Two Peas in Pod: Foreclosure + Fraudulent Sale

Think about this — a month before a debtor files bankruptcy, you buy his rental property at a foreclosure sale at a significant deal – 70% of the market value. Great deal!     Debtor then files bankruptcy and seeks to avoid the sale and take back his property from you because the debtor did not receive reasonably equivalent value in return, and thus a hidden “constructive fraudulent transfer.”

Under §548, a trustee (or debtor) may avoid a transfer made prepetition if the transfer was based upon actual fraud or if the transfer of the property resulted in the debtor receiving “less than reasonably equivalent value” in exchange (called constructive fraud).

So – how do we tell whether the Debtor received ‘reasonably equivalent value‘ in his prepetition foreclosure sale?

The Fifth Circuit used the 70% Rule, whereby if the debtor received less than 70% of the market value of the property – then it would likely be a constructive fraudulent transfer and subject to avoidance.  Durrett 

The Ninth Circuit said the 70% Rule was arbitrary.  Rather, the Ninth Circuit said whatever price obtained from the foreclosure sale was presumed to be reasonably equivalent value unless the debtor can show there was some element of fraud, unfairness or oppression that resulted in the sale price.   In re Madrid. 

SCOTUS stepped in in 1994 to resolve the circuit split in BFP v. Resolution Trust in order to define “reasonably equivalent value” for purposes of residential foreclosure sales.

Five justices followed the Ninth Circuit’s approach and held that that any price the Debtor received at a noncollusive foreclosure sale is reasonably equivalent value and thus not subject to avoidance, unless — price was so low as to “shock the conscience or raise a presumption of fraud or unfairness.”    Now, Courts are trying to figure out how low a price is from the fair market value that would “shock the conscience” so as to raise a presumption of fraud.

Back to the original hypo I proposed — I would think most court’s would find that a purchase of a property 70% below market level would “shock the conscience” and thereby raise a presumption of fraud.   So keep the above in mind as you head to the courthouse steps in Norwalk with your checkbook next time because the property owner could file bankruptcy and take it back.

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