In Aalfs v. Wirum (In re Straightline Investments, Inc.),1 the United States Court of Appeals for the Ninth Circuit considered whether a post-petition factoring of accounts receivable by the debtor was an avoidable transfer under section 549 of the Bankruptcy Code. The Court of Appeals affirmed the Bankruptcy Court, finding that the post-petition transfer had been properly avoided and that the lower court was justified in allowing the trustee both to recover the accounts receivable and their proceeds and to retain the consideration paid by the transferee.

Background

Straightline Investments, Inc. (“Straightline”) was in the business of leasing commercial real estate, when in 1997 it began operating a custom lumber milling business. That same year, on September 10, Straightline filed for chapter 11 protection. While in bankruptcy, Straightline requested that it be allowed to borrow up to $500,000 in debtor-in-possession financing from Charles D. Aalfs (“Aalfs”). The financing would be secured by equipment, inventory and accounts receivable. The Bankruptcy Court denied Straightline’s request for $500,000 in financing, but permitted Straightline to borrow up to $100,000 secured by equipment and inventory.

Despite the Bankruptcy Court’s ruling limiting the scope of the debtor-in-possession financing, Aalfs then entered into a factoring transaction with Straightline. Pursuant to that agreement, Aalfs purchased accounts receivable from Straightline valued at $200,600 for $186,455. Aalfs had collected $163,007 on the accounts receivable when the trustee challenged the transfer, as discussed below.

In April 1998, Straightline’s chapter 11 case was converted to a chapter 7 proceeding and a trustee was appointed. The chapter 7 trustee petitioned the Bankruptcy Court to avoid the transfers of the accounts receivable to Aalfs on the basis that it was an unauthorized post-petition transfer of property of the bankruptcy estate in violation of section 549 of the Bankruptcy Code. The Bankruptcy Court found that the transfer should be avoided and Aalfs appealed the decision to the Bankruptcy Appellate Panel for the Ninth Circuit, which affirmed the lower court’s decision. Aalfs thereafter appealed the decision to the Ninth Circuit Court of Appeals.

Avoidance of Transfers

Certain pre- and post-petition transfers2 may be avoided by a trustee in bankruptcy. Pursuant to sections 547 and 548 of the Bankruptcy Code, pre-petition preferential transfers (made by a debtor to satisfy a debt shortly before the filing date), and pre-petition fraudulent transfers (made for less than reasonably equivalent value when the debtor is financially troubled), may be avoided by the trustee. Pursuant to section 549, a court may also avoid post-petition transfers of property of the estate that are not authorized by the Bankruptcy Code or the court.3 Under sections 547 and 548, courts require that, to be avoidable, the transfer of property must have caused a depletion of the bankruptcy estate.4

Case Analysis

In Straightline, Aalfs first argued that the transfer of the accounts receivable should not be avoided because the estate was not in any way depleted from the transaction. The Court of Appeals noted that whether depletion of the estate is a necessary element under section 549 is an open question in the Ninth Circuit. The Court of Appeals concluded that no such requirement exists, explaining:

Although the primary purpose of 11 U.S.C. §549 is to allow the trustee to avoid postpetition transfers of property which deplete the estate. . . , the plaintiff’s failure to demonstrate a measurable depletion of the estate is not enough to allow a transfer to stand when it is otherwise avoidable under §549 because it satisfies all of the explicit requirements of an avoidable postpetition transfer.5

Aalfs’s second argument was that the factoring transaction took place in the ordinary course of Straightline’s business. Section 363(b) of the Bankruptcy Code requires a debtor to obtain court permission to sell property of the estate, unless the sale is in the ordinary course of the debtor’s business.6 To determine whether the transfer occurred in the “ordinary course of business,” the Court of Appeals first considered the “vertical dimension or creditor expectation test,” which examines the pre-petition relationship between the debtor and its creditors and whether the transaction subjects the creditor to a level of risk higher than that originally accepted. Although Straightline had not transferred any accounts receivable to Aalfs pre-petition, it had entered into somewhat similar transactions with other parties prior to its bankruptcy filing. Those transactions, however, involved vendors who received pre-paid discounts on their customer accounts, and not third parties to whom accounts receivable were sold outright. As a result, the Court of Appeals held that the Bankruptcy Court had properly concluded that creditors did not expect that Straightline would sell its accounts receivable in the ordinary course of its business. The Court of Appeals further found that, because the Bankruptcy Court had already denied a request by Straightline to use the accounts receivable as collateral for a loan from Aalfs, creditors would expect to have been provided with notice and a hearing prior to the disposition of the debtor’s accounts receivable.

