This post is the third in a series in which I will discuss fraudulent transfers. It covers the statutory definitions. This one’s a bit long because the definitions are a bit labyrinthine. If you think it’s dry, then avoid Syrahs and stick to Rieslings.
C. The Definition Of Fraudulent Transfer
1. The Intent Definition
i. The Bankruptcy Code’s Definition
11 U.S.C. § 548(a) contains two independent definitions of fraudulent transfer. We begin with the first definition, found in § 548(a)(1)(A). A transfer is fraudulent (with emphasis added):
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.
An interesting feature of this definition is that the transfer need not have been voluntary on the part of the debtor. Thus, even though the term “fraudulent transfer” seems to imply ill intent on the part of the debtor, the debtor might not have wanted the transfer to take place. The statutory ill intent is on the part of the transferor, who may or may not be the debtor.
This first definition in the Bankruptcy Code captures the essence of Horace’s behavior. (Horace was the ancient Roman we met in our first fraudulent transfer post.) The transfer was done with the intent to hinder, delay, or defraud the creditor. An important feature of this definition is that it requires the transfer to have been made after the debt in question was incurred. Therefore, using § 548 the trustee would be unable to avoid transfers that antedated the incurrence of the debtor’s debts. This is in contradistinction to the first definition given in California’s UFTA. (As with the Bankruptcy Code, the UFTA has two independent definitions of “fraudulent transfer.”)
ii. The UFTA’s Definition
California’s UFTA provides (with emphasis added):
A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation as follows: With actual intent to hinder, delay, or defraud any creditor of the debtor.
Therefore, if the trustee were to appeal to the UFTA to avoid a fraudulent transfer, the trustee would be able to avoid transfers that were antecedent to the incurrence of the debt to the creditor into whose shoes the trustee has stepped.
The UFTA provides a list of eleven factors — the so-called “badges of fraud” — for courts to consider when applying Cal. Civ. Code § 3439.04(a)(1):
In determining actual intent under paragraph (1) of subdivision (a), consideration may be given, among other factors, to any or all of the following:
(1) Whether the transfer or obligation was to an insider.
(2) Whether the debtor retained possession or control of the property transferred after the transfer.
(3) Whether the transfer or obligation was disclosed or concealed.
(4) Whether before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit.
(5) Whether the transfer was of substantially all the debtor’s assets.
(6) Whether the debtor absconded.
(7) Whether the debtor removed or concealed assets.
(8) Whether the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred.
(9) Whether the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred.
(10) Whether the transfer occurred shortly before or shortly after a substantial debt was incurred.
(11) Whether the debtor transferred the essential assets of the business to a lienholder who transferred the assets to an insider of the debtor.
The badges can be used to produce an illation of intent. While there is no analogue in the Bankruptcy Code to the UFTA’s badges of fraud, some of the badges are implicit in the Bankruptcy Code’s two definitions of fraudulent transfer.
As noted in my first fraudulent transfer post, in the absence of a Vulcan, it can sometimes be hard to establish intent — even when applying the UFTA’s eleven factors — especially if the transfer took place years ago. Therefore, both the Bankruptcy Code and the UFTA have a second definition that avoids the problem of proving intent.
2. The Below Market Value Definition
i. The Bankruptcy Code’s Definition
11 U.S.C. § 548(a)(1)(B) provides the second definition. A transfer is fraudulent:
if the debtor voluntarily or involuntarily —
(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and
(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;
(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, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.
The first part of this definition captures the problem of Horace’s sale of his home to his brother, Brutus, for below market value. Therefore, battles over this first part of the definition focus on the fair market value of the asset.
The second part of the definition must be coupled with the first part (note the conjunction “and”), but the second part itself is disjunctive (note the “or” at the end of (III)), meaning that only one of the four factors must be satisfied. The first three of these factors focus on the debtor’s impecuniousness as a result of the transfer: (I) the debtor is rendered insolvent, (II) the debtor’s business is rendered insolvent, and (III) the debtor doesn’t have the resources to pay the debt incurred. The fourth factor addresses transfers to insiders (see 11 U.S.C. § 101(31) for the Bankruptcy Code’s definition of “insider”.): the presumption is that such transfers are fraudulent.
I have had potential clients express great umbrage when told that they cannot transfer assets to their children, asserting that it is no one’s business what they do with their own property. My response is that if they have no debts they have Carte Blanche to do whatever they wish with their property (within legal limits — growing marijuana on the roof top is beyond those limits), but if they have creditors who expect to be paid, they no longer have that freedom.
The case law contains a fairly extensive exploration of what constitutes “reasonably equivalent value.” Some examples: BFP v. Resolution Trust Corp., 114 S. Ct. 1757 (1994) (foreclosure sale price conclusively establishes reasonably equivalent value); Batlan v. Bledsoe (In re Bledsoe), 569 F.3d 1106 (9th Cir. 2009) (transfer in regularly conducted divorce establishes reasonably equivalent value); Randy v. Edison Worldwide Capital (In re Randy), 189 B.R. 425, 438-39 (Bankr. N.D. Ill. 1995) (Because illegal services premised on illegal contracts, broker services provided in furtherance of a Ponzi scheme do not provide reasonably equivalent value).
As for the definition’s insolvency factors, a criminal enterprise such as a Ponzi scheme is presumed to be insolvent at its inception. See In re Lake States Commodities, Inc., 272 B.R. 233, 242 (Bankr. N.D. Ill. 2002) (“The cases generally concur that if a Ponzi scheme is proven, then the debtor is presumed insolvent from the time of its inception”). Therefore, any payouts by the Ponzi scheme to the early investors are avoidable fraudulent transfers.
ii. The UFTA’s Definition
California’s UFTA provides:
A transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation as follows: . . . Without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor either:
(A) Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction.
(B) Intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due.
This second definition has similar wording to the Bankruptcy Code’s second definition, but it does not include either insolvency as a consequence of the transfer, or transfer to an insider. (The insider factor shows up as the first of the eleven factors associated with the first UFTA definition.) Thus, it is easier to characterize a transfer as fraudulent under the Bankruptcy Code, but the Bankruptcy Code only includes transfers made after the incurrence of the debt. Therefore, a trustee seeking to avoid a fraudulent transfer must weigh the choice of statute to be used against the facts of the case. And in the absence of a real creditor — not merely a hypothetical one — into whose shoes the trustee can step, only the Bankruptcy Code’s definition is available.
The UFTA has yet another definition that is very similar to this second definition, with one key difference: the transfer must have been made prior to the incurrence of the debt — a requirement that echoes the Bankruptcy Code’s definition (with emphasis added).
A transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation
This final definition includes insolvency as a result of the transfer, but does not take into consideration whether the recipient was an insider, or whether the debtor had an insolvent business, or was unable to pay the obligation.
There are two main reasons fraudulent conveyances are significant: (1) the trustee can avoid them, and (2) the Court can deny the debtor a discharge.
Next time we’ll deal with the mechanics of fraudulent transfer avoidance.