Fraudulent Transfers

A major remedy for creditors to get debts repaid from defaulting debtors is to seize the debtor's property. Often, debtors have no executable property (property that can be sold by creditors to satisfy a debt), but those who do, will often try to protect their property by either hiding it or transferring the property to someone that the debtor trusts. A fraudulent transfer is the transfer of an asset from the debtor to a transferee with the express purpose of delaying, hindering, or defrauding a creditor. Usually, the transferee is an insider, which includes friends, relatives, and employees of a business debtor. The remedy is to avoid the transfer by forcing the transferee either to return the property to the debtor so that it can be levied by the creditor or to pay an amount equal to the value of the property.

A fraudulent transfer differs from a preference in that a preference is a transfer to a preferred creditor rather than an insider. However, preferential transfers can also be avoided, especially by a bankruptcy trustee if the debtor filed for bankruptcy.

Fraudulent transfer laws were developed to help unsecured creditors to collect their debts from defaulting debtors—secured creditors can rely on their lien on the collateral which is good against any transferees. Since debtors also fraudulently convey property when planning for bankruptcy, the bankruptcy trustee has great powers to avoid transfers.

Since debtors have been using fraudulent transfers to protect property for centuries, the laws used to combat such transfers is almost as old. Before 1918, fraudulent transfer laws were based on common law remedies that courts developed over the years after the United States adapted similar laws from English law. Since common law varied greatly with jurisdiction, the National Conference of Commissioners on Uniform State Laws developed the Uniform Fraudulent Conveyance Act (UFCA) in 1918, then updated it in 1984 as the Uniform Fraudulent Transfers Act (UFTA), which was adopted by more than half the states. However, even in those states that have not adapted either Act, the principles of fraudulent transfers and their remedies apply to all jurisdictions.

The Process of Avoidance

A creditor will only avoid a transfer if there was not enough executable property to satisfy its claim and if it has learned of a recent transfer of valuable property, especially to a friend or relative. Often, the property is transferred for little or no money or for far less than what it is worth.

To avoid a transfer, the creditor must sue the transferee. If the creditor believes that there was collusion between the two, then the creditor may add the debtor as a party.

The 2 grounds for an avoidance suit are actual fraud and constructive fraud. A transferee who accepted the transfer in good faith is generally protected from having the transfer avoided. If the transferee gave significant value for the transfer, then the transferee will be given credit for the value given.

Grounds for Avoidance: Actual Fraud or Constructive Fraud

A necessary component to a fraudulent transfer is fraud, either actual or constructive fraud.

Actual Fraud

A primary element of actual fraud is dishonest intent in transferring assets so that it won't be available to creditors. Because it is difficult to prove that the debtor's motivation was dishonest, courts have relied on badges of fraud, which are patterns of behavior that at least create a suspicion of fraud.

Some common badges of fraud that have been recognized by the courts over the years include:

Badges of fraud are not presumptions of guilt but are simply circumstantial evidence that the debtor is acting deliberately to frustrate creditors' efforts at collection. Some badges are considered stronger indicators of fraud than others. However, it is the totality of circumstances that will determine the final outcome. If the transfer exhibits several badges of fraud, then the creditor's case is strengthened, especially if some of those badges are the stronger indicators of fraud; otherwise, the creditor's case will be weak. Obviously, if the debtor can provide a reasonable explanation for the transfer that did not involve fraud, then the creditor's case is greatly diminished.

Constructive Fraud

While actual fraud is proved by considering all of the evidence, constructive fraud is established by certain acts of the debtor, whether or not there was a dishonest intent. Hence, the debtor is held strictly liable for transfers involving constructive fraud. The 2 elements of constructive fraud are that (1) the debtor transferred property for less than reasonable equivalent value (2) while he was insolvent or in financial stress. If the creditor can prove these 2 elements, then constructive fraud will be established as a matter of law, without the need to inquire as to the debtor's state of mind at the time of the transfer. The idea of constructive fraud was developed because even if the debtor was not acting fraudulently, the actions of the debtor hurt its creditors, and so, such transfers should be set aside.

However, to establish the 2nd element of constructive fraud, the creditor must show that one of the following actions indicating financial distress occurred, all involving a transfer for less than a reasonably equivalent value:

Reasonably Equivalent Value

The term reasonably equivalent value suggests that the value of what the debtor transferred need not be exactly equal to the value that the debtor received, but the greater the difference between what the debtor gave and what he received, the more likely that the court will find that did not receive reasonably equivalent value.

Whether reasonably equivalent value was received will also be determined by the circumstances of the transfer, such as the relationship of the parties, the market for the transferred asset, and how easily the asset can be valued. Indeed, if the asset is difficult to value, then the other elements of the transfer will be given a greater emphasis.

Insolvency: Balance Sheet Test and Equity Test

Another key element of constructive fraud is insolvency at the time of transfer, either before the transfer took place or because of it.

There are 2 methods of determining insolvency: under the balance sheet test, insolvency results when the debtor's nonexempt assets are less than his liabilities.

Under the equity test, the debtor is considered insolvent when the debtor is failing to pay his bills on time or at all.

It would be difficult for a creditor to prove the debtor's insolvency using the balance sheet test, because the creditor would have to know what assets the debtor has that are not exempt under state law from execution, and the value of those assets. However, UFTA §2(b) allows the creditor without the debtor's financial data to presume that the debtor is insolvent by using the equity test. The debtor could rebut the presumption by using the balance sheet test—a fair remedy since the debtor has access to his own financial records.

However, the equity test is not foolproof in establishing insolvency, since there may be other reasons why the debtor is not paying his bills. Whether the court will accept a presumption of insolvency will depend on the debtor's overall payment patterns on all of his debts, the length of time of no payments, and the reasons for missing payments.

Incurring Debts That Will Not be Paid

If insolvency can't be proved at the time of the transfer, then the debtor's inability to pay the debt on new loans received after the transfer may allow not only present creditors, but also future creditors to avoid the transfer. In most of these cases, the debtor is operating a business, but the business has few prospects of earning enough money to pay back the loans that it is acquiring.

However, creditors may have difficulty showing that the debtor had little prospect of success before taking out the loans.

Rights of the Transferee

Because the transferee has certain rights, a transfer is only avoidable if the transferee acted in bad faith or gave less than reasonably equivalent value. Any transferee, including any subsequent transferees after the 1st one, who acted in bad faith, which in most cases means that the transferee plotted with the debtor to protect assets, will not be protected from an avoidance action. The transferee will either have to return the property or pay its value in cash. Furthermore, the transferee will be given no credit for what she paid to the debtor.

A good faith transferee is completely protected if the transferee gave a reasonably equivalent value for the asset. Any transferee subsequent to the good faith transferee is protected, whether reasonably equivalent value was given or not.

However, a good faith transferee who gave less than reasonably equivalent value to the debtor will be liable for the difference between the value received and the value given.