Lenders track the amounts and dates of payments made on a borrower’s loan.  However many lenders do not monitor the source of those payments.  As shown by a recent Fifth Circuit opinion,In re Positive Health Management, issued on October 15, 2014 (12-20687), accepting payments from a borrower’s affiliate can result in unanticipated liabilities for lenders.

The facts of In re Positive Health Management may be illustrated by the following hypothetical.  Assume that a corporation has two subsidiaries; an “operating company” that provides healthcare services, and a “real estate company” that owns real estate upon which the healthcare business is operated.  The real estate company borrows $10 million from the bank, secured by the real estate.  While the parent company has guaranteed the loan to the real estate company, the operating company has not.

Further assume the operating company is the entity that actually sends the monthly payments to the bank, and during the year before bankruptcy, the payments total $1 million.  The operating company uses the real estate as its business premises, and accounts for those payments as “rent”.  Assume that the “market rate” of rent for the subject real estate is only $750,000 per year.  The operating company is insolvent.  The operating company knew it was in financial distress during the year before bankruptcy and chose to delay paying some creditors, while electing to pay “rent” to the bank thus enabling its affiliate to maintain ownership of the real estate.  Finally, assume that the bank had no knowledge that the operating company was in financial trouble and the bank is otherwise acting in “good faith”.

The In re Positive Health Management opinion teaches that while the entire $1,000,000 of payments is subject to avoidance as an intentional fraudulent transfer under Section 548 of the U.S. Bankruptcy Code, the bank may avail itself of the Section 548(c) “good faith” defense.  However the bank may only do so to the extent it gave “value”.  The applicable “value” given in this context according to the Fifth Circuit’s opinion means the fair rental value of the premises.  Thus under the hypothetical presented above, the bank is permitted to net the $750,000 of market rate rent value given against the $1,000,000 total loan payments it received from the operating company.  However that still leaves the bank liable for the remaining $250,000 shortfall.

One takeaway from the In re Positive Health Management opinion is that had the bank required a loan repayment process that first implemented a flow of payments from the operating company to the real estate company, and second from the real estate company to the bank, the bank likely could have eliminated this exposure.  This is because the bank would not have been considered an “initial transferee” under the Section 548 of the Bankruptcy Code.

Another important takeaway is that the definition of “value” under Section 548(c) of the Bankruptcy Code is not the same as “reasonably equivalent value” under its related Section 548(a).  The Fifth Circuit’s opinion states that “because consideration may be disproportionately small, to hold that a transferee who merely gives ‘good consideration’ in exchange for a fraudulent transfer may keep the entire amount would allow it to benefit at the expense of the debtor’s creditors based on the fortuity that it received a fraudulent transfer.”  Thus even if $750,000 of rent value is considered “reasonably equivalent value” for the $1,000,000 received by the bank for purposes of the so-called “objective” fraudulent transfer test, here the $1,000,000 of payments had been avoided under the “subjective” test, since the operating company knew it was delaying payments to other creditors.  While the bank was viewed as having given significant value ($750,000), that amount did not permit the bank to eliminate all liability.

Lenders should considering implementing procedures to monitor the source of payments on loans, as well as tracking the dates and amount of payments.  Lenders should ensure that payments have been made by the actual borrower (or guarantor) of the loan.  This is of special concern in loans made to one member of a corporate group.