The Court of Appeals next considered the “horizontal dimension test,” which determines whether the transaction was within the ordinary business activities of other similar businesses. Applying the horizontal test, the Court of Appeals found that the testimony presented in the Bankruptcy Court showed that factoring was not common in the custom milling business, but instead that it usually occurred only when a company had financial difficulties.

The Court of Appeals also rejected earmarking and recoupment defenses raised by Aalfs. Aalfs argued that the monies he paid for the receivables were in effect “earmarked” to pay him back on the debt the estate incurred to him. The Court of Appeals quickly rejected this claim seeing no evidence of earmarking. Aalfs also argued that the recoupment doctrine, which allows a set-off when certain equitable considerations exist, applied to his receipt of funds. Notwithstanding the issue of whether the technical requirements of recoupment applied, the Court of Appeals found that, because Aalfs had effected a transaction in contravention of the Bankruptcy Court’s order prohibiting financing against the accounts receivable, he was not entitled to the benefit of the recoupment doctrine. The Court of Appeals explained that recoupment is “an equitable remedy and equitable remedies may not be invoked to compensate someone who has engaged in inequitable conduct.”7 Since Aalfs’s conduct was deemed inequitable, use of this doctrine was not warranted.

After the Court of Appeals concluded that the transfers at issue could be avoided, the Court turned to the issue of whether the Bankruptcy Court properly determined that Aalfs should return the $163,007 he had collected from the accounts receivable, in addition to the uncollected accounts. Aalfs argued that if the estate was allowed to collect these amounts while retaining the monies Aalfs paid for the accounts receivable, the estate would receive a windfall.

Once a court determines that a transfer may be avoided, section 550 of the Bankruptcy Code outlines what remedies are permitted. This section allows a trustee to recover the transferred property, or the value of the property, from the initial transferee.8 The Court of Appeals concluded that, under the circumstances, it was not concerned with avoiding a windfall to the estate, explaining:

Aalfs was fully aware that Straightline was in bankruptcy proceedings and that the Bankruptcy Court had previously denied Straightline’s request to obtain loans secured by its accounts receivable. The uncollected accounts and the $163,007 which he collected should be returned to the estate for the benefit of the estate’s creditors instead of remaining in Aalfs hands.9

The Court of Appeals further found that Aalfs was not entitled to exercise a right of set-off for the monies he paid for the accounts receivable. Section 550(b) protects certain transferees who receive property of the debtor in good faith. The trustee was thus able to recover both the monies collected for the accounts receivable that Aalfs purchased and the remaining accounts receivable not collected, as well as retain the monies received from Aalfs from the purchase of the accounts. Since Aalfs was aware of the bankruptcy proceeding and the denial of the debtor’s request to use the accounts receivable to obtain debtor-in-possession financing, he was not a good-faith transferee. The Ninth Circuit thus affirmed the decision of the lower court.

Conclusion

In Straightline Investments, the Court of Appeals established that in the Ninth Circuit the recovery of post-petition transfers pursuant to section 549 of the Bankruptcy Code does not require a diminution of the estate. The transferee’s defenses of ordinary course transaction, earmarking, and recoupment were unavailing.

The decision of Straightline Investments should be viewed as a product of its unique facts. The transferee essentially defied the Bankruptcy Court’s order, purchasing the accounts receivable after the debtor had been barred from using those accounts receivable to secure debtor-in-possession financing. Under these circumstances, it is not surprising that the Court determined that the transferee was required to return the accounts receivable and the proceeds of the accounts, while the estate was permitted to retain the monies paid for these assets.

The holding of Straightline Investments, however, may be applied in situations in which the debtor and transferee have not violated any prior orders. In these cases, while the good faith defense should protect the parties from having their transaction reversed, the holding of Straightline Investments may make this defense more uncertain. Thus, to play it safe, parties dealing with the debtor would be well advised to obtain court permission for any post-petition transfer unless it is one that is clearly permissible under one or more sections of the Bankruptcy Code.