Opinion ID: 718704
Heading Depth: 2
Heading Rank: 1

Heading: The objective standard for determining good faith is

Text: 17 proper under 11 U.S.C. § 548(c). 18 Mr. McKay first argues that the bankruptcy and district courts erred in concluding that he did not receive the transfers from M & L in good faith and in thereby rejecting his defense to the trustee's § 548 claims. He maintains that both courts erroneously applied an objective standard of good faith, under which if the circumstances would place a reasonable person on inquiry of a debtor's fraudulent purpose, and a diligent inquiry would have discovered the fraudulent purpose, then the transfer is fraudulent. Jobin, 164 B.R. at 661 (quoting Hayes v. Palm Seedlings Partners-A (In re Agric. Research & Technology Group, Inc.), 916 F.2d 528, 536 (9th Cir.1990)). According to Mr. McKay, the proper measure of good faith under § 548(c) is subjective--a transferee does not lack 'good faith' unless he has some actual knowledge of the fraud. Aplt. Brief at 26. This argument raises a legal question regarding the proper interpretation of the Bankruptcy Code and is therefore subject to de novo review. See Dalton Dev. Project v. Unsecured Creditors Comm. (In re Unioil), 948 F.2d 678, 681 (10th Cir.1991) (Although [a] bankruptcy court's factual determinations will not be disturbed on appeal absent the most cogent reasons appearing in the record, conclusions of law may be reviewed de novo. (internal quotation and citation omitted)). 19 We begin our analysis with the language of the Bankruptcy Code. Section 548(a)(1) provides that the trustee may avoid transfers of the debtor's property made within one year before the filing of the bankruptcy petition if the debtor made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became ... indebted. Section 548(a)(2) authorizes the trustee to avoid transfers on somewhat different grounds. If the debtor received less than reasonably equivalent value in exchange for a transfer of the debtor's property, the trustee may avoid the transfer if several additional elements are established. 11 U.S.C. § 548(a)(2). 3 20 Section 548(c) provides a defense for individuals to whom the debtor's property is transferred: 21 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. 22 11 U.S.C. § 548(c) (emphasis supplied). 23 As the parties note, the Bankruptcy Code does not define good faith. Likewise, the legislative history related to section 548(c) never defines, and scarcely addresses, good faith. In re Telesphere Communications, Inc., 179 B.R. 544, 557 n. 20. (Bankr.N.D.Ill.1994) (citing S.Rep. No. 989, 95th Cong., 2d Sess. 89-90 (1978), H.R.Rep. No. 595, 95th Cong., 1st Sess. 375 (1977)). As a result, courts applying § 548(c) have generally refused to formulate precise definitions. See, e.g., In re Agric. Research & Technology Group, 916 F.2d at 536 (Courts have been candid in acknowledging that good faith 'is not susceptible of precise definition.' ) (quoting Consove v. Cohen (In re Roco Corp.), 701 F.2d 978, 984 (1st Cir.1983)); In re Telesphere, 179 B.R. at 557 (noting that there is no clear source of interpretive guidance in construing the term). In analyzing § 548(c), one leading commentator has concluded that [t]he unpredictable circumstances in which the courts may find its presence or absence render any definition of 'good faith' inadequate, if not unwise. 4 Collier on Bankruptcy p 548.07 at 548-72 (Lawrence P. King ed., 15th ed.1996). 24 Nevertheless, contrary to Mr. McKay's contention, good faith has frequently been construed to include an objective component. After noting that [g]ood faith is an intangible and abstract quantity with no technical meaning, Black's Law Dictionary states that the term includes not only honest belief, the absence of malice and the absence of design to defraud or to seek an unconscionable advantage but also freedom from knowledge of circumstances which ought to put the holder on inquiry. Black's Law Dictionary at 693 (6th ed.1990) (emphasis supplied). Prominent bankruptcy scholars agree: [T]he presence of any circumstance placing the transferee on inquiry as to the financial condition of the transferor may be a contributing factor in depriving the former of any claim to good faith unless investigation actually disclosed no reason to suspect financial embarrassment. 4 Collier on Bankruptcy, supra, p 548.07 at 548-73. 