In Part 1 of this series, we covered preferential transfers. In Part 2, we’re covering fraudulent transfers, which are transactions featuring actual or constructive fraud during the two years (or possibly longer) before a bankruptcy case begins. A fraudulent transfer action seeks to “avoid” or “undo” a pre-bankruptcy transaction so that the value of that transaction can be recovered by the debtor’s bankruptcy estate and redistributed to the debtor’s creditors. Bankruptcy Code Section 548(a)(1)(a) relates to transfers of the debtor’s property involving actual fraud, which means the debtor made the transfer with the actual intent to hinder, delay, or defraud a creditor. Section 548(a)(1)(b) relates to constructive fraud, which is generally limited to transfers for less than reasonably equivalent value.
State fraudulent transfer laws such as the Uniform Voidable Transactions Act or its predecessor, the Uniform Fraudulent Transfer Act (collectively, UFTA)—which are in effect in most states—are broadly similar to the Bankruptcy Code fraudulent transfer statute, 11 U.S.C. § 548 (Section 548). In addition to Section 548, the applicable state’s version of the UFTA may be enforced in a bankruptcy case.
Fraudulent Transfer Claims Under Bankruptcy Code Section 548
Section 548(a)(1) provides that a trustee or debtor-in-possession (collectively, the trustee) can avoid any transfer of the debtor’s interest in property that is made within two years before the date of the filing of the bankruptcy petition and either (a) made with the actual intent to hinder, delay, or defraud a creditor of the debtor (actual fraud), or (b) for which the debtor, while insolvent (or experiencing similar financial difficulty), received less than reasonably equivalent value (constructive fraud).
Actual Fraud. Fraudulent intent is rarely subject to direct proof; thus, courts rely on certain indicia of fraud to infer intent to defraud creditors (badges of fraud). Courts, including bankruptcy courts, have determined that the following badges of fraud, among others, may support the inference of fraudulent intent:
- lack or inadequacy of consideration;
- family, friendship, or close associate relationship between the parties;
- retention by the debtor of possession, benefit, or use of the property in question;
- financial condition of the debtor both before and after the transaction in question;
- existence or cumulative effect of a pattern or series of transactions or course of conduct after the incurring of debt, onset of financial difficulties, or pendency or threat of suits by creditors;
- transfer of property by the debtor to his spouse while insolvent, while retaining the use and enjoyment of the property; and
- shifting of assets by the debtor to a corporation wholly controlled by the debtor.
Constructive Fraud. Under Section 548(a)(1)(b), a trustee can avoid constructively fraudulent transfers if the debtor: (1) received less than equivalent value in exchange for the transfer; and (2) either (i) the debtor was insolvent at the time that the transfer was made, became insolvent as a result of the transfer, or the transfer left the debtor with unreasonably small capital, or (ii) the debtor intended to incur debts beyond its ability to pay.
Determining whether a transferee received “less than reasonably equivalent value” or whether the debtor was or became insolvent can be difficult questions of fact, likely requiring appraisals or other expert testimony.
Defenses to Fraudulent Transfers
Section 548(c) of the Bankruptcy Code provides an affirmative defense to the avoidance of fraudulent transfers. If a transferee receives property (1) for value and (2) in good faith, the transferee may retain the transferred property or be entitled to a lien on it equal to the value given.
Good faith is not defined in the Bankruptcy Code, and whether a transferee acted in good faith is fact specific. Generally, a transferee can establish good faith by showing: (1) an honest belief in the propriety of the activities in question; (2) no intent to take unconscionable advantage of others; and (3) no intent or knowledge of the fact that the activities in question would hinder, delay, or defraud others. The creditor bears the burden of proving that it is entitled to the Section 548(c) defense.
Strong-Arm Avoidance Powers
Trustees can also seek to avoid fraudulent transfers under Section 544(b) of the Bankruptcy Code, known as the “strong-arm” clause. Section 544(b) provides that the trustee may avoid a transfer “that is voidable under applicable law by a creditor holding an unsecured claim.” This allows trustees to assert claims against creditors using state laws, including fraudulent transfer claims under the UFTA. Generally, UFTA claims have a significantly longer statute of limitations, which allows for avoidance reach-back periods much longer than the two-year limitation of Section 548. Section 544(b) expands the trustee’s avoidance arsenal well beyond Section 548 to avoid and recover alleged fraudulent transfers made by the debtor before the filing of the bankruptcy petition.
Conclusion
Fraudulent transfer claims are generally fact specific. If a claim of this nature is asserted against you or your company, in a bankruptcy case or otherwise, experienced counsel can assist in analyzing the likelihood of success, potential defenses, and other factors that can help minimize liability or defeat fraudulent transfer claims in their entirety.
The Thought Leadership Committee of Barclay Damon’s Restructuring, Bankruptcy & Creditors’ Rights Practice Area issues alerts and blogs on an ongoing basis to keep clients, colleagues, and friends up to date on important developments in the insolvency space. If you have any questions regarding the content of this alert, please contact the author, Ilan Markus, partner, at imarkus@barclaydamon.com; Janice Grubin or Jeff Dove, Restructuring, Bankruptcy & Creditors’ Rights Practice Area co-chairs, at jgrubin@barclaydamon.com and jdove@barclaydamon.com; or Robert Wonneberger, Thought Leadership Committee chair, at rwonneberger@barclaydamon.com