The Importance of State Laws and the Evidentiary Record in Fraudulent Transfer Analysis

September 24, 2021

By Emily M. McAdam

A recent case out of the Bankruptcy Court for the Eastern District of New York—Mendelsohn v. Roslyn, Dkt. No. 22, Adv. Proc. No. 8-20-08012-reg (Bankr. E.D.N.Y. June 21, 2021) (Grossman, J.)—imparts important lessons for pleading and proving fraudulent transfer claims. The case involved a joint bank account of a debtor-husband and his non-debtor wife and whether the trustee could recover expenditures from that account as fraudulent transfers. The parties opted to forgo an evidentiary hearing, instead relying on written submissions and a handful of deposition transcripts. That sparse evidentiary record set forth the following: A debtor-husband and his non-debtor wife maintained a joint bank account into which each deposited all of their income. The wife maintained primary control of the account; most of the checks were signed in her name and there was no evidence that her husband controlled how she spent funds from the account. The expenditures from the account included, among other things, approximately $90,000 in rent payments over the course of five years for an apartment in which the wife’s sister lived and for which the wife was a co-signor on the lease. Deposition testimony indicated that the wife—who never occupied the apartment, although she had the right to under the lease—received rent payments from her sister, deposited those payments into the joint account, and then wrote rent checks to the landlord from the joint account.

After the husband filed for bankruptcy, the trustee brought an adversary proceeding against the landlord seeking to recover the rent paid from the joint account as fraudulent transfers under New York state law and § 548 of the Bankruptcy Code. Because the trustee had previously settled an adversary proceeding with the wife, thereby releasing any and all claims against her arising on or before the date of the settlement, the trustee could not sue the wife as the recipient of fraudulent transfers. Rather, the trustee argued that the rent payments to the defendant-landlord were avoidable because they came from the joint account between the debtor and his wife, and the debtor received no consideration in return. The Court disagreed, noting that the case “highlights that parties relying on the federal bankruptcy statues must be cognizant of the effect applicable state law may have on the relief requested.”

First, the Court looked to the nature of the funds within the joint account. The Court noted that whether the wife was the initial transferee under § 550 was of critical importance because it would determine whether the defendant-landlord was potentially protected under § 550(b)(1). Under New York law, the husband and wife were presumed to be joint tenants over the account and each held a possessory interest in the whole account. New York law also presumed that a person depositing money into a joint account makes an irrevocable gift to the other joint account holder of half the funds, giving each a present unconditional property interest in an undivided one half of the money deposited. Thus, when the husband deposited money into the joint account, his wife became the initial transferee of the half that was irrevocably gifted to her. As to the remaining half, which constituted the debtor’s property, the Court analyzed whether the wife exercised dominion and control over the funds or whether she was a mere conduit. The Court held, based on the fact that the wife had free reign to write checks from the account and there was no evidence that the husband controlled her expenditures, that she was not a mere conduit of the funds. Thus, as to any checks the wife wrote that drew from the husband’s half of the joint account, the wife was the initial transferee of those funds as well.

Next the Court looked to whether the trustee was required to avoid the transfers between the husband and wife before it could seek recovery from the defendant-landlords as subsequent transferees. Under § 550(a), the trustee may recover from a subsequent transferee if the initial “transfer is avoided.” The defendant-landlord argued that this initial avoidance was required, and that the trustee could not do so because of the settlement with the wife releasing all claims against her. The court rejected this argument and agreed with the majority of courts to hold that § 550(a) only requires a showing that the initial transfer is avoidable.

Despite not succeeding on its § 550(a) argument, the defendant-landlord still found protection under § 550(b)(1), which shields subsequent transferees from liability if they received the transfer in good faith, for value and without knowledge that the transfers could be avoided by the trustee. With regard to value, although the wife did not reside in the apartment in exchange for providing rent payments, she had a right to do so and the Court thus held that the defendant-landlord provided value to her. The Court also determined that, based on the record before it, there was no evidence that the defendant-landlord was on inquiry notice about the husband’s insolvency, nor that the defendant-landlord had knowledge that the transfer might be avoidable. The defendant-landlord, therefore, met the test under § 550(b)(1) and the trustee could not recover the rent payments.

Finally, although having already found that § 550(b)(1) protected the defendant-landlord, the Court went on to note that the trustee also failed to carry its burden in showing that the initial transfers from the debtor to his wife were avoidable on theories of either actual or constructive fraud. Even with certain presumptions falling in its favor, the Court—after first noting the sparse evidentiary record on which the trustee chose to rely—determined that the trustee failed to establish that any transfers of property were made from the debtor-husband’s estate. This is because the trustee did not present any evidence to support its contention that the transfers came from the debtor-husband’s half of the joint account as opposed to the wife’s half of the account. The Court ultimately entered judgment in favor of the defendant-landlord.

As the Court noted early in its opinion, this case indeed highlights the importance of recognizing how state law will play into a fraudulent transfer analysis. Not only that, it also illustrates that establishing an adequate evidentiary record is just as important in helping the court get to where you’re hoping it will go.

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