July 2017

                                                          Fraudulent Conveyances

Transferee of fraudulent conveyance is not entitled to good faith defense if transferee had actual knowledge of facts showing knowledge of transferor’s fraudulent intent. Given lack of actual knowledge, good faith defense applies.

Nautilus, Inc. v Yang (2017) 11 CA5th 33

Nautilus successfully sued a counterfeiter of its exercise machines and received a judgment lien in the amount of $8 million. Unfortunately, the judgment debtor transferred his interest in residential real property (owned with his brother) to Father. Father obtained a reverse mortgage of $308,576.72 on the property. He used the proceeds to pay off two prior recorded, existing liens against the property and to pay a small judgment lien against the same debtor son. Father received the remaining funds. A title report erroneously did not show the Nautilus abstract of judgment recorded on the property. The reverse mortgagor then sold the mortgage to another lender for $422,302.21. When Nautilus alleged a fraudulent conveyance of the property, seeking to quiet title and recover damages for fraud, the two lenders successfully claimed a good faith defense. The court of appeal affirmed.

A fraudulent conveyance under the Uniform Voidable Transactions Act (formerly known as the Uniform Fraudulent Transfer Act) occurs when a debtor intends to hinder, delay, or defraud a creditor so that it cannot reach its security interest to satisfy its valid claim. Such a conveyance is legally voidable. The conveyance here was legally fraudulent. Nevertheless, another creditor may evade liability for the alleged fraudulent conveyance if it can prove good faith under CC §3439.08. The good faith defense is not available to a transferee who had fraudulent intent, actively participated in the fraudulent conveyance, or colluded with a person who engaged in a fraudulent conveyance.

Based on legislative history, the court of appeal added another criterion barring the good faith defense, e.g., if the transferee actually knew facts that would illustrate the transferor’s fraudulent intent. The focus is on the lenders’ actual knowledge—not their constructive or inquiry notice—of whether the transferor had fraudulent intent. In a commercial context, enterprise “quickly would grind to a halt if every buyer had an affirmative duty to conduct an independent inquiry prior to purchasing an asset merely because the seller was involved in litigation or otherwise was accused of wrongdoing.” 11 CA5th at 45, quoting CyberMedia, Inc. v Symantec Corp. (ND Cal 1998) 19 F Supp 2d 1070, 1075 n7.

Although the property transfer to Father without financial consideration occurred shortly after Nautilus received its $8 million judgment, these “badges of fraud” commonly exist in a reverse mortgage scenario. The reverse mortgagor (and its successor) gave a reasonably equivalent value in exchange for the deed. Because of the title company’s errors, neither lender was actually aware of the Nautilus judgment or abstract of judgment, which provided the lenders with a defense without a reservation of rights.

The court of appeal also granted the successor lender equitable subrogation, giving it a priority over the Nautilus lien, which actually was recorded first. Although the title company could be charged with culpable and inexcusable neglect, that knowledge or neglect cannot be imputed to the reverse mortgage lenders.

THE EDITOR’S TAKE: At the beginning of its opinion, the court opines that a transferee cannot benefit from a good faith defense to a fraudulent conveyance if it had “actual knowledge of facts showing knowledge of the transferor’s fraudulent intent.” 11 CA5th at 37. This syntax is made puzzling by its double usage of “knowledge.” Was it enough for Security One to show that it did not actually know that its borrower, Chao Yang, had a fraudulent intent, or did it also need to show that it had no reason to suspect that was the case? Later parts of the opinion make it clear that only actual knowledge of a transferor’s fraudulent intent is sufficient to defeat its lender’s good faith defense (e.g., with its approval of the statement, “In our litigious society, commerce would quickly grind to a halt if every buyer had an affirmative duty to conduct an independent inquiry prior to purchasing an asset merely because the seller was involved in litigation or otherwise was accused of wrongdoing” (11 CA5th at 45)).

Assuming this is correct, a lender’s mortgage lien is not subject to attack as a fraudulent conveyance as long as that lender does not “actually know” (have actual knowledge) of its borrower’s shenanigans; it is not enough for the rival creditor to show that that lender had “constructive notice” (i.e., was without actual knowledge but is chargeable with knowing even so) or had “inquiry notice” (i.e., actually knew enough to be deemed sufficiently and reasonably suspicious as to be expected to ask about the matter, and thereby to have learned (gained actual notice) about it if it had inquired).—Roger Bernhardt

40 Real Property Law Reporter 11 (Cal CEB July 2017), © The Regents of the University of California, reprinted with permission of CEB.