This generally occurs when a debtor gives away assets for free or below market value, generally to friends and/or relatives, sometimes with the understanding that they are holding the property for the debtor until all of the problems and claims go away. It is typical to see someone give all of their property to their spouse, children, siblings, etc.
Most transfers in the months or years leading up to a bankruptcy are not fraudelent transfers, actual, or constructive. Transferees must be wary, particulary in a down economy, when dealing with an individual or business in financial distress or where a transaction or offer simply looks too good to be true. What seems like a bargain now may be an invitation to later litigation in bankruptcy court for the transferee who is not suffucienlty diligent.
Badges of Fraud
Circumstantial Evidence of Intent:
- Transfer of assets to insider fraud or relative
- Debtor retains control after transfer (lives in house, drives car, uses equipment)
- Tries to conceal transfer
- Has been sued or been threatened with suit
- Transfer of subtantially all assets owned
- Insolvent after transfer
- No or very low consideration paid for assets
- Balance Sheet: Company is insolvent- negative net worth
- Insider Preferences: When assets are transferred to one friendly creditor over another (your friend or famliy member made a loan to your company and you have a debt to a bank and you take an asset or cash to pay your friend or family member in full or substantially, then some short time later, you file a bankruptcy, leaving the bank with nothing to collect on (assuming the bank was an unsecured lender).
Bankruptcy Act of 1898 (as amended in 1903):
Contains 2 sections dealing with fraudulent transfers. Sections 67e and 70a(4) that provided for jurisdiction and the interpretation that divided fraudulent transfers into two types:
- Transfers made with intent to delay or defraud creditors
- Transfers deemed fraudulent by operation of state law
Chandler Act of 1938:
- Increased the “look back” for fraudulent transfers from 4 months to 1 year
(2) Current Law
- Section 548(a)(1)(A) of the Bkrtcy Code sets forth the federal fraudulent conveyance law applicable today
- Specific relevant provisions of section 548 are as follows
- (a)(1) The Trustee may avoid any transfer (including any transfer to or for the benefit of an insider under an employment contract) of an interest of the debtor in property, or any obligation (including any obligation to or for the benefit of an insider under an employment contract) incurred by the debtor that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily:
- Made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
- (I) received less than a reasonably equivalent value in exchange for such transfer or obligation
- (I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;
- was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
- Intended to incur, or believed that the debtor would incur debts that would be beyond the debtor’s ability to pay as such debts matured.
- made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit on an insider, under an employment contract and no the ordinary course of business
- Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee or such transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation
- For the purpose of this section, a transfer is made when such transfer is so perfected that a bona fide purchaser from the debtor against whom applicable law permits such transfer to be perfected cannot acquire an interest in the property transferred that is superior to the interest in such property of the transferee, but if such transfer is not so perfected before the commencement of the case, such transfer is made immediately before the date of the filing of the petition.
- In this section
- “Value” means property, or satisfaction or securing of a present or antecedent debt of the debtor, but does not include an unperformed promise to furnish support to the debtor or to a relative of the debtor;
Note: Section 544(b) of bkrtcy code allows a trustee to utilize state fruadulent transfer laws to recover fraudulent transfers.
(3) Actual of Constructive Fraud
Bankruptcy CodeSection 548:
- Section 548 of the Bankruptcy Code sets forth two basic methods to establish a fraudulent transfer claim, proof of "actual fraud", that is, an intent on the part of the transferor to hinder, delay or defraud debtor’s creditors, and "constructive fraud", that is, statutorily imposed fraud, regardless of intent, under certain statutorily defined circumstances. In fact, both types of fraud are “statutory” since the statute defines the necessary elements of proof.
- Whether actual or constructive fraud, section 548(a)(1) requires: (1) a transfer of property or incurrence of an obligation by the debtor; (2) of an interest in property by the debtor; (3) made or incurred on or within two years before the petition date. 11 U.S.C. 548(a)(1).
- Transfer of Property or Obligation Incurred
- A “transfer is a ‘fraudulent transfer’ if the property was transferred to defeat the creditor’s rights, or was made under the circumstances deemed to be fraudulent.” Murray v. Stacy Trust (in re Goldberg), 277 B.R. 251, 294 (Bankr. M.D. La. 2002). A “fraudulent obligation is an obligation which is created to defeat the creditors’ rights, or is made pursuant to circumstances which are deemed to be fraudulent.” Three Characteristics distinguish a fraudulent obligation from a fraudulent transfer; (I) the nature of the act; (ii) the trustee or debtor in possession’s (DIP’s) remedy; and (iii) the timing of its occurrence to determine whether it falls within the two year period of avoidance.
