Many of you are familiar with preferences actions and the defenses to those actions. You may not be aware of fraudulent transfer actions. With the increasing rise in bankruptcy cases in which the main secured creditor is “under water,” bankrupt debtors and trustees are using preference actions as a primary means for collecting funds to distribute to unsecured creditors. However, since unsecured creditors are increasingly aware of preference defenses and how to properly deal with questionable debtors, preference actions are becoming less profitable for the bankruptcy estate. As a result, we’re seeing an increase in the use of fraudulent transfer actions to recover funds for the estate.
There are two types of fraudulent transfer actions: actual fraud (the Debtor deliberately defrauds creditors) an constructive fraud (discussed below). Since actual fraud is somewhat rare, this article is focused on constructively fraudulent transfers.
A transfer is constructively fraudulent if: (1) the debtor received less than reasonably equivalent value in exchange for the transfer and (2) the debtor was (a) insolvent on the date of the transfer or became insolvent as a result of the transfer, (b) the debtor was engaged or was about to engage in a business or transaction for which any property remaining with the debtor was an unreasonably small capital, or (c) the debtor intended to incur or believed that it would incur debts beyond the debtor’s ability to pay as such debts matured.
Most of the cases relating to fraudulent transfers focus on the “reasonably equivalent value” language of the statute. Generally speaking, the courts look to (1) whether the value transferred by the Debtor is approximately equal to the value of what was received by the Debtor in exchange for the transfer and (2) whether the transaction took place at an arm’s length.
In a typical scenario, a vendor provides goods or services having a certain value and the Debtor makes payment sometime thereafter. In this situation, no fraudulent transfer has occurred because the Debtor received “reasonably equivalent value” for its payment.
However, imagine the following scenario: A construction company is composed of three affiliates. Company A cuts timber and delivers it to Company B. Company B processes the timber and makes plywood and delivers it to Company C. Company C uses the plywood to make kitchen cabinets. While these three companies share some common owners, they conduct business at arms-length, do not have any parent-subsidiary relationships and are, for all intents and purposes, separate and distinct legal entities.
Now imagine the creditor that provides $100,000 worth of monthly shipping services for Company A. This creditor is “bankruptcy savvy” and, therefore, insists on 30 day payment terms and strict adherence to payments made in the “ordinary course of business.” All three companies file for chapter 11 bankruptcy protection. When the creditor receives notice of Company A’s bankruptcy, the creditor is secure in knowing that any potential preference action would top out at $300,000 (three months worth of payments) and knows that it has strong defenses to such an action.
Months later, the creditor receives a complaint from the Trustee in Company C’s Bankruptcy demanding the return of $2.4 million worth of “fraudulent transfers.” The complaint indicates that for many years all three companies were insolvent and had problems balancing cash flow. Due to these problems, Company C would pay some of Company A’s Accounts Payable. Pursuant to this arrangement, Company C paid all of the creditors invoices that were directed to Company A. The trustee claims that when Company C paid the monthly invoices for Company A, Company C received no value whatsoever, since the services were delivered to Company A. The trustee therefore demands the return of 2 years worth of monthly payments paid by Company C. Upon review of its file, the creditor is shocked to notice that the checks it received on its invoices were from Company C and not Company A.
Sounds ridiculous, right? Well, while there are certain fact intensive exceptions, such transactions are generally considered “fraudulent transfers” that are recoverable by a bankruptcy trustee.
A creditor that unknowingly receives such a fraudulent transfer is in a very unfortunate situation. While preferences only occur during the 90 days preceding the preference action, the bankruptcy code’s “look back” period for fraudulent transfers is 2 years (which can actually increase depending on which state’s laws apply). Consequently, creditors are at risk of much larger lawsuits being filed to recover fraudulent transfers than the typical preference actions, making it very hard to limit a creditors’ exposure.
More importantly, preference defenses – i.e. ordinary course of business, new value, contemporaneous exchange – do not apply to fraudulent transfers. The fraudulent transfer defenses – typically that the payor received reasonably equivalent value and/or that the payor was insolvent at the time it made the payment – are heavily fact intensive. In other words, the litigation is time consuming and expensive.
For legal and tax purposes, most large companies are split into multiple affiliates, meaning the risks posted by fraudulent transfer actions to unknowing creditors are quite large. For those “bankruptcy savvy” creditors that I mentioned, the best way to protect against such an action is to demand payment from the debtor to which you supplied services. While accepting payment from an affiliate is often the easiest way to get paid timely, it may ultimately end up costing you substantially down the road.