Bankruptcy Law: Understanding Fraudulent Conveyances

Introduction

In bankruptcy proceedings, a trustee is chosen to administer the debtor’s estate in a fair and orderly manner.  Generally speaking, for bankruptcy purposes, the estate is comprised of those assets of the debtors in which the debtor’s creditors have an interest.   The trustee is given the power to set aside or “avoid” certain transfers of the debtor’s assets out of the estate that unfairly place assets beyond the creditor’s reach.  Such a transfer of the debtor’s assets to a third party, with the intent to prevent creditors from reaching the assets to satisfy their claims, is called a “fraudulent conveyance”.

Understanding Fraudulent Conveyances

There are two types of fraudulent transfers in bankruptcy law. The first, actual fraud, involves the intent to defraud creditors, the other, sometimes called constructive fraud, involves a transfer, which is made in exchange for grossly inadequate consideration.

Actual fraud is committed when 1) a transfer is made within one year before the date of the filing of a bankruptcy petition and 2) is made with the intent to hinder or defraud a creditor.  Actual fraud requires proof of intent from the person challenging the transfer.  Of course, a debtor intending to defraud his creditors will not be overt about his intentions to do so.  Therefore, courts have set forth circumstances, the existence of which indicate the intent to defraud.  Some examples of these circumstances are actual or threatened litigation against the debtor, a retention of possession or control of the property, transfer of substantially all the debtor’s assets, transfer to a newly created corporation, and a special relationship with the person to whom the property is transferred.  These are only factors to be considered in determining whether a person intended to defraud a creditor, and whether they do in fact prove the debtor’s fraudulent intent is to be determined on a case by case basis.

Constructive fraud also requires two conditions: 1) in exchange for the transfer, the debtor received less than “reasonably equivalent value”, and; 2) the debtor is unable to pay debts either at the time the transfer was made or as a result of the transfer itself.  In this case, intent need not be proven rather the focus of the inquiry rests on whether the debtor received reasonably equivalent value.  Of course, reasonably equivalent value can be in the eye of the beholder.  When there is nothing of value exchanged for the transfer of the debtor’s property, the answer is an easy one.  Not infrequently, however, something of value is given and the question becomes whether the value was really adequate compensation for the property.

When is a bargain just a bargain and not a fraudulent transfer?  Although the trustee of the estate must prove that reasonably equivalent value has not been given, there is no formula for determining reasonably equivalent value.  Courts will look at all the circumstances surrounding a transaction to determine whether the exchange looks even.  Some of the factors courts have considered in making a determination are whether the sale was for fair market value, whether the transaction was made in good faith in the ordinary course of business by parties of independent interests, the competitiveness of bids for the property, and the net effect on the debtor’s estate with respect to funds available to unsecured creditors.  Generally, for an exchange to be considered legitimate, value does not have to be received directly by the debtor, but may exist in the form of additional business opportunities made available through new lines of credit or new affiliations created by the transfer.  However, transfers made solely for the benefit of third parties are not reasonably equivalent value.  Value as determined by foreclosure sales is generally not questioned unless the foreclosure was collusive or otherwise in violation of state procedural law.

The timing of the transfer is important in determining whether the transfer will stand or not.  Only those transfers completed or “perfected” within a year of the filing of the petition for bankruptcy may be reversed.  The transfer of certain types of property requires more than one step to complete the transaction.  In the case of real estate, for example, the transfer is not complete until a deed is officially recorded.

Once a transfer has been deemed fraudulent, the trustee may recover the property, or the value of the property, and make it part of the bankruptcy estate.  They may do so from either the immediate recipient or from anyone else to whom the property was subsequently transferred.  One exception to this general rule, however, is the case of the “bona fide purchaser”.  The bona fide purchaser is one who acted in good faith to purchase the property without notice of the outstanding rights of others to the property.  The bona fide purchaser may retain the property.  Another exception is made in a case where valuable improvements to the property have been made.  In this case, those that made the improvements to the property are given a lien on the property, securing the improvements they made.  Finally, if the law places no other restrictions on the transfer, and the property was purchased for some value in good faith, in other words, with no knowledge of the fraudulent intent, the person receiving the transferred property may be allowed to retain the property or regain the value they paid for it in the settling of the estate.

Fraudulent transfers can have a negative effect on creditors with interests in the debtor's estate.  Creditors who suspect the fraudulent transfer of property may be able to obtain a temporary restraining order and preliminary injunction to prevent the transfer before it occurs.

Conclusion

There are many opportunities for dispute when it comes to fraudulent conveyances.  Options exist for the creditor who suspects that a fraudulent conveyance is in the making, for a bona fide purchaser whose property is the subject of a fraudulent transfer, or for a debtor defending a transfer of property.  An experienced bankruptcy attorney will help you to evaluate the options available to you based on the facts in your particular case.

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