- Nature of the Act
- The term “transfer” is defined under the section 101(54) of the Bankruptcy Code and the Legislative intent was that it be construed as broadly as possible. 5 Collier on Bankruptcy 548.02 (15th ed. Rev.). “Transfer” is broadly defined to include: “the creation of a lien; the retention of title as a security” and “each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property; or an interest in property.” 11 U.S.C. 101(54).
- The term “obligation” is not defined in the Bankruptcy Code but Courts have treated “obligation” as interchangeable with “debt” or “liability on a claim,” and interpreted to mean “a formal binding agreement or acknowledgement of a liability to pay a certain amount or to do a certain thing for a particular person or set of persons; esp., a duty arising by contract.” see, e.g., FCC v. Nextwave Personal Communications., Inc. (In re Nextwave Personal Communications., Inc.), 200 F.3d 43, 57 (2d Cir. N.Y. 1999); In re Asia Global Crossing Ltd., 333 B.R. 199, 203 (Bankr, S.D.N.Y. 2005) (“In most situations, therefore, the ‘obligation’ will impose a ‘debt’ on the obligor, and give a ‘claim’ to the obligee.”). However, “the term ‘obligation’ is broader than ‘claim’ because some ‘obligations’ cannot be discharged by the payment of money.”
- In short, the distinction between the two is that the law of fraudulent transfers applies to an actual disposition of property while the law of fraudulent obligations applies to the creation of liabilities to pay or to act by a debtor.
- Trustee’s or Debtor in Possession’s (DIP) Remedy
- The second characteristic that distinguishes a fraudulent obligation from a fraudulent transfer is the remedy available to the trustee or debtor in possession. The remedy for a fraudulent obligation is to invalidate the obligation such that it is not paid by the estate, while the remedy for a fraudulent transfer is to recapture the property transferred out of the estate. In re Revco D.S., 118 B.R. 468 (Bankr. N.D. Ohio 1990), “if the claim is deemed fraudulent, it will simply not be paid by the estate.” Avoidance of a fraudulent obligation simply voids that a claim without necessitating any recapture pursuant to Section 550 of the Bankruptcy Code.
- Timing of the Occurrence
- To determine whether a transfer was made within the two year avoidance period, section 548 of the bankruptcy code provides that a transfer is “made” when such a transfer is so perfected that a bona fide purchaser from the debtor could not obtain title in the property superior to the transferee, and if the transfer is not so perfected before the petition date, the transfer is deemed “made” immediately before the petition date. 11 U.S.C. 548(d)(1). The intent of section 548(d)(1) is to prevent fraudulent transfers from evading attack by being hidden until the limitations period has expired. 5 Collier on Bankruptcy 548.02 (15th ed. Rev.).
- While the Bankruptcy Code does not define the point at which an “obligation” is “incurred”, courts have generally held that “a debt is incurred on the date upon which the debtor first becomes legally bound to pay.” In re Balducci Oil Company 33 B.R. 843, 846 (Bankr. D. Colo. 1983) (debt incurred when the parties orally agreed to deliver fuel in consideration for timely payment). Section 101(12) of the Bankruptcy Code defines “debt” as “liability of an claim.” see FCC v. Nextwave Persona. Communs., Inc. (In re Nextwave Personal Communications, Inc.), 200 F.3d 43, 57 (2d Cir. N.Y. 1999) (while Bankruptcy Code is silent as to when debt or obligation is incurred, courts have not questioned that “obligation” to pay principal indebtedness under promissory note is “incurred” on date note is executed and delivered).
