Recent Development in Fraudulent Transfer Law

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

The United States Bankruptcy Court for the Eastern District of Virginia recently ruled that a bankruptcy trustee "may step into the shoes of the United States" and "utilize the transfer avoidance provisions" of the Federal Debt Collection Procedures Act.1 The ruling is important because it might significantly expand bankruptcy trustees' fraudulent-transfer avoidance powers in many bankruptcy cases. This article provides an overview of the law of fraudulent transfers in Virginia and explains the effect of the court's recent ruling.

Overview of Fraudulent Conveyance Law and Issues for Lenders

Broadly speaking, there are two types of fraudulent transfers: (1) ones involving "actual fraud" - i.e., the person or entity that made the transfer (the "transferor") did so in order to hide assets from his creditors (or at least make it harder for his creditors to reach the assets); and (2) ones involving "constructive fraud," meaning generally that the transferor was insolvent2 when it made the transfer, or was rendered insolvent by the transfer, and did not receive sufficient value in exchange.3 If a court finds that fraudulent transfer occurred, the typical remedy is for the recipient of the transfer to disgorge what it received.

A fraudulent transfer is different from a bankruptcy "preference." A fraudulent transfer diminishes the transferor's net worth because he does not receive fair value in exchange. A preference, on the other hand, involves the transferor simply paying one legitimate debt instead of another. This does not reduce the transferor's net worth because his payment correspondingly reduces his liabilities. Preferences are potentially avoidable if they were made within the 90 days preceding the transferor's bankruptcy filing, or within the one year preceding the bankruptcy filing if the preferred creditor is considered an "insider" of the transferor.4 As discussed below, the reachback period to avoid fraudulent transfers is far greater.

With respect to actually-fraudulent transfers, direct evidence of the transferor's fraudulent intent is often impossible to find, as fraudsters rarely admit their intent, so the courts have developed a list of circumstances, also known as "badges of fraud," that may be used to prove fraudulent intent. The badges of fraud include, without limitation, (1) retention of an interest in the transferred property by the transferor; (2) a transfer between family members for allegedly existing debt; (3) the pursuit of the transferor or threat of litigation by his creditors at the time of the transfer; (4) lack of or gross inadequacy of consideration for the transfer; (5) the retention or possession of the property by transferor; and (6) the fraudulent incurrence of indebtedness after the conveyance.5

While it is possible for a lender to receive an actually-fraudulent transfer - such as if the borrower turns out to have been operating a Ponzi scheme or other fraudulent enterprise - constructively-fraudulent transfers may be the greater area of risk for lenders. A straightforward example of constructive-fraud risk involves receiving loan repayment from someone other than the borrower. For example, if a lender makes a loan to Company A but receives payment from Company B, then the payment might be constructively fraudulent. If Company B is not obligated on the loan, did not receive a benefit from the loan, and is insolvent (or is made insolvent) by the payment, then the payment reduced Company B's net worth at a time when it was financially vulnerable, to the detriment of Company B's other creditors. The law of constructively-fraudulent transfers is designed to protect those other creditors of Company B.

Another risky transaction, albeit with the risk being less obvious, is a loan guaranty provided by a subsidiary of the borrower, which is often referred to as an "upstream guaranty." Those guarantees are sometimes also secured by a lien on the subsidiary's assets. In a major case in 2012, a federal appeals court upheld a bankruptcy court's ruling that the upstream guarantees and related liens at issue in that case were constructively fraudulent because the subsidiaries did not receive reasonably equivalent value in exchange.6 Accordingly, the financing that included the guarantees and liens was unwound, and the bank whose loan was repaid out of that financing had to disgorge over $400 million. In this regard, even though that bank was not the recipient of the guarantees and liens, it was the entity for whose benefit those transfers had been made, thereby making it a target under fraudulent-conveyance law. The court also found that under the circumstances, the bank should have done the due diligence needed to ensure that the financing was not based on a fraudulent conveyance.

