Chapter 15 Fraudulent Transfers

• Jurisdiction: United States

Chapter 15 Fraudulent Transfers

§ 15.1 ~ Introduction

This is the second of two chapters on trustees' avoiding powers. Here, we deal with a number of issues that surround the most ancient avoiding power: the power to avoid fraudulent transfers.

§ 15.2 ~ What Your Brother-In-Law Said at Thanksgiving

"So, you are a bankruptcy lawyer?" your brother-in-law says over drinks before Thanksgiving dinner. "I don't worry about bankruptcy. I transferred all my property to my wife's name."

Even the neophyte in the world of bankruptcy law will recognize the folly and potential for disaster in this bald statement. The brother-in-law appears to have carried out the crudest form of fraudulent transfer.¹ It probably will not work: In bankruptcy, the transfer may be avoided and the property recovered for the bankruptcy estate. But that may be only the beginning. The fraudulent transfer may also cause the debtor-transferor to lose his bankruptcy discharge.² In extreme cases, the conduct may be a crime. And the problem does not end with the debtor-transferor. The lawyer who led him into this mess may face liability of his own.

Fraudulent transfer law thus lies at the core of our understanding, and misunderstanding, of the bankruptcy process. It is so pervasive that we find it at many places throughout this book. Here we limit ourselves to outlining the substance of fraudulent transfer law. We try to put it in the context of its history and point to some places where the substance of fraudulent transfer law occurs under other names.

§ 15.3 ~ Background

For fraudulent transfer issues in bankruptcy, we have a full complement — indeed, perhaps a surplus — of fraudulent transfer law. The Bankruptcy Code offers its own substantive law of fraudulent transfers in § 548, but in many cases the trustee will deploy § 544(b) to avail himself of state law. Necessarily, state law varies from state to state. But a substantial majority of states and the District of Columbia have adopted the Uniform Fraudulent Transfer Act (UFTA), which bears many similarities to (and a few important differences from) § 548.³ A few states, including New York, retain the old Uniform Fraudulent Conveyance Act (the UFCA), a predecessor.

Nevertheless, to begin with, the current statutes may be misleading because fraudulent transfer law has a history that goes back long before the enactment of these particular statutes — all the way back to the statute of Elizabeth in 1571.⁴ Inevitably, judges will read the current statutes through the prism of this history.

§ 15.4 ~ Two Kinds of Fraudulent Transfers

Against this background, we turn to the prima facie case.⁵ The first thing to note is that the statute provides for the avoidance of two kinds of fraudulent transfers. Call them "actual fraud" (intentional transfers) and "constructive fraud" (less than reasonably equivalent value transfers).

§ 15.5 ~ The Classification

First, "actual fraud" transfers, as defined in § 548(a)(1)(A), are "[m]ade ... with actual intent to hinder, delay, or defraud...." Second, a "constructive fraud" transfer or, as defined in § 548(a)(1)(B):

- Received less than a reasonably equivalent value in exchange for such transfer or obligation; and

o was engaged (or was about to engage) in a business or transaction, for which any property remaining was an unreasonably small capital; or
o was intended to incur, or believed she would incur, debts beyond her ability to pay as they matured; or
o made such transfer, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.⁶

§ 15.6 ~ Why it matters

Just the briefest glance will suggest that there must be ways in which these categories blur into each other. For example, making a transfer by gift surely qualifies as making a transfer for "less than reasonably equivalent value." Yet, the fact that the transfer was by gift may also serve to give evidence of intent to hinder, delay or defraud. Indeed, we would speculate that most intentional fraudulent transfers are also transfers for less than reasonably equivalent value.

But difficult as it may be to distinguish in some cases, it is important to get it right. It affects the prima facie case. We can easily imagine a case in which the trustee could prove less than reasonably equivalent value, but might not be able to prove intent.⁷ We can also imagine, if a bit less easily, cases in which the trustee could not meet the standard of proof on value but could prove intent.⁸ The solution is perhaps obvious: If you can do so within the bounds of good faith, plead both and hope that the evidence will support judgment on at least one count. Of course, only one recovery is permitted.