- While outright gifts or selling property at a reduced price are obvious transfers, courts have considered any number of other events as “transfers” as well under section 548, including:
- Certain elections under the Internal Revenue Code, see In re fieler 230 B.R. 164 (B.A.P. 1999), aff’d, 218 F.3d 948 (9th Cir. 2000) (election to carry forward net operating loss (NOL) and to waive NOL carry back), see also pension transfer corp v. beneficiaries under third amendment to fruehauf trailer
- Corporations Retirement Plan No. 003, 319 B.R. 76 (D. Del. 2005), aff’d 444 F.3d 203 (3d Cir. 2006) (irrevocable election by debtor under pension plan to increase benefits was transfer under section 548);
- Consignment of goods, see in re factory tire distributors, inc., 64 B.R. 335 (W.D. Pa. 1986);
- Foreclosures, see BFP v. Resolution trust Corp., 511 U.S. 531, 114 S. Ct. 1757 (1994) (holding that pre-petition foreclosure sale cannot be set aside as a fraudulent conveyance where there is full compliance with state foreclosure laws);
- Lease termination, see in re Indridi, 126 B.R. 443 (Bankr. D.N.J. 1991);
- Levarage buyouts (mellon bank, N.A. v. Metro Communications, inc., 945 F.2d 635, 646 (3d Cir. 1991) (definitional language is sufficient to encompass LBO’s); cf. In re Hechinger Investment Co. of Delaware, 274 B.R. 71 (D. Del. 2002) (payments made to debtor’s shareholders to effectuate LBO not transfers but instead insulated from avoidance settlement payments);
- Mortgage modification, see matter of venice western motel, ltd., 67 B.R. 777, 780 (Bankr. M.D. Fla. 1986) (transfer had the net effect of increasing principle amount of loan.
- Transfers according to marital property settlement, separation agreement or divorce decree, see In re lange, 35 B.R. 579, 583 (bankr E.D. Mo. 1983
- “Interest in Property” is not defined in the Bankruptcy Code, and thus, bankruptcy courts look to state law to determine whether the debtor had an interest in the property transferred. In re Hulm, 738 F.2d 323, 326 (8th Cir. 1984), cert. denied, 469 U.S. 990, 105 S. Ct. 398 (1984) (citing Butner v. United states, 440 U.S. 48, 55, 99, S. Ct. 914, 918 (1979); Johnson v. first national bank of montevideo, 719 F.2d 270, 273 (8th Cir. 1983), Cert Denied, 465 U.S. 1012, 104 S. Ct. 1015 (1984). There are two general types of “interest in property” - (1) property where the debtor owns legal title; and (2) property where the debtor does not hold legal title but retains an equitable interest. Where the debtor owns legal title to the property, the debtor bears the burden of proof that de facto or equitable titel belongs to the alleged transferee.
- Made or Incurred Within Two Years
- As discussed above, section 548 generally has a two year look back provision, meaning that the trustee can only look back the two years preceding the petition date to avoid any transfer of an interest of the debtor that was made or incurred on or incurred on or within that two year period, if procured through fraudulent means of the debtor as described in section 548(a)(1)(A) 11 U.S.C 548 (a)(1)(A)
- The plain language of section 548 provides that it is only to prevent pre-petition transfers, not post-petition transfers. Therefore, a transfer that occurs after the bankruptcy petition is filed is not governed by section 548 of the bankruptcy code. Consolidated partners Inc. Co. v. lake 152 B.R. 485, 490 (Bankr. N.D. Ohio 1993); Fisher v. first union mortgage corp. (in re fisher), 80 B.R. 58, 60 (Bankr. M.D.N.C. 1987); Eisenberg v. Bank of New York (in re sattler’s inc.), 73 B.R. 780,790 (Bankr S.D.N.Y. 1987). Therefore, the timing of a transfer can be very important in defending a fraudulent transfer claim.
- ACTUAL FRAUD
- To prove ‘actual fraud’ it must be shown, in addition to the criteria above, that the debtor made the transfer or incurred the obligation with actual intent to hinder, delay or defraud the debtor’s creditors. 11 U.S.C. 548(a)(1)(A)
- Transferor’s intent
- Section 548(A)(1)(A) of the bankruptcy code looks only to the fraudulent transferor. See 11 U.S.C. 548 (“of the debtor.... made such transfer... with actual intent...”) See also In re Bayou Group, LLC (Bayou IV), 439 B.R. 284, 304 (S.D.N.Y. 2010). The transferee’s state of mind is irrelevant in looking at “actual intent.”
