The clawback provisions in the U.S. Bankruptcy Code are essential tools for protecting a bankruptcy estate and creditors' interests from preferential or fraudulent asset transfers that deplete estate funds and negatively impact financial recovery. Clawback actions were famously seen in the Bernie Madoff Ponzi scheme bankruptcy. In the aftermath of Madoff's fraud, the trustee appointed to liquidate Madoff’s company initiated numerous clawback suits to recover funds for the scheme's victims. The trustee clawed back over $7 billion from investors who had profited from the Ponzi scheme.
Purposes of the Clawback Action in Bankruptcy
At a policy level, the clawback rules serve three crucial purposes in bankruptcy:
To Deter Fraud: By allowing trustees to reverse preferential or fraudulent transfers, the clawback provisions discourage debtors from attempting to hide or dissipate assets before filing for bankruptcy.
To Promote Equity: It ensures that all creditors have a fair opportunity to share in the assets of the debtor, preventing any preferential treatment.
To Preserve the Bankruptcy Estate: The clawback provisions enable the recovery of assets that rightfully belong to the estate, increasing the resources available to satisfy creditor claims.
How Do The Clawback Rules Work in a Corporate Bankruptcy?
Clawback rules in bankruptcy are governed by the U.S. Bankruptcy Code and in certain instances state law. When a company files for bankruptcy, a trustee is appointed to manage and oversee the asset distribution process. The trustee will scrutinize transactions made by the debtor prior to the bankruptcy filing to determine if any transfers were made that unfairly favored certain creditors or were intended to defraud creditors. If such transfers are identified, the trustee has the authority to initiate clawback actions to recover the assets or their equivalent value. These recovered assets then become part of the bankruptcy estate, ensuring a more equitable distribution among all creditors. Sections 544, 547, and 548 of the Bankruptcy Code regulate the two distinct types of transfer that are subject to a clawback action:
Preferential Transfers (Section 547)
Preferential transfers are payments or asset transfers made to a creditor in the 90 day period immediately before the bankruptcy filing which give the creditor more than they would have received in a Chapter 7 liquidation. The lookback period is extended to 1 year for insiders such as relatives and affiliates. Notably, a preferential transfer does not require proof of wrongdoing.
In the ongoing FTX bankruptcy, the trustee has been actively pursuing clawback actions for preferential transfers to a range of recipients, including insider executives, vendors, and other entities that conducted business with FTX. The trustee has filed a substantial clawback action against Mirana Corp, its executives, and their family members alleging that they received $838 million in preferential transfers from FTX shortly before FTX filed for bankruptcy in November 2022.
Fraudulent Transfers (Sections 544 and 548)
Sections 544 and 548 deal with fraudulent transfers under Bankruptcy Code and state law, allowing the trustee to recover any asset transferred within certain specified years before the bankruptcy petition date either with actual intent to hinder, delay, or defraud creditors (actual fraud) or for less than reasonably equivalent value (constructive fraud). The trustee must also prove that the debtor was insolvent at the time of, or made insolvent as a result of, the fraudulent transfer.
How Far Can a Clawback Reach?
In a corporate bankruptcy case, the time limits for clawback provisions are governed by the U.S. Bankruptcy Code and state law. For preferential transfers, the trustee or debtor-in-possession can claw back payments made to non-insider creditors within 90 days before the bankruptcy filing date, provided the other elements of a preference are met. However, for transfers to insiders (such as relatives, officers, directors, or affiliates), the lookback period is extended to one year before the filing date.
Fraudulent transfers have a longer lookback period of two years under the Bankruptcy Code. In some cases, the trustee in bankruptcy can take advantage of longer lookback periods for fraudulent transfers under state law. Many states have adopted the Uniform Fraudulent Transfer Act (UFTA) or Uniform Voidable Transactions Act (UVTA) which allow for a four-year lookback period or longer for fraudulent transfers. Delaware, a popular jurisdiction for corporate bankruptcies due to its business-friendly statutes, follows the Delaware Uniform Fraudulent Transfer Act (DUFTA) which applies a four year clawback period for certain fraudulent transfers.
Understanding and complying with these time limits is critical for trustees and creditors as they are strictly enforced by bankruptcy courts. As far back as 2012, the Delaware courts ruled in Industrial Enterprises of America v. Burtis (In re Pitt Penn Holding Co., Inc.) that the 2-year period for actually fraudulent transfers cannot be equitably tolled or expanded because it is a substantive element of the fraudulent transfer claim itself rather than a statute of limitations.
Defenses to Clawback in Bankruptcy
Successfully defending a clawback claim requires a detailed understanding of applicable federal and state law and the facts of the case. Different defenses are available depending on the type of transfer:
Contemporaneous Exchange for Value Defense: This defense under (s.547(c)(1)) of the Bankruptcy Code is available when an allegedly preferential transfer was intended to be a contemporaneous exchange for new value given to the debtor, and the exchange was in fact substantially contemporaneous, e.g. goods purchased in a store or delivered to a debtor for cash on delivery.
Subsequent New Value Defense: Under this defense, a creditor can offset the amount of an alleged preferential transfer by the value of any new goods or services provided to the debtor after receiving the preferential payment, as long as the new value remains unpaid (s.547(c)(4)).
Ordinary Course of Business Defense: This defense applies when an allegedly preferential transfer was made in the ordinary course of business dealings between the debtor and creditor (subjective test) or according to ordinary business terms in their respective industries (objective test) (s.547(c)(2)).
Good Faith Defense: Section 548(c) of the Bankruptcy Code allows for a defense against the avoidance of a fraudulent transfer if the transferee took the transfer in good faith and for value, meaning they gave something of value like money, goods or services in exchange for the transfer. Most courts apply an objective standard to the good faith test, asking whether the transferee knew or reasonably should have known of the debtor's insolvency or fraudulent purpose, but some have introduced a subjective element (In re Taneja.)
Statute of Limitations Defense: Trustees must initiate clawback actions within certain time limits or the claim will be barred by the statute of limitations. These time limits are distinct from the lookback period, running forward, not backward, from the date of filing of the bankruptcy petition or appointment of trustee.
Contesting Elements of a Clawback Claim: Creditors can defend a clawback action by disproving one of the required clawback elements. In the FTX proceedings, for example, the trustee is pursuing Sam Bankman-Fried’s parents for fraudulent transfers (amongst other things) but Barbara Fried and Joseph Bankman have argued that the trustee has not shown the requisite intent to hinder, delay, or defraud or that the debtor was insolvent at the time of the transfers.
A clawback action is a powerful tool in a corporate bankruptcy. Strategic use of this tool requires meticulous attention to the details of the case as well as a precise understanding of applicable state law and the U.S. Bankruptcy Code. Formore detailed analysis of this area of the law or answers to your questions about corporate bankruptcy, contact the experience bankruptcy attorneys at Morris James.
