In the first installment of this article, we discussed the prevalence of preference litigation and some of the commonly-available defenses to business vendors to limit or even eliminate liability to the bankruptcy estate. While preference actions are by far the most common type of avoidance litigation brought in bankruptcy cases, this is not the end of the story.  Bankruptcy estate representatives can also bring actions to avoid fraudulent transfers and post-petition transactions. We will first discuss the elements of each of these avoidance claims, followed by some tips to avoid being the target of such an action in the first place or, if a defendant, some strategies to limit liability. 

I.  FRAUDULENT TRANSFERS.

Often pled as an alternative count along with preference claims, actions to avoid and recover fraudulent transfers are a common form of litigation in bankruptcy cases. There are two sources of statutory authority for the avoidance of fraudulent transfers. The first is found in Section 548 of the Bankruptcy Code and the second is state law fraudulent transfer statutes invoked under Section 544.

Section 548 of the Bankruptcy Code

The Bankruptcy Code, in Section 548, enables a trustee (or a party with derivative rights such as a debtor in possession, Chapter 11 trustee or a creditor’s committee) to avoid any transfers of an interest of the debtor in property or obligation incurred by the debtor that was made or incurred within 2 years before the petition date when it involves either “actual” or “constructive” fraud.

Actual fraud

A transfer or incurred obligation is “actually” fraudulent when it is made with intent to hinder, delay or defraud a past, present or future creditor of the debtor.

However, a debtor will rarely admit that a transfer was made with fraudulent intent. Recognizing the difficulties of demonstrating this subjective mindset absent admission, many courts will permit the inference of fraudulent intent through the demonstration of circumstantial evidence. These so-called “badges of fraud” include the inadequacy of consideration, a familial or close relationship between the parties, the debtor’s retention or use of the property following the transaction, suspicious timing or secrecy of the conveyance, the use of fictitious parties, and whether the transferor was rendered insolvent as a result of the conveyance. As the varieties of fraud are seemingly limitless, no definitive list of badges exists.

Not all of these badges of fraud need be established to prove actual intent, nor does any specific combination need be demonstrated. Further, while insolvency and inadequacy of consideration are two of the non-exclusive badges, neither is required to be proved. The focus is strictly on the debtor’s subjective intent and the state of mind of the transferee is immaterial. When the debtor is a corporation, the fraud of an officer is imputed to the company when the course of conduct was committed in the course of his or her employment and done for the benefit of the company.

The inquiry is always factual and the presence of one or more badges of fraud permits, but does not compel, the court to make a finding of actual intent. When a trustee establishes an  indicia of fraud based on the presence of one or more of these badges, the burden of proof shifts to the defendant to prove a legitimate purpose to the transfer. The ultimate determination of whether actual fraud exists often rests soundly on the skill and creativity of the advocates before the court.

In most situations, actual fraud must be proved by admission of intent by the debtor or the demonstration of circumstantial “badges of fraud.” However, special rules and presumptions apply to Ponzi schemes. A Ponzi scheme is a fraudulent investment operation that pays promised — and typically unrealistically high-rate — returns to earlier investors from new capital paid by latter investors rather than from profit earned by legitimate business endeavors. When the existence of a Ponzi scheme is established, there is a presumption that transfers were made with the actual intent to hinder, delay and defraud creditors which applies to every transfer made by the debtor. Because the enterprise lacks a legitimate purpose and is itself fraudulent, there is no need for a plaintiff to assert “badges of fraud” to meet his pleading burden. An enterprise will be found to be a Ponzi scheme when deposits were made by investors, the debtor conducted little or no legitimate business, the purported business operations of the debtor produced little or no revenue or profits, and the source of payments to investors was from cash infused by new investors.

Constructive fraud

Constructive fraud occurs when the debtor receives less than a reasonably equivalent value for a transfer and either is insolvent at the time of the transfer or becomes insolvent because of it. The party challenging a transfer as fraudulent carries the burden of proving by a preponderance of the evidence all elements of a constructive fraud claim under the Bankruptcy Code.