25 The Eighth Circuit has recently followed this objective approach in determining good faith under § 548(c), holding that a transferee does not act in good faith when he has sufficient knowledge to place him on inquiry notice of the debtor's possible insolvency. See Brown v. Third Nat. Bank (In re Sherman), 67 F.3d 1348, 1355 (8th Cir.1995) (citing Armstrong v. Ketterling (In re Anchorage Marina, Inc.), 93 B.R. 686, 693 (Bankr.D.N.D.1988); 4 Collier on Bankruptcy, supra, p 548.07 at 548-72 to 73). The Sherman court concluded that the transferee's knowledge of the debtors' substantial debts, of their delinquent mortgage payments, of a bank's plan to file foreclosure proceedings against them, and of a pending lawsuit placed the transferee on inquiry notice that the transfer of the debtors' property was not made in good faith under § 548(c). 67 F.3d at 1355-56. Similarly, in In re Agric. Research & Technology Group, the Ninth Circuit relied on several Supreme Court decisions construing good faith in other contexts to conclude that courts look to what the transferee objectively 'knew or should have known' in questions of good faith, rather than examining what the transferee actually knew from a subjective standpoint. 4 Significantly, the majority of bankruptcy courts construing good faith, as it is used in § 548(c), have followed the Eighth and Ninth Circuits, holding that a transferee who reasonably should have known of a debtor's insolvency or of the fraudulent intent underlying the transfer is not entitled to the § 548(c) good faith defense. See, e.g., In re Anchorage Marina, 93 B.R. at 693; Walker v. Littleton (In re Littleton), 82 B.R. 640, 644 (Bankr.S.D.Ga.1988), rev'd on other grounds, 888 F.2d 90 (11th Cir.1989); Williams v. Kidder Skis Int'l (In re Fitzpatrick), 73 B.R. 655, 658 (Bankr.W.D.Mo.), aff'd in part and rev'd in part, 60 B.R. 808 (W.D.Mo.1985); In re Polar Chips Int'l, 18 B.R. at 484. 26 In arguing that these decisions should not be followed and that good faith should be measured subjectively, Mr. McKay invokes this circuit's decision in Richards v. Platte Valley Bank, 866 F.2d 1576 (10th Cir.1989), two Fourth Circuit decisions, the analysis of several bankruptcy courts, and the definitions of good faith under the Uniform Commercial Code and various state laws concerning fraudulent conveyances. However, none of these authorities establishes that the objective measure of good faith applied by the bankruptcy and district courts is improper. 27 In Richards, we construed a provision of Colorado's version of the Uniform Fiduciaries Act, Colo.Rev.Stat. § 15-1-109, that imposed liability on banks paying checks written by fiduciaries when paying the check amounts to bad faith. Richards, 866 F.2d at 1579 n. 2 (quoting Colo.Rev.Stat. § 15-1-109). We observed that although the statute did not define bad faith, it defined good faith as a thing done 'honestly, whether it be done negligently or not.'  Id. at 1582 (quoting Uniform Fiduciaries Act, § 1(2), 7A U.L.A. 396 (1985)). We considered that definition in concluding that, under the Colorado statute, the mere failure to make inquiry, even though there are suspicious circumstances, does not constitute bad faith--unless the facts and circumstances are so cogent and obvious that to remain passive would amount to deliberate desire to evade knowledge because of a belief or fear that inquiry would disclose a defect in the transaction. Id. at 1583 (citations omitted). 28 Richards clearly does not address the circumstances now before us in this adversary proceeding under the Bankruptcy Code. As noted above, unlike the Uniform Fiduciaries Act, § 548(c) of the Bankruptcy Code does not define good faith in terms of knowledge and does not expressly exclude consideration of negligence. Moreover, the Richards decision is based in part on consideration of the purpose of the Uniform Fiduciary Act--the need for uniform rules to take the place of diverse and conflicting rules that had grown up concerning constructive notice of breach of fiduciary obligations in order that commerce might proceed with as little hindrance as possible. Id. (quoting Union Bank & Trust Co. v. Girard Trust Co., 307 Pa. 488, 161 A. 865, 870 (1932)). In the instant case--in which a bankruptcy trustee seeks to recover assets for the benefit of all creditors of a Ponzi scheme--the need for a good faith standard that removes hindrances to commerce is not the paramount concern that it was in Richards. See Gill v. Winn (In re Perma Pac. Properties, Inc.), 983 F.2d 964, 968 (10th Cir.1992) (It is the ultimate aim of the preference law in the Bankruptcy Code to insure that all creditors receive an equal distribution from the available assets of the debtor.). 29 As to the other authorities on which Mr. McKay relies, we agree with the district court that none of them expressly addresses the issue of whether the determination of good faith under § 548(c) has an objective component. See Jobin, 164 B.R. at 661-62. Smith v. Mixon, 788 F.2d 229 (4th Cir.1986), the more recent of the Fourth Circuit cases that Mr. McKay cites, interprets a provision of the Bankruptcy Code, 11 U.S.C. § 550(b)(1), which establishes a defense to a trustee's avoidance actions under 11 U.S.C. § 550(a)(2) for any immediate or mediate transferee of such initial transferee. Section 550(b)(1) provides that the trustee may not recover from these transferees if they take for value ... in good faith, and without knowledge of the voidability of the transfer avoided. 