29: Fraudulent transfers – overview, actual fraud

© Charles Tabb 2010

Purpose of fraudulent transfer law

Protect body of CREDITORS from unfair actions by the Dr that harm the Cr groups’ financial interests

Creditors

debto

r

Hide asset

s

Driving norms

1st – NAUGHTY debtor – misbehavior by Dr – actual, subjective fraudulent intent, to hinder, delay, or defraud her creditors

2nd – INHERENT harm to Crs – irrespective of Dr’s state of mind – action taken necessarily hurts the Cr group – constructive fraud Ex., Dr is insolvent, makes a gift – now has fewer

assets to pay Crs, and already did not have enough

Not limited to bankruptcy

Fraudulent transfer law is not conceptually limited to a collective proceeding (such as bankruptcy) Justification for collective action focuses more on

inter-cr

Applies whenever a Dr takes actions that could harm Cr group (indeed, even if just ONE Cr!)

So, every State has its own fraudulent transfer law, and Crs have power outside of Bk to set aside FT

State law models

(1) UFTA (Uniform Fraudulent Transfer Act – pp 490-96) The current recommended uniform law (since 1984) In force in 43 states and D.C.

(2) UFCA (Uniform Fraudulent Conveyance Act) The predecessor uniform law, circa 1918 Only 2 states and Virgin Is. – BUT the law in New York!

(3) Statute of Elizabeth Original English version, 1571! 5 states

history

Origins: 1571 – Statute of Elizabeth in England Had to prove Dr’s actual fraudulent intent Protect a transferee for value who lacked notice of fraud

“Objectification” & uniformity – UFCA 1918 Formally introduced “constructive” fraud Uniform law, adopted in almost every state

1978 Bankruptcy Code 548 Modified FT law in several respects, now some differences UFCA

Modernize, Uniform harmonization, UFTA 1984 Replaced old UFCA to reflect modern financial issues Closer harmonization to 1978 Bk Code

Actual vs constructive fraud

“Actual” fraud: set aside if prove that Dr made a transfer with an actual, subjective intention to hinder, delay, or defraud her Crs

“Constructive” fraud: strict liability – no mens rea of Dr required; instead, certain factors in combination conclusively establish the fraud Ex. gift transfer by an insolvent Dr

Primary issues

1st – set aside the transfer? I.e., voidable? i.e., was the transfer either actually or constructively

fraudulent?

2nd -- if set aside – what remedy? From whom (if anyone) can Cr or Trustee recover, and What (how much) can they recover?

standing

WHO may sue to set aside a fraudulent transfer?

In Bankruptcy – the trustee (or DIP)

Under State law – Creditors 1. “Present”

had a claim at time of transfer universal standing

2. “Future” Claim arose AFTER the challenged transfer Lack standing to challenge some types of constructive fraud

Statutes of limitation

Bankruptcy (548) Norm = 2 years

Increased from 1 year in 2005 Asset protection trusts (548(e) = 10 years

State law Norm = 4 years (see UFTA 9) Might incorporate in bk case via 544(b) “successor”

rule

Remedy?

Norm – set aside, thus recapture either (i) the property itself or (ii) its value

Possible safe harbor for transferee If transferee is gave reasonably equivalent value, and

was in good faith (i.e., not know of the fraud), is protected from recovery

Means is possible to have a “right without a remedy”

Costas

Facts: Dittlof created revocable trust under Arizona law Rachelle Costas (daughter) a beneficiary, remainder

interest Dittlof died Feb 25, 2002 Costas’ trust share = $34K Nov. 7 - Costas executed valid disclaimer under

Arizona law Dec. 3 – Costas filed chapter 7 Gaughan (trustee) sued to avoid Costas’ disclaimer as

a FT under 548

Issue?

Issue in Costas: did Dr make a transfer of an interest in

property when she disclaimed the trust interest?

Nature of the state law

Under Arizona law, a properly executed trust disclaimer is valid and enforceable, and relates back for all purposes to settlor’s death

i.e., by legal fiction it is treated as if beneficiary never had an interest in the trust property – up in smoke!