The procedure for evaluating reasonably equivalent value requires two steps. First, the court must determine whether the debtor received any value at all from the challenged transaction. “Value” is defined by the Bankruptcy Code as property, or satisfaction or securing of a present or antecedent debt of the debtor. Thus, transactions that satisfy, discharge or secure all or a part of a legitimate transaction are for value while transfers that are essentially gifts are not. Second, if the court finds that a debtor received at least some value, it must then decide whether the value received was roughly the value it gave. In assessing whether reasonably equivalent value was received, courts look to the totality of the circumstances, including (1) the fair market value of the benefit received as a result of the transfer, (2) the existence of an arm’s-length relationship between the debtor and transferee and (3) the transferee’s good faith. The court may consider in its evaluation both direct and indirect benefits conferred by the transfer. An exact dollar-for-dollar exchange is not required, but any significant disparity between the market value of what the debtor gave and what it received may preclude a finding of reasonable equivalence.

Courts will typically find that foreclosure sales, when conducted in accordance with proper procedures, will always result in reasonably equivalent value, regardless of the actual price paid.  Because the purpose of fraudulent conveyance laws is estate preservation, the question of whether the debtor received reasonable value must be determined from the standpoint of the creditors.

In addition to a lack of reasonably equivalent value, a finding of a constructively fraudulent transfer requires a showing that it was made at a time when the debtor was financially vulnerable: that the debtor was or became insolvent at the time of the transfer; was engaged in a business with unreasonably small capital; or intended to incur debts beyond the debtor’s ability to pay when matured. Insolvency is generally defined as the sum of the debts of the debtor exceeding all of its property at fair valuation. The issue of insolvency is frequently litigated in constructive fraud cases. However, this tends to occur only in larger cases due to the prohibitive cost of expert testimony usually required to establish insolvency valuations. The unreasonably small capital prong addresses situations where the transaction leaves the debtor solvent — but just barely — with the likely prospects of an eventual liquidation.  Adequate capitalization is a variable concept depending on the type of industry and size of business. The final prong may be established when there was a belief when the transfer was made that later creditors would not be paid as their claims matured.

Examples of commonly litigated constructively fraudulent transfers include pre-petition payments by a corporate debtor for the personal obligations of its principal, excessive executive compensation, and the transfer of a valuable house, car or business asset for a below-market price.

State Law Avoidance Statutes

Additionally, Section 544(b) of the Bankruptcy Code gives the trustee the right to avoid a transfer of an interest of the debtor that “is voidable under applicable law,” thus equipping a trustee with all of the rights and powers of an unsecured creditor under applicable non-bankruptcy law. Using these so-called strong-arm powers, a trustee can assert state-law fraudulent-transfer claims.                    

The Uniform Fraudulent Transfer Act (“UFTA”) has been adopted in various versions by most states, including Pennsylvania and New Jersey. While similar in many respects to the Bankruptcy Code, UFTA contains some significant differences that make it an attractive litigation weapon for trustees. Unlike the Bankruptcy Code, which gives the trustee the right to avoid constructive and fraudulent transfers, UFTA groups fraudulent transfers into those that can be avoided by existing creditors (constructively-fraudulent transfer claims) and those that can be avoided by existing and future creditors (actually-fraudulent transfer claims). The most notable distinction, however, is the respective lengths of the look-back periods. Bankruptcy Code Section 548 limits the trustee’s avoidance power to transfers that were made during the two-year period prior to the petition date. In contrast, UFTA enables a reach back of at least four years and may be even longer depending on the statute of the specific adopting state.

The trustee must bring a lawsuit under Section 548 or 544 within the later of two years after the bankruptcy or one year after the trustee’s appointment if that occurs within the two-year period.

Defenses – Transfers made in good faith and for value

Once the trustee establishes the statutory elements of a fraudulent transfer, the burden shifts to the defendant to raise an applicable defense such as good faith or reasonably equivalent value.

A transferee may avoid liability in an action to avoid a transfer based upon actual fraud by demonstrating that it received the transfer in “good faith” and for “value.” 11 U.S.C.S. § 548(c). “Good faith” is an affirmative defense for which the transferee bears the burden of proof. In evaluating the good faith element of the defense, courts typically apply — on a case-by-case basis — an objective or “reasonable person” standard, and look to what the transferee objectively knew or should have known about the underlying circumstances of the transfer, not to the subjective knowledge or belief of the transferee. A transferee is not automatically protected by the good faith defense merely because it had no actual knowledge that a fraud was being perpetrated. Where a transferee is on notice of suspicious circumstances regarding a transfer, it is obliged to conduct a diligent investigation which must allay those initial concerns or it may lose the benefit of the good faith defense. “Value” means property, or satisfaction or securing of a present or antecedent debt of the debtor and can include benefits both direct and indirect to the debtor.

