When a business faces financial distress, bankruptcy is often a last-resort option for resolving debts crippling the company. However, your company should be aware of the risks that can arise in bankruptcy, particularly allegations of fraudulent transfers. In bankruptcy proceedings, a court-appointed trustee may attempt to recover assets that were transferred from the company before the bankruptcy, claiming they were done to hinder, delay, or defraud creditors. This can lead to lawsuits, increased costs, and the potential reversal of the transfers. Understanding the legal framework and implementing best practices can help your company avoid or effectively defend against fraudulent transfer claims in bankruptcy.
What is a Fraudulent Transfer?
A fraudulent transfer occurs when a debtor transfers property or assets to another party with the intent to hinder, delay, or defraud creditors. The Bankruptcy Code and state laws, including California’s Uniform Voidable Transactions Act (UVTA), provide trustees with tools to recover these assets for the benefit of creditors. There are two primary types of fraudulent transfers:
Actual Fraudulent Transfers: These involve transfers made with the direct intent to defraud creditors. Evidence of intent may include selling assets for less than their value, transferring property to friends or family, or concealing the transfer.
Constructive Fraudulent Transfers: These occur when a debtor transfers assets for less than fair market value while insolvent or becoming insolvent as a result of the transfer. Even if there was no fraudulent intent, such transfers can still be challenged in court.
Best Practices for Avoiding Fraudulent Transfer Claims
Avoid Undervaluing Assets in Transactions
When selling or transferring assets, it’s crucial to ensure that the transaction is conducted at fair market value. A trustee can challenge any transfer made for less than the asset’s fair value. Businesses should document valuations and ensure they align with independent appraisals and other acceptable valuation methods where applicable.
Maintain Clear and Accurate Financial Records
One of the best defenses against fraudulent transfer claims is a well-documented transaction history. Keeping detailed financial records, including contracts, sale agreements, and valuations, can provide a strong defense if the transfer is later questioned. Sophisticated companies should regularly audit their financial records to ensure accuracy, transparency and compliance with applicable laws.
Additionally, maintaining regular communication with accountants, financial advisors, and legal counsel can help ensure that any transfers are appropriately documented and conducted in a manner that minimizes the risk of being challenged in court.
Assess Solvency Before Making Transfers
Before transferring significant assets, your company should evaluate its solvency—the company’s ability to meet its obligations as they come due. Transfers made while the business is insolvent, or that render the business insolvent, are highly susceptible to being classified as constructive fraudulent transfers in court. To avoid this, it is essential to perform a solvency analysis, particularly when transferring assets to insiders or affiliates.
Be Cautious When Transferring to Insiders
Transfers made to insiders, such as shareholders, board members, family members, close friends, or business affiliates, are closely scrutinized in bankruptcy proceedings. While insider transactions are not inherently fraudulent, they raise red flags and will likely attract increased scrutiny from trustees. Your company should ensure that all insider transactions are conducted at fair value and with full transparency.
Monitor Financial Distress Signals
Recognizing early signs of financial distress can help your company avoid making transfers that may later be deemed fraudulent. When financial trouble arises, it is advisable to seek professional assistance from restructuring advisors, financial consultants, or bankruptcy attorneys. Taking active steps to address solvency issues may help prevent the need for asset transfers that could later be challenged in a bankruptcy matter as fraudulent.
Understand the Lookback Period
Fraudulent transfer claims are subject to a “lookback” period, during which a trustee can examine past transactions. Under the Bankruptcy Code, the standard lookback period is 2 years, but state laws such as California’s UVTA extend this to 4 years. Your company should be mindful of any significant transfers made within this period before filing for bankruptcy. If any of these transfers are at risk of being labeled fraudulent, your company may need to take corrective action, such as negotiating with creditors or reversing the transaction and returning the assets to the company’s bankruptcy estate.
Defending Against Fraudulent Transfer Claims
If a trustee or creditor files a claim of fraudulent transfer, your company needs to be prepared to defend itself effectively. Key defenses include:
Good Faith Transfer: A transfer made in good faith, without intent to defraud, and for reasonably equivalent value may provide a strong defense. Documenting the rationale behind the transaction and ensuring it was done transparently can bolster your company’s position.
Statute of Limitations: Fraudulent transfer claims are limited by time. If the transfer falls outside the applicable lookback period under federal or state law, the trustee or creditor may be barred from pursuing the claim.
Solvency and Reasonably Equivalent Value: Demonstrating that the company was solvent at the time of the transfer, or that it received reasonably equivalent value in return, can neutralize claims of constructive fraud.
Ordinary Course of Business: Transfers made in the ordinary course of business, such as payments for goods or services, are typically less likely to be viewed as fraudulent. You company should maintain evidence that its transactions were part of normal business operations.
The Role of Legal Counsel
Companies facing bankruptcy or financial distress should consult with experienced bankruptcy attorneys to navigate these challenges well in advance of considering a bankruptcy filing. Legal counsel can provide valuable insights on how to structure transactions in a way that reduces the risk of future fraudulent transfer claims. Furthermore, should a claim arise, attorneys can help marshal all the important evidence, mount a robust defense and negotiate a resolution with trustees or creditors.
Companies who are organized and act early in their approach to financial distress will be better positioned to avoid the pitfalls of fraudulent transfers, ensuring their assets are protected as they navigate the complexities of bankruptcy.
About Finkel Law Group
Finkel Law Group P.C., with offices in San Francisco and Oakland, has assisted businesses navigate federal bankruptcy laws and state insolvency statutes for more than 25 years. With guidance from the experienced attorneys at Finkel Law Group, your business can navigate the challenges posed by federal bankruptcy laws effectively, ensuring compliance with the law and optimizing your company’s chances of a successful financial restructuring. When you need intelligent, insightful, conscientious and cost-effective legal counsel to assist you with the bankruptcy issues confronting your company, please contact us at (415) 252-9600, (510) 344-6601, or info@finkellawgroup.com to speak with one of our attorneys.