As an immediate transferee of a preference, the law firm is entitled to assert the provisions of Bankruptcy Code §550(b)(1) as a defense. To be shielded under this section, the law firm must establish that it received its attorney's fees for value, in good faith, and without knowledge of the potential voidability of the transfer. The trustee has stipulated that Quint & Valkevich took for value. The remaining issues to be determined are whether the law firm took its fees in good faith and without knowledge of the voidability of the transfer. The facts necessary to resolution of these issues follow.

II. Facts

Edwin Fleming was a minority shareholder in both Mountain Bay Tek (MBT) and its subsidiary MSI. He served as President of MSI from its creation in September, 1990 through May 6, 1991 and was a director of both MSI and MBT. On May 6, 1991, Fleming was terminated as President of MSI and was prevented thereafter from entering its premises.

Fleming retained Quint & Valkevich to represent him in his disputes with MSI and he entered into a fee agreement which required him to pay regardless of the outcome of the case. Fleming filed a shareholder's derivative action on May 23, 1991 against MSI, MBT and David and Virginia Ciruli, who were also directors and shareholders of the corporations, alleging breach of fiduciary duty. The Cirulis cross-complained, alleging that Fleming had failed to perform his duties as a director and President of MSI.

During the course of litigation, David Ciruli negotiated the sale of MSI to S&R Disk. A condition of the sale was that the litigation with Fleming be resolved. After protracted negotiations, a settlement agreement and mutual releases were executed in March, 1992, by MSI, MBT, and Fleming. The agreement provided for a payment to Fleming in the amount of $146,300.19, allocated as: $6,901.19 for Fleming's shares in MSI; $14,399.00 for Fleming's shares in MBT; and $125,000.00 for "indebtedness" of MBT to Fleming. MSI issued a check to Fleming and Quint & Valkevich for $146,300.19, which the law firm deposited into its client trust account. The law firm wrote two separate checks from this account, one to itself in the amount of $17,421.71 for legal fees, and another to Fleming for the balance. MSI filed bankruptcy on September 19, 1992, within the one-year preference period for insiders.

As the attorney handling the litigation and the settlement, Matthew Quint testified for the law firm. Quint was admitted to practice in California in 1972 and has practiced since primarily in the field of commercial litigation. He has appeared in the bankruptcy court as special counsel three or four times in his career but has never represented either a debtor or a creditor in the bankruptcy court.

Quint testified that his knowledge of MSI's financial situation was limited. He had received a copy of the proposed Agreement of Purchase and Sale of Stock between S&R and MSI in February, 1992, including a copy of MSI's attached financial statement dated August 31, 1991 and a copy of its income tax return for the period from September 1, 1990 to August 31, 1991. Other than these documents, neither Quint & Valkevich nor Fleming had direct access to MSI's financial information after Fleming's ouster from the corporation. In fact, Quint did not see the amendment or the final version of the purchase and sale agreement with S&R Disk until the trial of this action.

The August, 1991 financial statement showed that MSI had liabilities of $768,967 and assets valued at $650,476.43. This financial statement overstated MSI's assets since equipment valued on the statement at $374,070.54 was owned by MBT rather than MSI. A liability for the same equipment in the amount of $1,400,000 was also not reflected in the financial statement.

Ciruli testified that he prepared the August, 1991 financial statement. He acknowledged that the assets were overstated as a result of the inclusion of the MBT equipment. However, he also testified, without satisfactory explanation, that the financial statement fairly and accurately reflected the condition of the company at the time.

The only other source of information available to Quint was from James Brain, a consultant for the trustee in bankruptcy of Xebec, Inc., which was also a creditor of MSI. Quint testified that Brain was optimistic that the S&R Disk transaction would provide capital, new management and substantial business expertise, which were necessary to MSI's success as a going concern.

It is the trustee's position that an experienced commercial litigator reviewing the August, 1991 financial statement should have known that MSI was insolvent and that the settlement payment was potentially voidable. The trustee asserts that Quint should have discussed the accuracy of the financial statement with Fleming and thereby he should have discovered that MSI's assets were overstated in the statement.

The law firm refutes this position. Quint believed that S&R Disk was the source of the settlement payment and further that the sale of MSI to S&R Disk would provide the capital, expertise and management to ensure MSI's success.

III. Analysis

A. The standard for determining good faith and knowledge of the voidability of the transfer.

The law firm has the burden of proving the elements of its defense under 11 U.S.C. §550(b)(1)⁽¹⁾. Thompson v. Jonovich (In re Food & Fibre Protectives, Ltd.), 168 B.R. 408, 422 (Bankr. D. Ariz. 1994). Section 550(b)(1) provides that a trustee may not recover from an immediate transferee "that takes for value . . . . in good faith, and without knowledge of the voidability of the transfer avoided."