The bank argued that while the subsidiaries who provided the guarantees and liens did not receive value in return directly from the transferee of the guarantees and liens, they did receive value indirectly from the totality of the transaction and that such value was reasonably equivalent to the guarantees and liens. The court did not disagree with the notion that value can be provided indirectly,7 but it upheld the bankruptcy court's ruling that the bank had not provided sufficient proof of that indirect value.

Fraudulent Transfers Under Virginia Law and Bankruptcy Law: Relative Strengths and Weaknesses

a. Actually-Fraudulent Transfers

Virginia Code section 55-80 makes void any actually-fraudulent transfer. This law can be invoked by any creditor - even one that did not exist at the time the transfer was made - and it has no statute of limitation.8 However, section 55-80 also requires proof not only that the transferor had fraudulent intent but that the transferee had notice of the fraudulent intent.9

By contrast, in a bankruptcy case, Bankruptcy Code section 548(a)(1)(A) allows a bankruptcy trustee to avoid an actually-fraudulent transfer without any showing that the transferee was aware of the transferor's fraudulent intent.10 However, section 548(a)(1)(A) applies only to transfers that occurred within the two years preceding the bankruptcy filing.

b. Constructively-Fraudulent Transfers

Virginia Code section makes constructively-fraudulent transfers void, and it has a five-year statute of limitation. However, section 55-81 voids only transfers that were not "upon consideration deemed valuable in law," and the courts have interpreted that phrase to be a far lower standard than "reasonably equivalent value." The courts have said that as long as "something" is gained by the transferor in exchange for the transfer, then the transfer is not avoidable under section 55-81.11 Also, at least one court has ruled that section 55-81 cannot be used to avoid the incurring of an obligation, as opposed to, for example, the transfer of an asset.12

Bankruptcy Code section 548(a)(1)(B) allows a bankruptcy trustee to avoid a constructively-fraudulent transfer, and it is stronger than section 55-81 because (a) it voids transfers that were not made for "reasonably equivalent value," and (b) it can be used to avoid the incurring of an obligation. However, section 548(a)(1)(B), like section 548(a)(1)(A), covers only transfers made within the two years preceding the bankruptcy filing.

Recent Court Ruling Might Expand a Bankruptcy Trustee's Toolkit to Avoid Fraudulent Conveyances in Many Cases

A bankruptcy trustee has traditionally had at her disposal, among other things, (a) the avoidance powers of Bankruptcy Code sections 548(a)(1)(A) and (a)(1)(B) and (b) the avoidance powers available under applicable state law so long as some creditor exists at the time the bankruptcy case was filed who could exercise those state-law powers. In other words, in addition to having section 548 powers, the bankruptcy trustee is allowed to "step into the shoes" of any creditor who has the right to avoid a transfer under the applicable state law. In a bankruptcy case in Virginia, this often means that the trustee is able to avoid any transfer avoidable under either section 548 or under sections 55-80 or 55-81. However, as noted above, both section 548 and sections 55-80 and 55-81 have weaknesses: section 548 covers only transfers made within two years before the bankruptcy, and sections 55-80 and 55-81, while having longer reachback periods, have different standards than section 548 that can make them less effective.

In Arrowsmith v. Mallory (In re Health Diagnostic Lab., Inc.),13 however, the bankruptcy court ruled that a bankruptcy trustee can also step into the shoes of the United States and use the federal government's fraudulent-transfer avoidance powers under the Federal Debt Collection Procedures Act (the "FDCPA").14 This ruling is potentially significant for three reasons. First, the United States is a creditor in many bankruptcy cases, often because the debtor has tax debts, so the court's ruling will be applicable in many bankruptcy cases. Second, the FDCPA has a six year reachback period, substantially longer than the two year period available under Bankruptcy Code section 548 and longer even than the five year period of Virginia Code section 55-81. Third, as stated by the bankruptcy court, "the elements for actual and constructive fraudulent conveyance actions under ... [the FDCPA] are nearly identical to the elements for actual and constructive fraudulent conveyance actions under § 548(a)(1) of the Bankruptcy Code."15In other words, when examining transfers that occurred more than two years before the bankruptcy filing, the trustee will no longer be limited by the weaknesses of Virginia Code sections 55-80 and 55-81 - she will effectively have the stronger tools of Bankruptcy Code section 548 at her disposal.

