Fraudulent Conveyances

Originally published by Jason B. Freeman.

Section 548 of the Bankruptcy Code provides a bankruptcy trustee (or the debtor-in-possession) the power to set aside or “avoid” certain transfers of the debtor’s assets out of the bankruptcy estate that may otherwise place assets beyond creditors’ reach. Such a transfer of the debtor’s assets to a third party, with the intent to prevent creditors from reaching the assets to satisfy their claims, is known as a “fraudulent conveyance” or a “fraudulent transfer.”

Elements:

There are two types of fraudulent conveyances. The first, actual fraud, involves the intent to defraud creditors. The second, constructive fraud, involves a transfer that is made in exchange for grossly inadequate consideration. Both types of fraudulent transfers involve a two-year “look back period” and a two-year statute of limitations. Thus, to be considered a fraudulent conveyance, a transfer must occur within two years immediately before a bankruptcy filing. However, a trustee may be able to set aside certain transactions under state laws, which may provide for longer look-back periods. A transfer cannot be set aside if it occurs after a bankruptcy filing.

Actual Fraud:

Actual fraud is committed when a transfer is made with the intent to hinder or defraud a creditor. The intent of the transferee is irrelevant—the only relevant inquiry is the intent of the debtor. Actual fraud requires proof of intent from the individual challenging the transfer. Courts have set forth circumstances, the existence of which indicate the intent to defraud. Some examples of these circumstances are:

• actual or threatened litigation against the debtor,
• a retention of possession or control of the property,
• transfer of substantially all the debtor’s assets,
• transfer to a newly created corporation, and
• a special relationship with the person to whom the property is transferred.

These are merely factors to be considered by the court in determining intent. Whether they do in fact prove the debtor’s fraudulent intent is determined on a case by case basis.

While not an absolute defense to actual fraud, establishing that the debtor received reasonably equivalent value for the transferred property tends to rebut inferences of intent to defraud.

Constructive Fraud:

Constructive fraud requires two conditions: 1) in exchange for the transfer, the debtor received less than “reasonably equivalent value”, and; 2) the debtor is unable to pay debts either at the time the transfer was made or as a result of the transfer itself. In this case, intent is irrelevant. The only important issue is whether the debtor received reasonably equivalent value. Of course, “reasonably equivalent value” is a subjective measure. When there is no value given in exchange for the transfer of the debtor’s property, the answer is an easy one. However, when something of value is given, the question becomes whether the value was truly adequate compensation for the property.

Courts will, again, look at the circumstantial evidence surrounding a transaction to determine whether the exchange appears fair. Some of the factors the courts consider include:

• whether the transaction was made in good faith in the ordinary course of business by parties of independent interests,
• the competitiveness of bids for the property, and
• the net effect on the debtor’s estate with respect to funds available to unsecured creditors.

Generally, for an exchange to be considered legitimate, value does not have to be received directly by the debtor, but may exist in the form of additional business opportunities made available through new lines of credit or new affiliations created by the transfer. However, transfers made solely for the benefit of third parties are not reasonably equivalent value.

Timing of the Transfer

Again, to be considered a fraudulent conveyance, a transfer must occur within two years immediately before a bankruptcy filing. Thus, it is important to determine precisely when a transfer occurred. A transfer is deemed to be made once is it “perfected” under applicable state law. Perfection occurs when a bona fide purchaser buying property from the debtor cannot acquire an interest superior to that of the transferee. The transfer of certain types of property require multiple steps to complete the transaction. For example, the transfer is not complete until a deed is officially recorded.

Defenses to a Fraudulent Conveyance Action

• The debtor received reasonably equitable value
• The debtor was solvent at the time of the transfer
• The transfer did not occur within the look-back period
• The statute of limitations has tolled
• The transferee was a good-faith purchaser
• The transferee repaired, improved, or preserved the property
• The transferee was a “mere conduit,” meaning that they had no real control over the property. A financial intermediary is a typical example.
• The transfer was a settlement payment. For example, in a divorce settlement, a debtor may not be able to get “reasonably equivalent value.”

Effect of a Fraudulent Conveyance

Once a transfer has been deemed fraudulent, the trustee may recover the property, or the value of the property, and make it part of the bankruptcy estate. One exception to this general rule, however, is the case of the “bona fide purchaser”. The bona fide purchaser is one who acted in good faith to purchase the property without notice of the outstanding rights of others to the property. The bona fide purchaser may retain the property.

Another exception is made where valuable improvements to the property have been made. In such circumstances, those that made the improvements to the property are provided with a lien on the property, securing the improvements they made. Finally, if the law places no other restrictions on the transfer, and the property was purchased for some value in good faith, in other words, with no knowledge of the fraudulent intent, the person receiving the transferred property may be allowed to retain the property or regain the value they paid for it in the settling of the estate.

Fraudulent transfers can have a negative effect on creditors. Creditors who suspect the fraudulent transfer of property may be able to obtain a temporary restraining order and preliminary injunction to prevent the transfer before it occurs.

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