Defer to state law?

Why did the court defer to state law? Applied general principle of Butner -- property

interests for federal bankruptcy purposes - created and defined by state law

Policies – avoid forum shopping, no windfalls to Crs (treat same in or out of bk)

And under state law is as if disclaimant never had the property

Drye?

Supreme Court in Drye faced issue of whether an IRS tax lien attached to an inheritance, notwithstanding fact that the taxpayer/beneficiary disclaimed, & state law had relation-back rule

Held: tax lien DID attach to “property” inherited Reality of disclaiming was that taxpayer channeled

property to someone else

Analogy to Butner/CBOT?

S Ct in Drye announced a mode of analysis eerily reminiscent of the bankruptcy property two-step with Butner & CBOT:

Look to state law to determine what rights taxpayer has in the property (like Butner)

Then to federal law to see if the state-delineated rights qualify as “property” for purposes of federal tax lien law (like CBOT)

Trustee argument

What was the trustee’s argument in Costas, relying on Drye?

That the debtor’s power to channel who got the inherited property (by disclaiming) = “property” for federal bankruptcy purposes

Debtor’s disclaiming “transfer"

disclaimsDebtor Siblings

Dad dies, Trust Property

What is the right question to ask in bankruptcy?

Applying Butner & CBOT, what is precise analytical question you need to ask in a disclaimer case?

NOT that if disclaimed, ≠ “property” under state law b/c labeling Q -- “is it ‘property’” = federal Q (CBOT)

Right question: look at relevant attributes under state law namely, if Dr disclaimed under state law, would disclaimer be effective against creditors outside of bankruptcy, even if circumstances suggest fraud

policy

If a state law disclaimer outside of bankruptcy would defeat the rights of creditors, even in circumstances suggesting fraud (e.g., Dr insolvent, relinquished valuable inheritance & got nothing in return), then the Butner anti-forum shopping & anti-windfall policies are implicated

Distinguished Drye

Court distinguished Drye:1) timing – in Drye, tax lien already in place before disclaimer, so is like disclaimer divested the existing federal property right, whereas in Costas the disclaimer occurred prior to bankruptcy, so no federal bankruptcy property interest being divested – instead never had it in the 1st place

Any arguments - logic is fallacious?? Is “property” in pre-bk period (for purposes FT law) any different than “property of estate”

Drye distinction # 2

Tax liens are just differentPolicy of federal tax law is to grab

EVERYTHING Even if Crs normally could not reach

Whereas bankruptcy law norm isto respect & honor property undernon-bankruptcy law

-> the Butner norm against “windfall by reason of happenstance of bankruptcy”

Died after bankruptcy?

Court says would be a different result if Dittlof had died AFTER Costas had filed bankruptcy, instead of before

Why?

What about 541(a)(5)(A)? (estate includes any interest Dr acquires “or becomes entitled to acquire” w/in 180 days after filing, by inheritance)

Special power?

Relevance to case (or post-bk death hypo) of inferences to be drawn from 541(b)(1)?

b) Property of the estate does not include--(1) any power that the debtor may exercise solely for the benefit of an entity other than the debtor; …

Suggests that property of estate DOES include any “power” that the Dr COULD exercise for her own benefit (such as a general power appointment – or an election whether to disclaim an inheritance??)

Practical effect?

Reality of Costas is that Dr can choose for her family members to get property rather than her creditors, even if she is insolvent at the time she takes the act that redirects that property to her family

Actual fraud

Set aside transfer if DEBTOR had an actual intent to “hinder, delay or defraud” her Crs

DEBTOR

the “evil mind” ground

Focus on the subjective state of mind of DR when she made the challenged transfer

Badges of fraud

How prove Dr’s subjective state of mind? Assuming no Perry Mason-like confessions

Circumstantial evidence

Goes by fancy name of “badges of fraud”

Twyne’s Case

Facts: Pierce (Dr) owed ₤400 to Twyne and ₤200 to “C” C sued Pierce While action pending, Pierce transferred all his

property (worth ₤300) to Twyne by deed of gift But, Pierce retained possession of some property