- Proof of Circumstantial evidence and the badges of fraud
- Since actual fraud is difficult to establish without direct evidence or an admission, a finding of fraudulent intent on the part of the debtor under section 548 (a)(1) can be made on the basis of circumstantial evidence, or the “badges of fraud”. see In re AFI Holdings, Inc., 525 F.3d 700 (9th Cir. 2008); Krol v. Unglaub (In re Unglaub), 332 B.R. 303 (Bankr. N.D. Ill. 2005) (discussing that when badges of fraud are present in a sufficient number, they may give rise to an inference or presumption of an intent to defraud). Courts look to the nature of the transfer and the relationship between the parties to determine fraudulent intent. “Badges of fraud” include, but are not limited to: (i) a transfer of all or substantially all of the debtors property; (ii) retention of possession of property by the debtor, when title exists in another entity; (iii) a level of secrecy in the transfers; (iv) the existence of a trust between the debtor and the person to whom the property is conveyed; (v) the transfer of the property while a suit against the debtor pending or litigation has been threatened against the debtor; (vi) the instrument effecting the transfer suspiciously states that it is bonafide; (vii) inadequate consideration in exchange for the the transfer; (viii) gifts to affiliates, insiders and family members; and (ix) insolvency or other unmanageable indebtedness on the part of the debtor. See e.g. In re Bayou Group, LLC, 439 B.R. 284 (S.D.N.Y. 2010)(payments to investors in Ponzi scheme were accompanies by numerous “badges of fraud” sufficient to imply actual intent to defruad); ASARCO, LLC v. Americas Mining Corp., 396 B.R. 278 (S.D. Tex. 2008) (court found actual intent to hinder, delay and defraud after examining the badges of fraud as circumstantial evidence of fraudulent intent).
- The badges of fraud are considered in totality and a trustee or debtor in possession does not have to prove any one of the badges with any degree of certainty. The facts, in totality, only need to lead to the conclusion that actual fraud existed. Harmon v. First Am. Bank of Md. (In re Jeffery Bigelow Design Group, Inc.), 956 F.2d 479, 483-84 (4th Cir. 1992). The test requires a subjective determination of the debtor’s intentions in making the transfer.
- Numerous courts have held that the existence of a Ponzi scheme is sufficient to establish actual intent to defraud under section 548(a)(1). See In re AFI Holdings, Inc., 525 F.3d 700 (9th Cir. 2008) (existence of Ponzi scheme sufficient to establish fraudulent intent); See In re Evergreen Security, Ltd., 319 B.R. 245, 253 (Bankr. M.D. Fla. 2003) (debtor’s intent to hinder, delay or defraud creditors present when transfer is made in furtherance of Ponzi scheme); In re World Vision Entertainment, Inc., 275 B.R. 641, 656 (Bankr. M.D. Fla. 2002) (Ponzi scheme is by definition fraudulent).
- Constructive Fraud
- Just as with a claim for actual fraud, a claim of constructive fraud requires proof under the introductory language of section 548(a)(1) of the following: (1) a transfer of property or incurrence of an obligation by the debtor, (2) of an interest in property by the debtor (3) made or incurred on or within two years before the petition date. 11 U.S.C. 548 (a)(1)
- Once those elements are proven, two additional elements are necessary to establish constructive fraud. First, the trustee must prove that “the debtor involuntarily or voluntarily ... received less than reasonably equivalent value in exchange for such transfer or obligation.” 11 U.S.C. 548(a)(1) and (a)(1)(B)(I). Second, any one of the following four criteria must be established regarding the debtor: (I) was insolvent on the date that such transfer was made or such obligation incurred, or became insolvent as a result of such transfer or obligation; (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital (III) intended to incur or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured; or (IV) made such transfer to or for the benefit of an insider, under an employment contract and not in the ordinary course of business. 11 U.S.C. 548(a)(1)(B)(ii)(I)-(IV). Whether the debtor received reasonably equivalent value and whether the debtor was insolvent are the two most frequently litigated issues.
- Reasonably Equivalent Value (REV)
- REV is on of the most litigated issues in fraudulent transfer litigation. The first inquiry is whether any value was received by the debtor in exchange for the transfer. see, e.g. In re Tower Environmental, Inc., 260 B.R. 213, 225 (Bankr. M.D. Fla. 1998). Second, if value was given was it reasonably equivalent to the funds transferred. Value is assessed by a case by case basis by looking at the surrounding circumstances and by focusing on the precise nature if the transfer. In re World Vision Entertainment, Inc., 275 B.R. 641, 657 (Bankr. M.D. Fla 2002). The focus is on the value of the goods and services provided rather than on the impact the goods and services had on the bankrupt enterprise. In re Financial Federated Title & Trust, Inc., 309 F.3d 1325, 1332 (11th Cir. 2002).
