On July 14, 2014, the US Court of Appeals for the Tenth Circuit, in Klein v. King & King & Jones, affirmed a district court decision that held that a transferee was unable to assert a good faith defense to a fraudulent transfer action under the Uniform Fraudulent Transfer Act (UFTA) despite having acted in good faith because it provided reasonably equivalent value to a third party instead of to the debtor (No. 13-4131, (10th Cir. July 14, 2014)).

In 2006, the law firm King & King & Jones (KKJ) defended Enrique Baca against pending criminal charges. Mr. Baca's $25,000 payment to KKJ for legal services came from the bank account of Winsome Investment Trust (Debtor).

Between 2005 and 2011, the Debtor operated an illegal Ponzi scheme, collecting millions of dollars from investors and losing much of that money in a series of ill-fated ventures. The funds paid to KKJ to represent Mr. Baca were derived from this Ponzi scheme. The relationship between Mr. Baca and the Debtor did not appear in the record.

In January 2011, the Commodity Futures Trading Commission (CFTC) filed an action and appointed Wayne Klein as receiver for the Debtor (Receiver). The CFTC charged the Receiver with recapturing and returning investor funds that had been diverted as part of the Ponzi scheme. The Receiver filed this action under Utah's UFTA to recover the $25,000 that KKJ received from the Debtor.

The Receiver argued that:

The parties filed cross-motions for summary judgment. The US District Court for the District of Utah granted the Receiver's motion for summary judgment and denied KKJ's motion. The District Court found that the payment was both an actual and constructive fraudulent transfer under the UFTA. KKJ conceded that the Debtor made the transfers with actual intent to defraud its creditors. The Court further concluded that the transfer was constructively fraudulent because although KKJ acted in good faith, it did not provide reasonably equivalent value to the Debtor.

KKJ appealed to the Tenth Circuit.

The Tenth Circuit reviewed the District Court's findings de novo and agreed that the transfers were actually and constructively fraudulent and that KKJ was not entitled to assert a defense.

The Tenth Circuit explained that, in order to be entitled to a defense to a fraudulent transfer under the UFTA, a transferee must either:

The Tenth Circuit found that KKJ satisfied neither of these conditions. First, although KKJ acted in good faith, the legal services it provided did not benefit anyone except Mr. Baca. The Court concluded that a payment made solely for the benefit of a third party does not satisfy the "reasonably equivalent value" requirement. To satisfy this requirement, KKJ must have provided reasonably equivalent value to the Debtor.

Second, KKJ was not a "subsequent" transferee. Rather, KKJ was a direct and "initial" transferee because the funds were wired directly from the Debtor's account to KKJ. The Tenth Circuit rejected KKJ's argument that Mr. Baca was the initial transferee because KKJ did not show that the wire transfer gave Mr. Baca actual dominion or control over the funds.

The Tenth Circuit's decision offers a narrow interpretation of the good faith defense to fraudulent transfers under the UFTA. The court's decision clarifies that a transferee must prove that it provided reasonably equivalent value to the debtor for the transfer. This reasonably equivalent value cannot be made solely for the benefit of a third party. While the UFTA does not explicitly state who must receive reasonably equivalent value, case law has developed this conclusion. However, this ambiguity has been addressed by the recent amendments to the UFTA, now known as the Uniform Voidable Transactions Act (UVTA) (see Article, Goodbye UFTA, Hello UVTA).

This case also serves as a reminder that to avoid liability under the UFTA, a transferee should always be aware of the source of the payment it receives and be cautious about accepting payment from a financially troubled third party. In that case, transferees should consider rejecting the payment or demanding alternative payment arrangements. However, even if it is not possible to know the financial condition of the payor, the UFTA, as a matter of policy, allocates the loss to good-faith transferees rather than to the creditors of the insolvent payor.

The result might have been different under the Bankruptcy Code. In contrast to the UFTA, to the extent that the good-faith defenses under the Bankruptcy Code require "value" be given in exchange for the transferred property, that value is not required to be reasonably equivalent (see Practice Note, Fraudulent Conveyances in Bankruptcy: Overview: Good Faith Defenses).