(sheep) C got judgment vs Pierce Sheriff went to levy on sheep,was blocked – said not Pierce’ssheep, but Twyne’s C sued Twyne to set aside the transfer

Twyne

Pierce ₤400 Twyne

₤300

“C”

Badges in Twyne

Held for C – allow to set aside transfer from Pierce to Twyne and levy on sheep

Why? Said Pierce had “actual intent” to defraud Proof? “badges of fraud”:

1. The gift was general, of all of Pierce's property, without excepting even his apparel or anything of necessity.

2. Pierce retained possession of the property supposedly transferred, and treated it as his own.

3. The transfer was made in secret.4. The transfer was made while C's suit was pending against Pierce.5. Twyne held the property in trust for Pierce.6. The deed contained a recital that the gift was bona fide.

Common “badges”

some of the badges in Twyne are common, especially Made in secret While C’s suit was pending

Other badges commonly used over the centuries: transfer to a family member or another "insider" gift transfer (i.e., for no consideration) transfer for less than full consideration insolvency of the debtor at the time the transfer was made

See UFTA 4(b), p. 467

Asset protection trusts

in an asset protection trust, a Dr both (i) sets up the trust with her own property (i.e., is settlor) AND(ii) is the beneficiary of that trust; furthermore, common for trust to block the power of Crs to collect from beneficiary’s interest

DR Trust Dr as Beneficiary

Creditors

548(e) avoidance

The elements of that avoiding power are: Transfer of an interest of the debtor in property Made on or within 10 years before the

bankruptcy filing To a self-settled trust or similar device By the debtor Debtor a beneficiary of the trust Actual fraudulent intent

9.4(a)

Facts: Debtor owes 10 creditors $50K; in default on 7 of the

debts Five creditors bring lawsuits against the Debtor. Debtor’s only nonexempt asset is a valuable painting she

inherited from her father, worth $40K Debtor sells the painting to Art Mann,

a wealthy collector, for $38K Art Mann knows nothing of Debtor’s financial situation Debtor deposits the cash in her bank, wire transfers the

money to a Swiss bank, and disappears Two months later, an involuntary chapter 7 order for

relief is entered against Debtor

Analysis 9.4(a)

Fraud? What “badges”?

Widespread defaults Pending lawsuits Insolvent (assets = 40, debts = 50) Convert only leviable asset into cash & make

unavailable to Crs (Swiss bank) Absconds

-> what about fact got fair value for painting?

Analysis 9.4(a)

Protected? i.e., is Art Mann within safe harbor, or is he vulnerable?

11 USC 548(c): … a transferee or obligee of such a transfer or obligation that takes for value and in good faith has a lien on or may retain any interest transferred or may enforce any obligation incurred, as the case may be, to the extent that such transferee or obligee gave value to the debtor in exchange for such transfer or obligation.

UFTA: SECTION 8. DEFENSES, LIABILITY, AND PROTECTION OF TRANSFEREE.(a) A transfer or obligation is not voidable under Section 4(a)(1) against a person who took in good faith and for a reasonably equivalent value or against any subsequent transferee or obligee.

protection

In what important way are the safe harbors for innocent transferees who gave value different under the Bankruptcy Code and the UFTA?

Would it matter, for example, if the painting that Art bought for $38K was now worth $150K?

Is Art protected?

Under 9.4(a), did Art:

1. Give “value” (548(c)) or “reasonably equivalent value” (UFTA 8a) ?

2. was Art “in good faith” ? (same in both)

If “YES” to both – what are the consequences?

9.4(b)

Facts: Same as a., except: Dr sells to Art for $20K, not $38K Art then gives painting to his daughter

DR Art Daughter $20K Gift

Analysis 9.4(b)

Fraud? All the same “badges” as in a, PLUS have the sale of

the Dr’s one nonexempt asset for less than reasonably equivalent value

Analysis 9.4(b)

Is Art protected (under 548(c) or 8(a))?

