Health Diagnostic Laboratory Trustee Pursues Charities and Others For Alleged Fraudulent Transfers

Posted on by Neil E. McCullagh in Creditors' Rights, Bankruptcy and Insolvency

The Liquidating Trustee of Health Diagnostic Laboratory, Inc. and its affiliated debtors in bankruptcy1 (collectively, "HDL") is attempting to recover (i.e., claw back) certain payments that HDL made in the years leading up to HDL's bankruptcy filing on June 7, 2015, including certain payments to charities. Entities that received one or more payments from HDL might receive a letter from the Liquidating Trustee's counsel stating an amount of "fraudulent payments received," describing the payments as "fraudulent transfers," and proposing to resolve the matter without litigation. Trustees in bankruptcy often pursue actions to claw back fraudulent transfers, and it's typical for them to start the process with letters of this kind. The law of fraudulent transfers can be complex, and recipients of alleged fraudulent transfers might have one or more defenses that protect them from claw back. This article reviews some important points of fraudulent-transfer law, including some of the potential defenses to a fraudulent-transfer lawsuit.

1. "Actual Fraud" versus "Constructive Fraud." There are two kinds of fraudulent transfers: (1) ones involving an allegation of "actual fraud" - i.e., the allegation is that the entity that made the transfer (the "transferor") did so in order to hide assets from its creditors (or at least make it harder for its creditors to reach the assets); and (2) ones involving an allegation of "constructive fraud," meaning generally that the transferor was financially insolvent when it made the transfer (or was rendered insolvent by the transfer) and did not receive sufficient value in exchange. The name "fraudulent transfer" is therefore too broad - it suggests fraud in every instance even though a transfer may not have involved fraud at all; there may merely be technical issues of whether the transferor received insufficient value in exchange and whether the transferor was insolvent when it made the transfer (or was rendered insolvent by the transfer).

2. Payment of Debt is Not a Fraudulent Transfer. A payment of a legitimate debt is generally not a fraudulent transfer, as the entity that makes the payment receives something equally valuable in return: release from the debt. Bear in mind, however, that such payments may nonetheless be vulnerable to being clawed back as "bankruptcy preferences" if they were made during the 90 days before the bankruptcy filing (or the year before the bankruptcy filing in the case of a payment made to an "insider" of the transferor).

3. The Two Kinds of Clawback Lawsuits: Bankruptcy Code Section 548 (Federal Law) and Bankruptcy Code Section 544 (State Law). A bankruptcy trustee has two tools to claw back fraudulent transfers, and he can use either or both of them. The first tool is Bankruptcy Code section 548, which allows a trustee to claw back fraudulent transfers as a matter of bankruptcy law (which is federal law). The second tool is Bankruptcy Code section 544, which allows a trustee to claw back fraudulent transfers under applicable state law (e.g., Virginia law). There can be significant differences between section 548 lawsuits and section 544 lawsuits, including the potential defenses to the lawsuits. Here are a few examples:

a. The Look-Back Period. In a section 548 lawsuit, the trustee can pursue only transfers that occurred during the two (2) years preceding the bankruptcy filing, but in a section 544 lawsuit the look-back period can be significantly longer. For example, in Virginia (i) it's generally five years for constructively-fraudulent transfers, and (ii) there is no certain limit on the look-back period for actually-fraudulent transfers.

b. The "Value" Defense to an Alleged Constructively Fraudulent Transfer. In a section 548 lawsuit alleging a constructively-fraudulent transfer, the person or entity that received the transfer (the "transferee") has a good defense if the transferor received "reasonably equivalent value" in exchange for the transfer. In a section 544 lawsuit alleging a constructively-fraudulent transfer, however, the transferee might have a substantially easier standard to meet. For example, Virginia law requires only that the transferor received "consideration deemed valuable in law," which some courts have interpreted to mean that the transferor merely has to have received "something." Importantly, in either a section 548 lawsuit or a section 544 lawsuit, the value the transferor receives does not have to come directly from the transferee - it can come indirectly from a third party.