11 U.S.C. § 550(b)(1) (emphasis supplied). In construing this section, the Smith court focused on the use of the term knowledge and concluded that that term referred to actual notice and not constructive notice. Smith, 788 F.2d at 232. In this case, because Mr. McKay received the disputed funds directly from the debtor, M & L, he was not an immediate or mediate transferee of [an] initial transferee, 11 U.S.C. § 550(b)(1). The reasoning of Smith is therefore inapplicable. 30 The earlier Fourth Circuit decision on which Mr. McKay relies, Gilmer v. Woodson, 332 F.2d 541 (4th Cir.), cert. denied, 379 U.S. 834, 85 S.Ct. 67, 13 L.Ed.2d 42 (1964), is also based on a statute not at issue here--section 67(d)(2) of the Bankruptcy Act. Construing that section, the Gilmer court stated that good faith cannot be said to be lacking unless the transferee knowingly participated in the debtor-transferor's purpose to defeat other creditors or lacked good faith in valuing the property exchanged. Gilmer, 332 F.2d at 547. However, the court did not expressly hold that good faith must always be subjectively measured under section 67(d) of the Bankruptcy Act. Moreover, in reversing the district court's finding of a lack of good faith, the Gilmer court considered several objective factors--the value of the antecedent debt and the value of the security received. See id. Therefore, Gilmer also does not establish that good faith under § 548(c) must be measured subjectively. 31 As to the decisions of bankruptcy courts, Mr. McKay relies primarily on Merrill v. Abbott (In re Indep. Clearing House Co.), 77 B.R. 843 (D.Utah 1987), and Practical Inv. Corp. v. Rellen (In re Practical Inv. Corp.), 95 B.R. 935 (Bankr.E.D.Va.1989). However, as the district court noted, neither case held that good faith under § 548(c) must always be measured subjectively. In particular, although at one point the Independent Clearing House court referred to good faith as a subjective question, 77 B.R. at 862, the court also noted that the presence of circumstances placing the transferee on inquiry as to the debtor's insolvency may deprive him of the good faith defense, id. (citing 4 Collier on Bankruptcy, supra, p 548.07 at 548- ). Moreover, the Independent Clearing House court explained (albeit in a mixed anatomical metaphor) the determination of good faith in a manner that emphasized objective factors: The test is whether the transaction in question bears the earmarks of an arm's length bargain. Id. Similarly, in In re Practical Investment, the court focused on the particular facts before it in concluding that a transferee was entitled to the good faith defense and did not expressly hold that a subjective test was required. 95 B.R. at 942-45. 32 Finally, we are not persuaded by Mr. McKay's argument that the definitions of good faith under the Uniform Commercial Code and state fraudulent conveyance laws should be adopted in interpreting § 548(c). Many of these provisions contain language different than the language used in § 548(c) and, like the Uniform Fiduciaries Act, which we considered in Richards, 866 F.2d at 1583, involve policy concerns not applicable here. See, e.g., Territorial Sav. & Loan Ass'n v. Baird, 781 P.2d 452, 461 (Utah App.1989) (referring to the definition of good faith set forth in Utah Code Ann. § 70A-1-201(19) (1989)--honesty in fact in the conduct or transaction concerned); Money Mart Check Cashing Ctr., Inc. v. Epicycle Corp. 667 P.2d 1372, 1373 (Colo.1983) (noting that [t]he drafters of the Uniform Commercial Code intended that this standard [of good faith] be a subjective one). Significantly, none of the decisions cited by Mr. McKay concern an investor in a Ponzi scheme who had notice of the kind of suspicious circumstances that surrounded M & L. In construing the term good faith, as it is used in § 548(c), we find the decisions of the Eighth and Ninth Circuits and the majority of bankruptcy courts more persuasive than the authorities on which Mr. McKay relies. 33 Accordingly, we conclude that the bankruptcy court and the district court properly held that good faith under § 548(c) should be measured objectively and that if the circumstances would place a reasonable person on inquiry of a debtor's fraudulent purpose, and a diligent inquiry would have discovered the fraudulent purpose, then the transfer is fraudulent. Jobin, 164 B.R. at 661 (quoting Agric. Research & Technology Group, 916 F.2d at 536).