1st, was he “in good faith”? Purchase for 50% discount raises serious doubts If not = good faith, no protection at all Liable under 550(a)(1) as initial transferee

Not have painting, so trustee gets judgment for value of painting, i.e., for $40K

9.4(b) protection, cont.

2nd, even if somehow Art is in good faith, even though got a 50% discount, what about “value”?

In bankruptcy 548(c) – should be no difference in analysis, b/c, if in good faith, just protect to same extent, viz., to extent gave value, here, $20K Note problem, though – lien on what? UFTA provides (in 8(d)(3)) for this case simply by

reducing the amount of the judgment

Art v Dr, estate

Assuming that trustee can recover from Art, what are Art’s rights?

Art has claim against the DR for the $20K he paid for the painting Allowed in bankruptcy case, under 502(h) once pays back

trustee

And the debt might well be nondischargeable for fraud under 523(a)(2) Which means Art can go after Dr after bankruptcy, if he

can find him!

Daughter’s protection?

Remember that Art gave the painting to his daughter

1) daughter no defense under 548(c) – only works for transferee from the DR – and she gave no value anyway

2) daughter liable under 550(a)(2) as a secondary transferee – either give back painting, or its value No defense 550(b), b/c did not give value, and Art not

protected

Single satisfaction

Note, though, that trustee is entitled only to a single satisfaction, under 550(d)

9.4(c)

Facts: Same as a., except Dr sells to her mother, not Art

DR MOM $38K

Analysis 9.4(c)

Fraud? Badges?

All the same as before, PLUS a transfer to a family member – historically one of the most significant badges

In some states, transfers to family members raise a presumption of fraud, and shift the burden of going forward to defend the legitimacy of the transfer

Analysis 9.4(c)

Is Mom protected?

Gave “value”

But her “good faith” will be scrutinized very closely – looks like she may have cooperated with her daughter in a fraudulent scheme designed to (i) put the painting itself out of reach of Dr’s crs and (ii) give Dr the cash

9.4(d)

Facts: Same as a., except Dr gives painting to her mother

DR MOM Gift

Analysis 9.4(d)

Fraud? All the same badges as before Plus transfer to relative Plus gift transfer – nothing in exchange

This is the classic fraudulent transfer – just give your property to a relative so your Crs can’t get it

Analysis 9.4(d)

Mom protected?

No – gave no value so no protection 548(c) (and good faith dubious anyway)

And as initial transferee is strictly liable 550(a)(1) – must give back painting to trustee, or its value

9.4(e)

Facts: Same as a, except Dr donates painting to Art Institute

DR Art Institute Gift

Analysis 9.4(e)

Fraud? Same badges as before, plus outright gift

Analysis 9.4(e)

Is Art Institute protected?

NO – not under 548(c), b/c gave no value

Not under “charitable contribution” safe harbor of 548(a)(2), b/c that is limited to Constructive fraud cases, not actual fraud And anyway only if is a cash donation, or financial

instrument, 548(d)(3)

Strictly liable as initial transferee, 550(a)(1)

9.5(a)

Facts: 1996: Debtor planning on starting new business as a sole proprietorship At time, had debts of $50K and assets of $100K; no lawsuits pending Projected income statements showed a net positive monthly cash flow of $9K

(expenses of $15K, income of $24K) However, the income projection depended on Debtor accurately

predicting the direction of worldwide gasoline prices Debtor had spent the last 20 years working in the energy field Recognizing the inherent riskiness of his business plan, Debtor in 1996

transferred $50K to an asset protection trust in the Cook Islands Debtor was the sole beneficiary of this trust

For several years, business worked well. However, after U.S. invasion of Iraq, gasoline prices initially fell, but then rose dramatically; by July of 2005, gasoline was selling for double what it had been two years earlier. Debtor, unfortunately, had made a big investment predicting a decline in gasoline prices.

Debtor filed chapter 7 bankruptcy in August 2005 At the time of filing, Debtor had assets of $250K and debts of $900K Trustee brought suit to avoid the 1996 transfer to the Cook Islands trust.

