Proving a Fraudulent Conveyance in a Business Bankruptcy Case
When a business files for bankruptcy, its creditors have the right to protect their interests by seeking payment through the bankruptcy estate. Under the U.S. Bankruptcy Code, businesses that file for bankruptcy must fully disclose their assets that properly belong in the estate, and they may not transfer assets prior to (or during) the bankruptcy process in an effort to shield them from their creditors.
Transferring assets in order to avoid having them fall into a bankruptcy estate is referred to as a fraudulent conveyance. It is prohibited under the U.S. Bankruptcy Code, and the Code includes provisions that allow creditors to unwind fraudulent conveyances in appropriate cases. As a practical matter, however, creditors will often need to act quickly to challenge fraudulent conveyances, as the parties that receive debtors’ assets may use or dispose of the assets upon receipt.
Fraudulent Conveyances in Business Bankruptcy Cases: Defined
Fraudulent conveyances are addressed in Section 548 of the U.S. Bankruptcy Code. Section 548 begins by specifying the remedy for fraudulent transfers, stating that the bankruptcy trustee “may avoid any transfer . . . of an interest of the debtor in property, or any obligation . . . 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 [transfer is fraudulent].”
Section 548 then goes on to specify when a transfer or conveyance is considered fraudulent for federal bankruptcy purposes. Under Section 548, fraudulent conveyances fall into two broad categories:
1. Conveyances Made with Actual Intent to Defraud
Section 548(A) provides that a conveyance is fraudulent if executed “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.”
2. Conveyances for Less Than Reasonably Equivalent Value
Section 548(B) provides that a conveyance is fraudulent if the business receives “less than a reasonably equivalent value in exchange for such transfer or obligation” and one of four additional conditions is satisfied. These additional conditions are:
- The business is insolvent on the date the transfer was made or became insolvent as a result of the transfer;
- The business was engaged in a transaction, or was about to engage in a transaction, for which the debtor’s remaining property was “unreasonably small capital;”
- The business intended to incur or believed it would incur debts that exceeded its ability to pay; or,
- The transfer was made for the benefit of an insider “under an employment contract and not in the ordinary course of business.”
Conveying a debtor’s property for less than reasonably equivalent value is referred to as constructive fraud; and for federal bankruptcy purposes, it has the same practical effects as actual fraud under Section 548(A).
Importantly, with both actual and constructive fraud, the transferee’s intent is irrelevant—in most cases. Even if a transferee accepts a business debtor’s assets in good faith, the transferee is not protected from the remedies afforded to creditors under Section 548 as a general rule.
However, there are exceptions that allow transferees to retain assets received through fraudulent conveyances in some cases. One of the most commonly used exceptions is the “bona fide purchaser” rule, which allows transferees to keep business debtors’ assets if purchased in good faith and without notice of creditors’ rights therein. If a good-faith transferee improves the transferred property before creditors challenge a fraudulent conveyance, this can impair creditors’ ability to claw back the transferred property as well.
Evidence of Actual or Constructive Fraud Under Section 548
To prove a fraudulent conveyance in a business bankruptcy case, creditors must either be able to establish actual fraud under Section 548(A) or constructive fraud under Section 548(B). While overt evidence of intent (or a “smoking gun”) won’t always be available, the courts have recognized various “badges of fraud” that they will consider to be evidence of a fraudulent conveyance in appropriate cases.
In actual fraud cases under Section 548(A), factors that can be used to prove a fraudulent conveyance include (but are not limited to):
- The debtor transfers all, or substantially all, of its assets;
- The debtor is facing actual or threatened litigation at the time of the transfer;
- The debtor retains possession or control of the asset despite the transfer of ownership;
- The debtor transfers the assets to a newly-formed business entity; and/or,
- The debtor has a relationship with the transferee (whether commercial, familial or otherwise).
In constructive fraud cases under Section 548(B), examples of “badges of fraud” include:
- The transfer was made in exchange for less than the fair market value of the conveyed asset;
- The transaction was not made in the ordinary course of business;
- The debtor did not obtain competitive bids prior to choosing the transferee;
- The debtor engaged in a pattern of transactions resulting in the dissipation of its assets or value; and/or,
- The transaction or series of transactions had the overall effect of worsening the debtor’s financial condition.
With both actual and constructive fraud, timing is a key consideration as well. If the timing is suspicious (i.e., if a debtor transfers assets outside of the normal course of business and shortly before filing for bankruptcy), this can help support a claim that the transaction was fraudulent. Likewise, if a debtor attempts to conceal or misrepresent information about a conveyance during the bankruptcy process, this is also broadly considered to be a red flag for fraud. When challenging fraudulent transactions during business bankruptcies, the key is for creditors to determine what evidence is available (or may come available through the bankruptcy litigation process) and then to act promptly while the assets are still available to be reclaimed.
Request a Consultation with a Creditors’ Rights Lawyer at Edelboim Lieberman Revah
We have extensive experience representing creditors in business bankruptcy proceedings in Florida. If you have questions about challenging a fraudulent conveyance, we encourage you to call 305-768-9909 or contact us online to learn more.