- The following factors have been utilized to determine REV, for the purposes of the Bankruptcy Code’s fraudulent transfer provision: (1) the fair market value of the benefit received as a result of the transfer; (2) whether the transaction took place at arms length; and (3) the good faith of the transferee. see, e.g., In re Fruehauf Trailer Corp., 443 F.3d 203, 210 (3d Cir. 2006). A transfer will not be voided under a constructive fraud argument if the transfer “confers an economic benefit upon the debtor” either directly or indirectly. Of “the debtor’s net worth has been preserved,” there is no injury to the interests of the creditors by the transfer. Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979, 991 (2d Cir. 1981). The benefit received by a debtor does not need to be direct in order for it to constitute reasonably equivalent value. See In re Advanced Telecom. Network, Inc., 490 F.3d 1325, 1326 (11th Cir. 2007): But see In re Rodriguez, 895 F.2d 725 (11th Cir. 1990) (corporate debtor did not receive the REV for constructively fraudulent payments made on behalf of its subsidiary).
- As long as the unsecured creditors are no worse off because of the transfer, then the debtor received REV to that which left the estate because of the transfer. Harman v. First Am. Bank of Md (In re Jeffrey Bigelow Design Group, Inc.), 956 F.2d 479, 484 (4th Cir. 1992). The debtor, however need not receive a dollar for dollar exchange in order to have been paid REV. In re Fruehauf Trailer Corp., 443 F.3d 203, 212-213 (3d Cir. 2006) (court must determine whether under circumstances debtor got roughly the value it gave); In re Fairchild Aircraft Corp., 6 F.3d 1119, 1125-26 (5th Cir. 1993); In re Southmark Corp., 138 B.R. 820, 829 (Bankr. N.D. Tex. 1992)
- One line of cases has found that anything less than 70% of the value is not reasonably equivalent. Durret v. Washington Nat’l Ins. Co., 621 F.2d 201, 203 (5th Cir. 1980)(stating in dicta that anything less than 70% is presumptively not REV); In re Thrifty Dutchman, Inc., 97 B.R. 101, 108 (Bankr. 13 S.D. Fla. 1988). See In re Fargo Biltmore Motor Hotel Corp., 49B.R. 782, 788 (Bankr. D.N.D. 1985) (flat percentage basis approach is inappropriate but good starting point to gauge reasonableness of transfer). Some courts only follow the 70% rule only in the cases of private sales, while others hold that a determination of reasonably equivalent value should be done on a case by case basis. Madrid v. Lawyers Title Ins. Corp. (In re Madrid), 725 F.2d 1197 (9th Cir. 1984); First Federal Savings & Loan Assn. of Bismark v. Hulm (In re Hulm), 738 F.2d 323, 327 (8th Cir.), cert denied, 469 U.S. 990 (1984). In the context of foreclosure sales properly conducted according to state law, the United States Supreme Court has rejected the 70% rule. BFP v. Resolution Trust Corp., 511 U.S. 531, 114 S. Ct. 1757 (1994).
- Payment if an antecedent debt or for an obligation for which the debtor was liable presumptively constitutes REV. Rubin v. Manufacturers Hanover Trust Co., 661 F.2d 979, 991 (2d Cir. 1981); Pablo v. Gonzaba (In re APF Co.), 308 B.R. 183, 187 (Bankr. D. Del. 2004). Similarly, assumption of a contract by the debtor may also provide a defense in view of the requirement under 11 U.S.C. 365 that in order for debtor to assume the contract the creditor must first be made whole, i.e., all terms of the contract, including payment, must be brought up to date. See, e.g. In re Network Access Solutions Corp., 330 B.R. 67 (Bankr. D. Del 2005).