Special rules for charitable and religious contributions

Certain transfers to religious or charitable organizations are protected from avoidance, despite no exchange of corresponding value. Congress, out of a concern that religious and charitable organizations were being targeted for the avoidance of contributions made by debtors, passed the Religious Liberty and Charitable Contribution Protection Act in the late 1990’s, which provides that an individual debtor’s contribution to a qualified organization is not a constructively-fraudulent transfer regardless of value exchanged if it does not exceed 15% of the debtor’s gross income for the year. If the contribution exceeds 15%, it is nevertheless not considered a fraudulent transfer if it was consistent with the debtor’s prior practice of charitable giving. However, if the contribution exceeds 15% and is inconsistent with prior practice, the entire amount is avoidable, not just the portion that exceeds 15%.

II.  POST-PETITION TRANSFERS.

Often pled as an alternative to a preference avoidance count, Section 549 of the Bankruptcy Code enables the trustee (or a Chapter 11 debtor in possession) to avoid post-petition transfers by the debtor that are not authorized by the Bankruptcy Code or the court. A common example is a payment made after the petition date and without court approval for a pre-petition obligation. For purposes of determining whether the payment falls in or outside of the 90-day preference period, a check transfer is “made” when it is honored by the payor’s bank. Thus, a check written and delivered pre-petition for a debt obligation may nevertheless fall into the avoidance scope of §549 if it is not honored until after the petition date. In addition to the aforementioned statutory elements, some jurisdictions require a showing that the transaction resulted in a detriment to the estate as a prerequisite to a §549 action while other courts impose no such requirement.

III.  STRATEGIES TO DODGE OR DEFEND AVOIDANCE LITIGATION

Avoidance litigation is everywhere and many larger cases routinely feature the filing of hundreds of preference and fraudulent transfer complaints seeking the claw back of payments made by the debtor. What can a creditor to do to avoid being sued in the first place or, if it is the  unfortunate recipient of such a demand or complaint, to minimize or eliminate the sums required to be paid back to the estate.

First and foremost, never refuse a payment by a debtor out of a concern that there may be later efforts to avoid the transfer. The only thing worse than receiving a preference payment is not having received the payment in the first place. There are many instances where a payment may fit the definition of a preference but a demand or complaint is never ultimately made. Even if an avoidance action is filed, skillful application of defenses often results in the retention of much, if not all, of the payment.

In dealing with a troubled customer who may later file for bankruptcy, if possible, change the credit terms to eliminate avoidance exposure. Requiring the payment of cash in advance should provide an absolute defense to an avoidance action since the challenged payment is no longer made on account of an antecedent debt. Similarly, a cash on delivery transaction should be immune to avoidance with the application of the contemporaneous exchange defense.

However, customers — especially those in financial distress who are experiencing cash flow difficulties — are likely to be highly resistant to a change in credit terms to cash in advance or upon delivery, particularly if they have other purchasing options. In the face of such opposition and if the relationship with the customer is too valuable to discontinue, the best course of action is to preserve the ordinary course of business defense by maintaining normal and routine payment schedules. For example, if existing credit terms are net 30 days, the creditor should take gentle and non-coercive steps to ensure that payments are made within this timeframe or to maintain existing patterns of payment. Small deviations from stated terms usually will not remove the transactions from the ordinary course of business especially where there is an established pattern of accepting such late payments.

If you ultimately repay all or a portion of the transfer back to the bankrupt estate to resolve an avoidance demand or adversary complaint, bear in mind that you are entitled under Section 502(h) of the Bankruptcy Code to file an unsecured, prepetition claim for every avoidance dollar returned. Trustees, in an effort to minimize the administrative costs of making distributions on these claims, will often request a waiver from the settling creditor. Thus, it is imperative to determine the value of the waived claim and factor this amount into any settlement negotiation. If a waiver of the Section 502(h) claim is not a part of any settlement, ensure the filing of a proof of claim for the returned amount within thirty days of the court approval of any settlement.

Now that basics of avoidance are covered, future blog postings will address emerging issues of significance to the law.


Alex BarnesMr. Barnes represents businesses and individuals facing preference and avoidance litigation, Chapter 11 debtors-in- possession, Chapter 7 and 11 Trustees, Liquidating Trustees, Creditor Committees, secured and unsecured creditors, asset purchasers, and equipment lessors in all facets of commercial bankruptcy. Additionally, Mr. Barnes represents individuals and business clients in commercial litigation and transactional matters.  He can be reached at alexander.barnes@obermayer.com or at 215.665.3184.