In sum, the bankruptcy court's ruling effectively means that in many cases the reachback period in which the strong fraudulent-transfer avoidance standards of Bankruptcy Code section 548 are available will be tripled, from 2 years to 6 years. Accordingly, many more transfers will become subject to scrutiny and potential avoidance by bankruptcy trustees. Appeals of the court's ruling are almost certain to come, so please stay tuned for further developments.

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[1] Arrowsmith v. Mallory (In re Health Diagnostic Lab., Inc.), 2017 Bankr. LEXIS 2230, *58 (Bankr. E.D.Va. 2017).

[2] “Insolvent” in this context normally means that the transferor’s debts exceed the value of its assets.

[3] Under bankruptcy law, a finding that the transfer left the transferor with “unreasonably small capital” for its business or that the transferor “intended to incur” debts beyond its ability to pay can be substituted for the insolvency requirement.

[4] The prototypical “insider” is a corporate officer of the transferor entity, but an insider can take many forms.

[5] Hyman v. Porter (In re Porter), 37 B.R. 56, 63 (Bankr. E.D. Va.1984).

[6] Senior Transeastern Lenders v. Official Comm. of Unsecured Creditors (In re TOUSA, Inc.), 680 F.3d 1298 (11th Cir. 2012).

[7] The federal Fourth Circuit Court of Appeals, which covers Virginia, has made clear that value indirectly received can constitute reasonably equivalent value so as to negate a finding of a fraudulent conveyance. See Harman v. First Am. Bank (In re Jeffrey Bigelow Design Group, Inc.), 956 F.2d 479, 485 (4th Cir. 1992) (“It is well settled that reasonably equivalent value can come from one other than the recipient of the payments, a rule which has become known as the indirect benefit rule.”).

[8] The limit on when an action under section 55-80 can be brought is the equitable doctrine of “laches,” which bars an action if there has been an undue delay in bringing it that would prejudice the adverse party.

[9] Gold v. Sovreign Bank (In re Taneja), 453 B.R. 618, 623 (Bankr. E.D.Va. 2011).

[10] The transferee can limit his potential exposure by proving the extent of value he gave in exchange for the transfer and that he was unaware of the transferor’s fraudulent intent. However, he carries the burden of proof of these issues.

[11] Schnelling v. Crawford (In re James River Coal Co.), 360 B.R. 139, 167 (Bankr. E.D.Va. 2007).

[12] Tavenner v. Wells Fargo Bank, N.A. (In re Ferguson), 2014 Bankr. LEXIS 1046, *15 (Bankr. E.D.Va. 2014) (“Section 55-81 “does not address an obligation incurred without receipt of adequate consideration.”)

[13] 2017 Bankr. LEXIS 2230, *58 (Bankr. E.D.Va. 2017).

[14] Notwithstanding their identical acronym of FDCPA, the Federal Debt Collection Procedures Act should not be confused with the federal Fair Debt Collection Practices Act. The former establishes procedures the federal government can use to collect debts owed to the government, while the latter regulates the actions private entities can take to collect consumer debts.

[15] 2017 Bankr. LEXIS 2230, *58 (Bankr. E.D.Va. 2017). As the court stated, the FDCPA’s standards are “nearly identical” to the standards of section 548, but they are not actually identical. One way in which they differ is that in order to avoid a constructively-fraudulent transfer under the FDCPA based on the transferor having been “insolvent” at the time of the transfer, the transferor must have owed a debt to the United States at the time of the transfer. That limitation does not apply if an avoidance action is based not on insolvency but, rather, on the transferor having had “unreasonably small capital” for its business or an intention to incur debts beyond its ability to pay. 28 U.S.C. § 3304(b)(1)(B).

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.