California Court of Appeal Clarifies Good Faith Defense Against Fraudulent Transfer Claims

In its recent decision in Nautilus, Inc. v. Yang, the California Court of Appeal for the Fourth District addressed a split of authority regarding the good faith defense to fraudulent transfer claims in California.

In 1986, California adopted, with minor alterations, the Uniform Law Commission’s Uniform Fraudulent Transfer Act as Civil Code sections 3439, et seq.  Effective January 1, 2016, that chapter was amended and renamed the Uniform Voidable Transactions Act (the “UVTA").  The UVTA creates a civil cause of action by a creditor against a debtor, the debtor’s transferees, and/or the subsequent transferees of the debtor’s transferees to void transfers made by the debtor to defraud the creditor or prevent the creditor from collecting on his claim.  Civ. Code § 3439.07(a).  A creditor’s claim is defined broadly to include almost any right to payment, including an accrued cause of action or a judgment.  Civ. Code § 3439.01(b).

Under the UVTA, a transfer is voidable if it is made (1) "[w]ith actual intent to hinder, delay, or defraud any creditor of the debtor" or (2) where the transferor is or will likely become insolvent and the transfer is made "[w]ithout receiving a reasonably equivalent value in exchange.”  Civ. Code § 3439.04(a).  Importantly, even where actual intent to hinder, delay, or defraud is present, a transfer is expressly “not voidable…against a person that took in good faith and for reasonably equivalent value given the debtor or against any subsequent transferee or obligee.”  Civ. Code § 3439.08(a).  

The Legislative Committee comments to Civil Code Section 3439.08 state that “‘good faith’ means that the transferee acted without actual fraudulent intent and that he or she did not collude with the debtor or otherwise actively participate in the fraudulent scheme of the debtor. The transferee's knowledge of the transferor's fraudulent intent may, in combination with other facts, be relevant on the issue of the transferee's good faith of the transferor [sic] or of the transferor's insolvency.”  However state and federal courts addressing the meaning of “good faith” have interpreted this comment differently and there has been no authoritative judicial analysis of the meaning of “good faith” under this section.

Some courts have held that the good faith defense is available to a transferee in the absence of “deliberate wrongful conduct” by the transferee.  See Lewis v. Superior Court (1994) 30 Cal.App.4th 1850, 1859.  Other courts have been more restrictive, holding that the good faith defense is not available to a transferee who had “actual knowledge of facts which would suggest to a reasonable person that the transfer was fraudulent.”  See Cybermedia, Inc. v. Symantec Corp. (N.D. Cal. 1998) 19 F.Supp.2d 1070, 1075.  Other courts have been more restrictive still, establishing what is essentially an inquiry notice standard, holding that the good faith defense is not available to a transferee who possessed enough knowledge to induce a reasonable person to inquire further into the legitimacy of the transaction.   See Plotkin v. Pomona Valley Imports (In re Cohen) (B.A.P. 9th Cir. 1996) 199 B.R. 709, 719.  

In Nautilus, Plaintiff Nautilus, Inc. (“Nautilus”) obtained a judgment against Defendant Stanley Kuo Hua Yang (“Yang”) and recorded a lien on a piece of real property owned by Yang.  Nautilus, Inc. v. Yang (2017) 11 Cal.App 5th 33, 35-37.  Yang subsequently transferred title to the property to his father and his father took out a mortgage on the property.  Another entity purchased the mortgage from the original lender.  Nautilus subsequently sued Yang, his father, the originator of the mortgage, and the purchaser of the mortgage for avoidance of the transfers and encumbrances on the property.  The trial court held that the originator of the mortgage and the purchaser of the mortgage acted in good faith under Civil Code section 3439.08(a) and their encumbrances could not be voided.  The Court of Appeal affirmed.

In its analysis, the Court of Appeal reviewed the conflicting authority discussed above.  Noting that the Legislative Committee comment states that “[d]etermination of the voidability of the transfer ought not to require the court to inquire into the legal sophistication of the transferee,” the Court stated that the appropriate standard should be dependent on the fraudulent intent of the defendant, not on the character of the transfer.  Thus, the duty of inquiry into the legitimacy of the transaction applied by some courts was misplaced.  Similarly, the investigation conducted by some courts into the reasonableness of a defendant’s conduct or the nature of the transfer at issue was misplaced. 

Ultimately, the Court of Appeal held that “a transferee does not take in good faith if the transferee had actual knowledge of facts showing the transferor had fraudulent intent.”

The Court of Appeal’s decision in Nautilus strikes a happy medium between the divergent standards applied previously by other courts.  Under the Nautilus standard, transferees have no duty to inquire as to the legitimacy of the transaction.  On the other hand, transferees are not absolved of liability by simply showing they did not deliberately participate in a fraudulent scheme.  Instead, under Nautilus, if a transferee is aware of facts showing that a transfer it receives is being made to defraud a creditor, it cannot assert the good faith defense.

At the very least, Nautilus provides a thoughtful recitation of the state of the law and a clear standard for litigants and courts to reference.  Whether other courts will follow it remains to be seen.

-Brian Lauter 

Brian Lauter is a Shareholder at Eanet, PC.  Eanet, PC is a boutique law firm focusing on business litigation, real estate litigation, labor and employment litigation, and corporate transactions.