Ninth Circuit Adopts Indirect Benefit Rule
A potential lender confronted with a borrower that cannot provide adequate independent assurance of its ability to repay a loan commonly demands a guarantee of the debt by related entities (e.g., affiliates, shareholders or partners). However, even a guarantee is not enough in some cases. Instead, the lender will agree to extend financing to a more financially sound, related entity, which in turn makes the funds available to the actual beneficiary the original potential borrower.
Albeit not at all unusual, a lending transaction structured in this way can become problematic if the ultimate beneficiary of the loan later files for bankruptcy. This is so because payments made by the beneficiary of a loan who is not the signatory under the loan agreement are routinely attacked by bankruptcy trustees as fraudulent transfers, which the Bankruptcy Code empowers a trustee to "avoid," or invalidate, to the extent that the debtor did not receive reasonably equivalent value in exchange. A dispute of this nature was recently adjudicated by the Ninth Circuit Court of Appeals. In Frontier Bank v. Brown (In re Northern Merchandise, Inc.), the Court adopted the "indirect benefit rule," thereby allying itself with the other circuit courts of appeal that have weighed in on the question of what constitutes value in connection with a challenged transaction.
Avoidance of Fraudulent Transfers in Bankruptcy
Among the powers conferred upon a bankruptcy trustee or chapter 11 debtor-in-possession under the Bankruptcy Code is the ability to avoid asset transfers that are either actually or constructively fraudulent. Section 548 of the Bankruptcy Code provides that the trustee can avoid any transfer made by the debtor in the year preceding a bankruptcy filing, if effected with the actual intent to hinder, delay or defraud creditors. The statute also authorizes avoidance of transfers or obligations incurred in the absence of fraudulent intent. Specifically, section 548 provides that the trustee may avoid any transfer made or obligation incurred by a debtor in the year preceding bankruptcy if the debtor received "less than a reasonably equivalent value" in exchange and was insolvent, undercapitalized or unable to pay its debts generally as they matured (or became any of the foregoing as a consequence of the transaction).
"Value" is defined in the Bankruptcy Code, but "reasonably equivalent value" is not. For purposes of section 548, "value" means "property, or...
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