Of even greater practical importance, the difference between "actual fraud" transfers and "constructive fraud" transfers is critical to other aspects of fraudulent transfer law. Denying a discharge requires a showing of intent to hinder, delay or defraud, for example.⁹ Intent is also critical to conviction of a bankruptcy crime.¹⁰ In short, about the worst that can happen to a constructive fraud transfer is that it will be avoided. But actual fraud transfers can bring a lot more grief in tow.

Finally, the issue may be important as effecting a limitation on the trustee's recovery.¹¹

§ 15.7 ~ Transfer

The first prerequisite for a fraudulent conveyance is the existence of a "transfer." Thus, it is essential to understand what a "transfer" is. The term is defined in § 101(54).¹² Obviously, it includes conveyance of an asset — e.g., if you sell your car to your brother, that is a "transfer" — but it also includes granting a lien (that is "transferring" a security interest).

One of the difficult cases on the "transfer" issue is the debtor who moves money from nonexempt to exempt status, such as taking cash from a (nonexempt) checking account and buying an (exempt) annuity. One is tempted to try to deal with this through the fraudulent conveyance laws, but it may not fit within the definition of "transfer" (and in any event, what's wrong with trying to take full advantage of the exemptions?).¹³

Another difficult case is illustrated by In re Bernard,¹⁴ in which the court held that withdrawal of funds from a bank account for purposes of preventing attachment constitutes a fraudulent conveyance. One can imagine this case coming out differently, and, indeed, a dissent was written taking the position that no "transfer" occurred.¹⁵ A final interesting example, showing how broadly the term "transfer" can be interpreted, is illustrated by the case of United States v. Sims (In re Feiler),¹⁶ which held that making a tax election can constitute a "transfer" and, therefore, be avoidable under the fraudulent conveyance laws.

§ 15.8 ~ Actual Fraud

Section 548(a)(1) denounces transactions done with "actual intent" to hinder, delay, or defraud. But there is a difficulty here: How do you define "actual" intent? As a practical matter, seldom — and as a matter of strict metaphysics, perhaps never — do we know the mind of another sufficient to know his "actual" intent as distinct from (we assume) his intent presumed at law.

So the fact is that we are ordinarily working with external indicia from which we infer state of mind. For this reason, the law has developed what have come to be called "badges of fraud"¹⁷ — indicia that may be used as evidence of the internal state. The drafters of the UFTA went so far as to include a nonexclusive list of factors to consider in deciding whether there has been fraud:¹⁸

- The transfer or obligation was to an insider;
- The debtor retained possession or control of the property transferred after the transfer;
- The transfer or obligation was disclosed or concealed;
- Before the transfer was made or obligation was incurred, the debtor had been sued or threatened suit;
- The transfer was of substantially all of the debtors' assets;
- The debtor absconded;
- The debtor removed or concealed assets;
- 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;
- The debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred;
- The transfer occurred shortly before or shortly after a substantial debt was incurred; and
- The debtor transferred the essential assets of the business to a lienor, who then transferred the assets to an insider of the debtor.

The UFTA says that consideration "may be given" to these "among other factors." The official commentary elaborates that the list is a nonexclusive catalogue of factors appropriate for consideration by the court in determining whether the debtor had an actual intent to hinder, delay, or defraud one or more creditors. Proof of the existence of any one or more of the enumerated factors may be relevant evidence as to the debtor's actual intent, but it does not create a presumption that the debtor has made a fraudulent transfer or incurred a fraudulent obligation.

The commentary also sets forth a representative sampling of the supporting case law. There is no comparable list in the Bankruptcy Code or the UFCA. But insofar as the list is a crystallization of the case-law tradition, and insofar as the Bankruptcy Code crystallizes the same tradition, this kind of case law would seem as relevant in bankruptcy as otherwise.¹⁹

§ 15.9 ~ Two Classic Frauds

This is not a treatise on fraud in general, but there are two frauds so common in bankruptcy practice that they deserve special mention.

One is the Ponzi scheme named after its master practitioner, Charles Ponzi, who fleeced a whole community of small savers around Boston just after World War I. A Ponzi scheme works this way: I promise to double your money in a week. Two people "invest" one dollar and then, a day later, two more. I pay $2 each to the first two, using their own money, plus the money invested by the next two. I...