c. Standing. In a section 548 lawsuit, a bankruptcy trustee will almost always have legal standing to pursue recovery of a fraudulent transfer. Generally, the only requirement for standing is that there is some creditor in the bankruptcy case who would benefit from the transfer being clawed back (i.e., some creditor who will receive a greater recovery in the bankruptcy case by virtue of the transfer being clawed back). In a section 544 lawsuit, however, the trustee has to prove that at the time the bankruptcy case was filed, there was at one least creditor who could have clawed back the transfer under the applicable state law. If Virginia law applies in a section 544 action concerning an alleged constructively-fraudulent transfer, this means the trustee must prove that there was at least one creditor when the bankruptcy was filed who also was a creditor of the transferor at the time of the transfer (as Virginia law allows claw back of a constructively-fraudulent transfer only by creditors who existed when the transfer took place).

4. The "Insolvency" Defense to an Alleged Constructively Fraudulent Transfer. As noted above, one of the elements of a constructively-fraudulent transfer is that the transferor was insolvent when it made the transfer (or was rendered insolvent by the transfer). Under both sections 548 and 544, a transferor is "insolvent" if its liabilities exceed its assets - i.e., it's a balance-sheet test. Therefore, a transferee of an alleged constructively-fraudulent conveyance might have a good defense if it can show that the transfer was made at a time when the transferor's assets exceeded its debts (and that the transfer did not change that fact). Note, however, that in a section 548 lawsuit to claw back an alleged constructively-fraudulent conveyance, the trustee can also prevail, even if the transferor wasn't insolvent, if the transferor (a) had "unreasonably small capital" for the business it was in (or was about to be in) when it made the transfer, or (b) intended to incur debts that would be beyond its ability to pay. Either of these tests may require a more in-depth factual analysis into the reasonableness of the transfer than does the insolvency test.

5. Charitable Contributions Defense. Bankruptcy Code section 548 provides a defense with respect to alleged constructively-fraudulent transfers if the transfer(s) at issue was a "charitable contribution to a qualified religious or charitable entity or organization." However, that defense is available only if the transferor is a "natural person," so transfers received from corporate entities do not qualify for the defense. Also, the defense is limited to transfers that (a) do not exceed 15 percent of the transferor's annual gross income, or (b) are consistent with the transferor's past charitable contributions.

6. Claims Arising from Recovery of Fraudulent Transfers. The claw back of a fraudulent transfer might give rise to a claim by the transferee against the bankruptcy estate. For example, while a transfer might have been constructively fraudulent insofar as the value the transferor received in exchange was not "reasonably equivalent value," the transferor still might have received some value from the transferee, and the transferee may therefore have a claim against the bankruptcy estate for that value. That kind of claim might have substantial real-world value - for example, the bankruptcy estate might be paying a significant percentage of claims - and therefore how it is to be treated must be taken into consideration in analyzing any potential resolution of an alleged fraudulent conveyance. There usually is also a short deadline for filing those kinds of claims with the bankruptcy court after the fraudulent-transfer matter is resolved.

In sum, the law relating to fraudulent transfers can be complex and might offer defenses and opportunities to the target of a claw back effort that are not immediately apparent. Recipients of demand letters from a bankruptcy trustee, including letters from the HDL Liquidating Trustee, might therefore be well advised to consult experienced counsel before responding to the trustee.

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[1] The affiliated debtors are Central Medical Laboratory, LLC and Integrated Health Leaders, LLC.

About the Author

Neil E. McCullagh is an attorney who works with banks on a wide variety of issues, including lending, insolvency, workouts, creditors' rights, bankruptcy, and collections.

Spotts Fain publications are provided as an educational service and are not meant to be and should not be construed as legal advice. Readers with particular needs on specific issues should retain the services of competent counsel.