Analysis 9.5(a)

What section would trustee sue under?548(e):

within 10 years before the bankruptcy; to a self-settled trust; transfer was by the debtor; debtor is a beneficiary of trust; and the debtor made such transfer with actual intent to

defraud present or future crs

Only part at issue is debtor’s actual fraudulent intent

9.5(a)

What arguments would you make that Dr DID have actual fraudulent intent?

What arguments did NOT have such intent?

9.5(b)

Same facts as a., except Dr made transfer to Cook Islands trust in June 2005, just 2 months before filed bankruptcy

How does this change the analysis of the debtor’s actual fraudulent intent?

Alan Drey

Facts: Generation, business magazine publisher,

bought subscription lists from Alan Drey, a list broker, and executed promissory note

Defaulted on note, in March, Drey got default judgment $98K, notified Generation

Generation insolvent at the time & thereafter Customer lists only substantial asset Generation undertook to sell those lists Eventually negotiated with McGraw Hill

Continued next slide

Facts, cont.

Generation, through Pres. (Handler) offered to M-H for $500K

M-H knew of judgment for DreyM-H called Drey, confirmed judgment in effectDrey called G, asked “what’s up,” & G lied – said not going

out of business or sellingG agree to sell lists to M-H for $150KSale put G out of businessM-H requested indemnity; knew G in financial straitsG asked M-H to keep sale confidentialNo notice given to Drey of sale$150K put in secret trust account, used to buy G insiders shares

in new business, pay some other Crs– but zero paid to Drey

issues

Issues in Alan Drey?

1st – was it an actually fraudulent transfer? i.e., did Generation have an actual intent to hinder,

delay or defraud Drey?

2nd, if so, is McGraw-Hill a protected innocent purchaser for valuable consideration, w/o knowledge of the fraud?

Fraud?

Why did court find actual fraudulent intent? i.e., what are all the badges of fraud here?

Protected?

Why did court find that McGraw-Hill was NOT a protected transferee?

What remedy?

When a creditor sets aside a fraudulent transfer, they may either (i) recover the asset or (ii) get a judgment form the transferee for the value of the asset

Here, Drey did not recover the asset, but instead got a money judgment agst M-H for the value of the asset (up to amount of Drey’s $98K judgment)

Why?

Dean v Davis

Facts: Farmer Jones owed Bank $1600 on forged notes Bank threatened criminal prosecution unless Jones made good Jones begged his father for help, and father got Jones’ brother-in-

law (Dean) to take over the Bank debt, with Jones then to be liable to Dean on 4 promissory notes for the $1600

In exchange, Jones gave Dean collateral – mortgaged everything to Dean – store stuff, farm, etc.

The notes came due within week (before mortgage even executed) , Jones defaulted, Dean took possession of all collateral

Jones insolvent at time, had many Crs Involuntary bk filed against Jones Mortgaged property sold, yielded ~ $1600 – so unless mortgage

set aside, Dean gets everything & other Crs nothing

Dean v Davis

Jones Bank

Dean

take

on

$160

0

$1600, notes

Claim

-

$1600m

ortgage

Other creditors

Why not a preference?

Trustee (Davis) of Jones’ bankruptcy sued Dean to set aside the mortgage on 2 theories: (1) preference and (2) fraudulent conveyance

Supreme Court held: Not a preference Mortgage from Jones to Dean and Dean’s claim

against Jones were substantially contemporaneous, i.e., no antecedent debt

Fraud?

Supreme Court held that Jones acted with an actual fraudulent intent against his general creditors when he transferred the mortgage to Dean

Why? {Jones}

Why wasn’t it a good defense that Jones received equivalent value in return for the loan by Dean (viz., the assumption of the bank debt)?

Protected?

Supreme Court also held that Dean was not a protected transferee (need “good faith and a present fair consideration” [predecessor to 548(c)])

But didn’t Dean give fair value? In effect, loaned Jones $1600, got a mortgage in exchange