- Insolvent, unreasonably small capital, debts beyond ability to pay, OR payment to insider under employment contract
- Insolvent debtor
- Courts apply different standards to determine solvency, but section 101(32)(a) of the bankruptcy code defines “insolvency” as a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation. 11 U.S.C. 101(32)(A). This is referred to as the “balance sheet test,” and in determining whether a debtor is solvent, the bankruptcy courts look to see if the debtors debts are “greater than [its] property at fair market valuation” - or what a buyer would be willing to pay for all of the debtor’s assets and liabilities. Covey v. Commercial National Bank of Peoria, 960 F.2d 657, 660 (7th Cir. 1992); Mellon Bank, N.A. v. Metro. Communications, Inc., 945 F.2d 635 (3d Cir. 1991), cert. denied, 112 S. Ct. 1476, 117 L. Ed. 2d 620 (1992); In re bay vista of virginia, Inc., 428 B.R. 197 (Bankr. E.D. Va. 2010) (for fraudulent transfer purposes debtor’s insolvency is determined by balance sheet insolvency under which debtor is “insolvent” when debtor’s liabilities exceed debtor’s assets, excluding the value of preferences, fraudulent conveyances and exemptions); In re Eckert, 388 B.R. 813 (Bankr. N.D. Ill. 2008) (Bankruptcy Code employs “balance sheet approach to question of debtor’s solvency/insolvency at a time of alleged fraudulent transfer pursuant to which court must determine what willing buyer would pay for debtor’s entire package of assets and liabilities; debtor is either solvent or insolvent depending on whether price is positive or negative.
- In short, under the balance-sheet test, insolvency exists when the value of the transferor’s assets is less than its liabilities at the time the transfer was made. Courts apply a two-step analysis to see if the company was insolvent. First, the court determines whether it is proper to value the company’s assets on a going concern or liquidation basis. Next, the court conducts its own fair valuation and assigns a value to the assets and liabilities to see if the debts exceed the assets.
- While the basic concept of balance sheet insolvency is clear, uncertainty arises in its application of a “fair valuation” because a determination has to be made as to whether the debtor’s assets and liabilities are to be valued as if they were to be liquidated immediately or be values as if the debtor is a going concern. “Fair valuation” is indistinguishable from “fair market value,” and is the:
- Estimate of what can be realized out of the assets within a reasonable time either through collection or sale at the regular market value, conceiving the latter as the amount which could be obtained for the property in question within such period by a ‘capable and diligent business man’ from an interested buyer ‘who is willing to purchase under the ordinary selling conditions.’
- In re Duque Rodriguez, 75 B.R. 829, 831 (Bankr. S.D. Fla. 1987) (citing to 2 Collier on Bankruptcy 101.29 n. 60-63 (15th Ed. 1987)); See also Wieboldt Stores, Inc. v. Schottenstein, 94 B.R. 488 (bankr. N.D. Ill. 1988) (finding that “fair valuation” is near enough in meaning to “fair value of saleable assets” to defeat motion to dismiss”
- Additionally, courts may consider actual values of assets as opposed to historical values when determining insolvency under the balance sheet test, as well as the value of debtor’s intangible assets. In re EBC I, Inc., 380 B.R. 348 (Bankr. D. Del. 2008) (in utilizing “balance sheet” approach to assess solvency of debtor/toy retailer at the time of first of two transactions challenged as constructively fraudulent to creditors it was appropriate to consider value of debtor’s intangible as well as tangible assets); In re Roco Corp., 21 B.R. 429 (B.A.P. 1st Cir. 1982) (Bankruptcy Court use of unaudited corporate balance sheet to determine insolvency of debtor at time of transfer was not clearly erroneous; balance sheets may generally only reflect historical value, but these unaudited statements did reflect fair market value; since the issue is fair market valuation and debtor valued inventory at retail sales price for the preceding year’s cost, the figures more likely reflected an actual value rather than historical value, and therefore reliance on the balance sheet was not an error).
- Courts, however disagree whether contingent liabilities and assets should be considered in an insolvency determination. In re WRT Energy Corp., 282 B.R. 343 (Bankr. W.D. La. 2001) (concluding that in assessing debtor’s solvency for fraudulent transfer avoidance purposes court should include debtor’s contingent assets or liabilities as part of the balance sheet insolvency test); In re Taylor, 228 B.R. 491 (Bankr. M.D. Ga. 1998) (for purposes of determining insolvency court should consider only those assets on balance sheet readily susceptible to liquidation and payment of debts and only those debts that are valid under applicable state or federal law).