The test to determine "knowledge" under §550(b)(1) is not defined by the Bankruptcy Code. The Fourth Circuit held that the term, "knowledge," does not include the concept of "constructive" notice, but only "actual" notice. Smith v. Mixon (In re Mixon), 788 F.2d 229, 232 (4th Cir. 1986). In considering this issue, other courts recognize that while constructive notice of a voidable transfer would not constitute knowledge under §550(b)(1), actual notice of facts that would lead a reasonable person to investigate may result in a finding that the recipient that failed to inquire further lacked good faith. See Bonded Financial Services v. European American Bank, 838 F.2d 890, 897-98 (7th Cir. 1987).

Under the facts of the Bonded Financial Services case, the Seventh Circuit found that an immediate transferee satisfied the requirements of §550(b)(1) where the transferee had no knowledge of the debtor's precarious financial condition or the principal's plan to use the debtor's money to pay his personal debts. Bonded, 838 F.2d at 898. The bank received a check from a corporation to be deposited into the individual account of the principal, who then made a payment from the account to the bank on an outstanding loan. The corporation filed a bankruptcy petition twenty days after sending the check. Id. at 891. The corporation was not the bank's customer and there was no reason for the bank to suspect that the principal was not using his own money to pay his personal debts. The Court also found that, if inquiry had been made, the bank would not have discovered anything pertinent, but would have only found that the check was authorized by the appropriate officials. Id. at 898. In its ruling the Court pointed out that the purpose behind the good faith and knowledge requirement of §550(b)(1) is "to prevent a transferee from whom the trustee could recover from transferring the recoverable property to an innocent transferee, and receiving a re-transfer from him, that is, 'washing' the transaction through an innocent third party." Id. at 897, citing H.R. Rep. No. 95-595, 95th Cong., 2d Sess. 376 (1978); S.Rep. No. 95-589, 95th Cong., 2d Sess. 90 (1978).

Recently, the Eighth Circuit followed the same standard, but found a preference where the recipient of an immediate transfer had knowledge to suggest that there had been a voidable transfer. In Brown v. Third National Bank (In re Sherman), 67 F.3d 1348, 1357 (8th Cir. 1995), the trustee sought to avoid the transfer of twelve properties to the debtors' parents as a fraudulent transfer, eliminating the bank's liens on the property. The Court found that the bank knew of the debtors' financial difficulties, that there were delinquent taxes on the properties, that the properties were transferred to the parents of the debtors and that the transfer constituted substantially all of the debtors' assets. The Court held that "[i]f a transferee possesses knowledge of facts that suggest a transfer may be fraudulent, and further inquiry by the transferee would reveal facts sufficient to alert him that the property is recoverable, he cannot sit on his heels." Id. at 1357.

In Mosier v. Goodwin (In re Goodwin), 115 B.R. 674, 677 (Bankr. C.D. Cal. 1990), the Court also adopted a standard which required further inquiry by the transferee. The Court found liability where there was "knowledge of sufficient facts that (i) puts the transferee on notice that the transfer might be avoidable or (ii) requires further inquiry into the situation and such inquiry is likely to lead to the conclusion that the transfer might be avoidable." Id.

The court agrees that an appropriate test requires the law firm to establish that it did not have knowledge of facts sufficient (i) to put it on notice that the transfer was potentially avoidable or (ii) to require further inquiry likely to have led it to the conclusion that the transfer was potentially avoidable. B. Quint & Valkevich's knowledge was insufficient to put it on notice of the potential voidability of the transfer.

Quint & Valkevich received a financial statement that revealed MSI's assets to be less than its liabilities by approximately $118,491. However, the financial statement was six months old when received by Quint & Valkevich and was received in conjunction with the Agreement of Purchase and Sale of Stock between S&R and MSI, a transaction that was expected to provide capital, expertise, and additional customers to MSI.

Knowledge of the financial distress of a transferor is not necessarily sufficient to place the recipient on notice of the insolvency of the transferor. In Thompson v. Jonovich (In re Food & Fibre Protectives, Ltd.), 168 B.R. 408 (Bankr. D. Ariz. 1994), the lender was aware of the limited cash flow of its borrower when it made its loan. However, the lender also knew that uneven cash flow is routine in agricultural lending and relied upon the debtor's eight year history. Since the lender had no reason to believe the debtor was not operating as usual, the Court held that the lender did not have knowledge of the voidability of the transfer and acted in good faith. In re Fruit & Fibre, 168 B.R. at 422. See also In re Goodwin, 115 B.R. 674 (Bankr. C.D. Cal. 1990).

Considering the expectations from the S&R transaction and the law firm's role representing an ousted former CEO in the litigation and ultimate settlement, the law firm did not have sufficient knowledge of MSI's financial difficulties to be on notice of the insolvency of MSI.