What is a Fraudulent Transfer?

Fraudulent transfers in bankruptcy mean that someone has gained some value without paying a fair price for it. Getty Images

Fraud: not a word to be bandied about lightly, especially in bankruptcy circles. Fraud occurs when a creditor doesn’t get equivalent value back for the money it loaned or the property it gave in exchange during a transaction with borrower or buyer. When that borrower or buyer files a bankruptcy case and becomes a debtor subject to the jurisdiction of the bankruptcy courts, all of its recent financial transactions can be scrutinized to determine if the creditors received fair value.

Why do We Look at Past Financial Transactions?

Treating all creditors fairly is a major principle of bankruptcy law. But that does not mean that all creditors are treated exactly alike. How creditors are treated in bankruptcy depends in part on what type of debt it is. For instance, unsecured creditors are treated differently than secured creditors because secured creditors can look to their collateral to satisfy at least a part of their debt. But within a class of creditors, each of the creditors must be treated substantially the same as all other members of that class.

This applies not only to how creditors are treated as they’re getting paid after a bankruptcy is filed. It also applies to transactions that took place as the debtor was struggling before filing, the reason being that there is a presumption that the debtor knew that it was financially insecure and favoring one creditor over another was inappropriate and unfair.

To that end, Congress has given the bankruptcy trustee, who is appointed by the court to oversee the case and marshal the debtor’s assets, broad powers to recapture transfers that improperly depleted the assets that would have been available to distribute to creditors equally.

What are Transfers?

Transfers or transactions that are affected include actual transfers of cash and property, as in purchases of good or services.

But a transfer can also include virtually anything that might diminish the rights of creditors. For instance, gifts of property are probably the prime example because the property or money is given to another with no gain of something, whether equivalent value or not, in return. if the borrower gives one creditor a security interest in a piece of property, that is considered a transfer because it could potentially reduce the assets that could be liquidated to pay all the creditors. Re-titling a property into someone else’s name is a transfer, or sometimes, merely giving someone control over a property is a transfer. Paying a bill for goods or services rendered either at the time of payment or sometime after the goods or services were delivered is also a transfer.

Types of Fraud

There are two types of fraudulent transfers in a bankruptcy case. One is “actual” fraud, and the other is other is often called “constructive fraud.” The primary difference between the two is the level of intent to defraud creditors.

     Actual Fraud

Actual fraud occurs when one party makes a transfer with the intent to hinder or defraud a creditor. A creditor or trustee in bankruptcy would have to prove that the transferor (the debtor, usually) had the actual intent to get something for little or no exchange.

Proving intent can be formidable task. Most people who intend to defraud go to pains to hide it. After they’re caught, they rarely admit it. This level of intent often must be inferred from the debtor’s actions. These “indicia” or "badges" (indicators) of fraud may include:

  • The debtor’s retention of possession or control of the property in question.
  • Transfer of substantially all the debtor's assets
  • Transfer to a newly created corporation
  • The presence of a special relationship with the person to whom the property is transferred, like a spouse, other relative or a business associate
  • The debtor was insolvent at the time of the transaction
  • The transfer was done in secret
  • The transfer was made without an exchange of consideration
  • The transfer was part of a pattern of activity
  • Whether the transfer had the effect of turning nonexempt assets into exempt assets

    This is not an exclusive list. Courts take into account many different facts and circumstances to decide if an actor intended fraud.

         Constructive Fraud

    Constructive fraud is a bit of a misnomer. Although it is called fraud, the element of intent is treated differently. The one challenging the transaction as constructive fraud is not required to show that the debtor intended the transaction to hinder creditors.  By saying that the transaction constituted “constructive” fraud, we’re saying that the transaction favored a creditor or a group of creditors to the exclusion of other, similar creditors and was fundamentally unfair.

    To be considered constructive fraud, two conditions must be present:

    • The debtor received less than “reasonably equivalent value” in the exchange.

    In addition, one of the following must be true:

    • The debtor was insolvent before the transaction or as a result of the transaction.
    • In a business transaction, the transfer left the debtor with unreasonably low capital.
    • In making the transaction, the debtor intended to incur debt that he knew was beyond his ability to pay, or
    • The debtor make the transaction for the benefit of a business insider under an employment contract.

    Those conditions can be difficult to establish, and may cause considerable litigation. Determining the value of what was exchanged, depending on the property, could take appraisals and expert testimony. The question of insolvency - whether the debtor owed more than it held in assets - is likewise problematic and will often require the testimony of accountants or others knowledgeable in the ways a business keeps track of its money.

    Avoiding the Transfer

    The trustee is appointed by the court and charged with the responsibility of marshaling the debtor’s non-exempt assets, liquidating (selling) them and distributing the proceeds to the eligible creditors. The bankruptcy code grants the trustee what are often termed “strong arm” powers or “avoiding” powers. These powers give the trustee the right to undo the fraudulent transactions for the benefit of the bankruptcy estate and all creditors.

    If the trustee is unable to convince the recipient to turn over the transfer voluntarily, the trustee will most likely file a lawsuit within the bankruptcy case. The lawsuit is called an adversary proceeding and it works much the same as any other lawsuit, with the trustee as a plaintiff on behalf of the bankruptcy estate and the recipient or creditor as defendant.

    Defenses to a Fraudulent Transfer Suit

    The transferee can assert defenses to explain why he should not be required to give back the money or property. For instance, the transferee gets credit to the extent that the transferee gave the debtor value, conducted the transaction in good faith and did not have knowledge of the debtor’s insolvency. For instance, the if the transferee paid $1,000 to the debtor for a horse worth $3,000, the debtor did not receive reasonable equivalent value for the horse, but the debtor did receive $1,000. Therefore, the transferee would not be required to pay the estate $3,000, but just the $2,000 additional that the debtor should have received (or the horse back, if that is feasible).

    Good faith is a very subjective concept. The transferee must show that he had (1) an honest belief that the transaction was appropriate; (2) no intent to take unconscionable advantage of the debtor; and (3) no intent, or knowledge that the transaction would hinder, delay or defraud the debtor’s creditors.

    Who Can Bring a Fraudulent Transfer Adversary?

    • The Trustee
    • Creditors, if the trustee declines to take action
    • The Debtor, if the trustee declines to take action and the property would have been exempt

    Timing or Statute of Limitations

    Under the bankruptcy code, fraudulent transfer adversary proceedings must be brought no later than two years after the the entry of the order for relief (usually the date the bankruptcy case was filed) or one year after the first trustee is appointed in the case (if the trustee is appointed within the first two years of the case). The bankruptcy court can extend the filing deadline in certain cases.

    To learn more about the trustee's avoiding or strong arm powers, see What is a Preferential Transfer?