- Unreasonably Small Capital
- While “unreasonably small capital” is not a defined term in the Bankruptcy Code, most courts hold that the definition indicates a financial condition short of insolvency. E.g., Murphy v. Meritor Sav. Bank (In re: O’Day Corp.), 126 B.R 370, 407 (Bankr. D. Mass. 1991). However, the condition must be severe enough that insolvency is imminent. If not, the statute would be too broad. Vadnais Lumber Supply, Inc. v. Byrne (In re Vadnais Lumber Supply, Inc.), 100 B.R. 127, 137 (Bankr. D. Mass. 1989).
- Inability to Pay a Debt Incurred by a Transfer
- The last alternative under Section 548 (a)(2) of the Bankruptcy Code requires evidence that the debtor intended to incur, or believed he would incur, debts that would be beyond his ability to pay. 11 U.C.S 548(a)(2)(iii). Courts look to the intent of the debtor when the transfer was made as this provision of section 548 requires an affirmative act by the debtor. Thus, it is arguable that involuntary transfers are not contemplated by Section 548(a)(2)(B)(iii). See Hall v. Quigley (In re Hall), 131 B.R. 213, 218 (Bankr. N.D. Fla. 1991) (concluding that involuntary transfers were not contemplated by 548(a)(2)(B)(iii).
- Insider Employment Contract
- As noted above, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) extended the look back from one year to two and added a provision regarding payments to insiders under employment contracts. Under section 548 (a)(2)(B)(iv). the trustee may avoid any transfer or obligation incurred within two years of the petition filing for which the debtor voluntarily or involuntarily did not receive reasonably equivalent value or where the debtor made such transfer to or for the benefit of an insider, under an employment contract and not in the ordinary course of business. See In re TSIC, Inc., 428 B.R. 103 (Bankr D. Del. 2010) (finding severance payment to former insider constructively fraudulent and not in the ordinary course).
(4) Adversary Proceeding Required to Recover Fraudulent Transfers
- Adversary Proceeding Required to Recover Fraudulent Transfers
- Fraudulent transfers are not automatically void. To avoid a fraudulent transfer, the trustee or debtor in possession must bring an adversary proceeding, i.e., file a complaint, under the Federal Rules of Bankruptcy Procedure. Fed. R. Bankr. P. 7001
- Statute of Limitations and Equitable Tolling
- While section 548 of the Bankruptcy Code provides the trustee or debtor in possession with the power to avoid the transfer, Section 546 of the Bankruptcy Code sets forth limitations on the trustee or debtor in possession’s avoidance powers by providing that:
- An action or proceeding under [section 548] may not be commenced after the earlier of -
- The later of -
- 2 years after the entry of the order for relief; or
- 1 year after the appointment or election of the first trustee under section 702, 1104, 1163, 1202, or 1302 of this title if such appointment or such election occurs before the expiration of the period specified in subparagraph (A); or
- The time the case is closed or dismissed
- 11 U.S.C. 546(a)(1)-(2). Thus, in order to avoid a fraudulent transfer, an adversary proceeding must be brought within two years after the petition date or one year after the appointment of the trustee.
- Under the doctrine of equitable tolling, however, the statute of limitations may be tolled: (1) where the defendant has actively misled the plaintiff regarding the plaintiff’s cause of action; (2) where the plaintiff has been prevented in some extraordinary way from asserting its rights: or (3) where plaintiff has asserted its rights but mistakenly did so in the wrong forum.
- Pleading Fraud with Particularity
- Like any other allegation of fraud, a claim alleging fraudulent transfer must be alleged with particularity but courts differ on the level of particularity required. Burtch v. Dent (In re Circle Y), 354 B.R. 349 (Bankr D. Del. 2006) (rejecting checklist simply restating language of statute); In re Oakwood Homes Corp., 340 B.R. 510 (Bankr. D. Del 2006) (Where complaint identified transfers at issue and stated that less than reasonably equivalent value received pleading sufficient to withstand motion to dismiss).
- Affirmative Defenses
- While one approach to defending a fraudulent transfer claim is to attack the prima facieelements of a fraudulent transfer (i.e. establish lack of intent, reasonably equivalent value, or insolvency), Section 548(c) of the bankruptcy code provides an affirmative defense to recovery of fraudulent transfers from a transferee. Specifically, Section 548(c) Provides
- Except to the extent that a transfer or obligation voidable under this section is voidable under section 544, 545, or 547 of this title, a transferee or obligee of such transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such a transferee or obligee gave value to the debtor in exchange for such transfer or obligation.
