement. According to Judge Duncan, "Nordlicht's actions were all directly related to that authority" and, considering the circumstances, all of Nordlicht misdeeds were foreseeable. Id. at 355. He explained that cases relied on by the Rechnitzes in which a principal was not found liable for its agent's criminal acts were distinguishable because, unlike this case, they "involved radical detours from the agent's duties." Id. at 356. In this case, Judge Duncan emphasized, "Nordlicht defrauded Black Elk's creditors—to the Rechnitzes' benefit—by manipulating the very PPBEO investment the Rechnitzes had authorized him to manage." Id.
Finally, Fifth Circuit panel held that the bankruptcy court committed no error in employing equitable tracing principles to identify the sale proceeds among commingled funds. According to Judge Duncan, the bankruptcy court's decision not to rely on tracing reports offered by the parties' experts in favor of a "lowest intermediate balance" approach assuming that, "when tainted and untainted funds are commingled, the tainted funds are used first," was well within its discretion. Id. at 358 (emphasis in original; citation omitted).
Outlook
The Fifth Circuit's ruling in Black Elk provides useful guidance concerning the parameters of the good-faith defense to the recovery of proceeds from an avoided transfer under section 550(b)(1) of the Bankruptcy Code. Notably, the Fifth Circuit reaffirmed the conventional understanding that an agent's knowledge and actions—even if criminal—are imputed to its principal under applicable non-bankruptcy law, unless those actions were taken beyond the scope of the agent's authority. The court also emphasized that lawmakers premised section 550(b)(1) upon that common law principle, rather than creating a different standard for holding a principal accountable for the actions of its agent.
Although it is not the focus of this article, the Fifth Circuit made some interesting observations in Black Elk concerning the Rechnitzes' standing under the "person aggrieved" standard, applied in the Fifth Circuit, to appeal orders the bankruptcy court entered extending the duration of the litigation trust established under Black Elk's liquidating chapter 11 plan. Under this standard, only persons "directly, adversely, and financially impacted by a bankruptcy court order may appeal it." Furlough v. Cage (In re Technicool Sys., Inc.), 896 F.3d 382, 384 (5th Cir. 2018).
In Black Elk, the Fifth Circuit observed in a footnote that the person aggrieved standard "may be incompatible with the Supreme Court's decision in [Lexmark Int'l, Inc. v. Static Control Components, Inc., 572 U.S. 118 (2014)], which cast doubt on the role of prudential standing rules in federal courts" as being incompatible with "constitutional" standing principles traditionally applied by non-bankruptcy federal courts, which is broader than standing to appeal a bankruptcy court order. Id. at 351 n.4 (internal quotation marks omitted). However, because the Rechnitzes never argued that the person aggrieved standard should not apply, the Fifth Circuit declined to address the issue. Id.