- 11 U.S.C 548(c) This is referred to as the “good faith for value defense.” In order for a transferee to satisfy the good faith for value defense, the transferee bears the burden of establishing by a preponderance of the evidence (1) that it gave value for the transfer; and (2) that it took the transfer in good faith. See In re Bayou Group, LLC, 439 B.R. 284, 308 (S.D.N.Y. 2010) (reversing in part Bankruptcy grant of summary judgement against certain investors based on finding that certain “red flags” put investors on notice of some infirmity in the investment such that reasonable investor would conduct some investigation); In re M & L Business Mach. Co.,84 F.3d 1330, 1338 (10th Cir. 1996). The intent of the transferee is determinative under Section 548(c). See In re Hill, 342 B.R. 183 (Bankr. D.N.J. 2006).
- The first prong of good faith for value defense requires that the transferee prove an exchange of value. Under Section 548(a)(1)(B)(I), the relevant inquiry is the value given by the transferee and not the value received by the debtor. In re Hannover Corp., 310 F.3d 796, 801 (5th Cir. 2002). Thus, the inquiry under section 548(c) as to whether value was provided is the same inquiry as “reasonably equivalent value” as it is applied in constructive fraud cases.
- Good Faith
- The second prong of the affirmative defense under Section 548 of the Bankruptcy Code is good faith. Good faith is an objective standard. See In re Evergreen Security, Ltd., 319 B.R. at 254. While not defined in the bankruptcy code, courts have defined good faith in a number of ways. Gilmer v. Woodson (In re Decker), 332 F.2d 541, 547 (4th Cir. 1964) (good faith not lacking unless transferee knowingly participated in transferor’s purpose to defeat other creditors or lacked good faith in valuing property exchanged); In re Windor Indus., Inc., 459 F. Supp. 270, 279 (N.D. Tex. 1978) (good faith under former 11 U.S.C. 107 not present where transferee at time of transaction had knowledge of facts sufficient to put him on inquiry as to the insolvency or possible insolvency of debtor). Indeed, courts have generally recognized that the variables are manifold and thus what constitutes “good faith is not susceptible to precise definition. In re Bayou Group, LLC, 439 B.R. at 308 (Citations Omitted).
- To determine whether a transferee acted in good faith, courts must look at what the transferee objectively “knew or should have known,” and if the transferee had sufficient knowledge to place it on inquiry notice of the voidable nature of the transfer or the debtors insolvency, then the transferee did not act in good faith. see also In re Evergreen Securities, Ltd., 319 B.R. at 254; In re World Vision Entertainment, Inc., 275 B.R. at 659. A transferee cannot remain willfully ignorant of facts which would cause notice of a debtor’s fraudulent purpose. See Wiand v. Waxenberg, 611 F. Supp. 2d 1299 (M.D. Fla. 2009) (good faith determination looks to whether reasonably person would have made inquiry based on their knowledge of the facts). Since good faith is an objective standard, a transferee can not put on binders prior to entering into transactions with the debtor and then subsequently claim the benefit of Section 548(c) of the Bankruptcy Code, particularly if the circumstances would place the transferee on inquiry notice of the debtors fraudulent purpose. In re Evergreen Security, Ltd. 319 B.R. at 254
- Extent of Liability Under Section 550 and Additional Good Faith Defense
- In addition to avoiding a transfer under Section 548, Section 550 of the Bankruptcy Code sets forth the liability of a transferee if a transfer is avoided under Section 548 of the Bankruptcy Code. Section 550 of the Bankruptcy Code Provides that to the extent a transfer is avoided under section 548, the trustee or debtor in possession may recover, for the benefit of the estate, the property transferred, or, if the court orders, the value of such property from (I) the initial transferee of the transfer or the entity for whose benefit the transfer was made; or (ii) any immediate or mediate transferee of such initial transferee. 11 U.S.C. 550(a). However, there are protections for immediate or mediate transferees of the initial transfer in that a trustee or debtor in possession cannot recover from an immediate or mediate transferee (1) the transferee takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided; or (2) any immediate of mediate good faith transferee of such transferee. 11 U.S.C 550 (b). Thus, such transferees may have an additional good faith defense.