Dallas Bar Association

A Primer on Fraudulent Transfer Actions in Bankruptcy Court

by Judge Harlin Hale, Andrew Edson, Maria G. Fernandez and Moira Chapman

Fraudulent transfers are common in bankruptcy. They occur when principals take advantage of companies, when assets are transferred for less than reasonable value, or when the debtor has made unusual payments. Fraudulent transfer issues also arise under guaranties, leveraged buyouts, and donations. This article summarizes the statutes governing fraudulent transfers and offers advice for practitioners.

Section 548

Section 548 of the Bankruptcy Code gives trustees or debtors the power to avoid fraudulent transfers made within two years of filing a petition. A “transfer” includes every method of disposing of or parting with property. Foreclosures, leveraged buyouts and mortgage modifications are examples of “transfers.” A party must prove that the transfer was actually or constructively fraudulent.

Actual fraud requires a showing of actual intent to hinder, delay, or defraud a creditor. Since direct evidence is rarely available, movants often present evidence through “badges of fraud”—circumstantial conduct surrounding the transfer that raises a strong presumption of fraud. The burden then shifts to the defendant to prove some legitimate purpose for the transfer(s).

Unlike actual fraud, constructive fraud requires no showing of intent. Rather, the movant must show: (1) that the debtor received less than reasonably equivalent value; and (2) that the debtor was insolvent or would become insolvent. Factors such as market value and good faith are used to determine reasonably equivalent value. Insolvency generally means that the debtor is unable to pay its debts when due.

There is, however, a defense for good faith transferees (GFT). A GFT may receive a lien or allowed to retain any interest transferred if the transfer was made in good faith and for value. “For value” is usually determined by the market value of the interest. “Good faith” requires an inquiry into whether the GFT knew or should have known that the transfer was fraudulent.

TUFTA

The Texas Uniform Fraudulent Transfer Act (TUFTA) borrows heavily from the Bankruptcy Code. In addition to actual and constructive fraud, Texas codifies two other transfers that are deemed invalid.

Actual and constructive frauds are analyzed in the same manner as in section 548. Importantly, however, GFT’s are limited to a lien under a constructive fraud theory in the amount given.

Current or future creditors may also avoid a transfer where reasonably equivalent value is not given and leaves the debtor with insufficient capital to conduct normal business operations. This is known as a “quasi-fraudulent” transfer. It does not require a debtor to be insolvent and gives GFT’s a lien in the amount they paid.

A transfer made to an “insider,” (e.g., a close family member, partner, etc.) who had reason to believe that the debtor was insolvent at the time of the transfer is avoidable under an “insider preference” theory. This action can only be brought by an existing creditor and requires the debtor to have been insolvent at the time of the transfer. The insider may be required to pay back the amount, despite giving fair value.

Statute of Limitations

Both section 548 and TUFTA have statute of limitations (SOL) prescribing the time within which to bring an action. Under TUFTA, a party must bring an avoidance action within four years from the date of the transfer for actual or constructive fraud. The limitations period is reduced to one year if the transfer was made to an insider. However, the discovery rule is built into the SOL for actual intent, so that parties receive an additional year upon discovering the existence of the transfer, not when learning of the alleged fraudulent intent. A two-year SOL exists for actions brought on behalf of a spouse, minor, or ward.

Under section 548, the debtor or the trustee must commence an avoidance action within two years of the bankruptcy filing and before the case is closed or dismissed.

Generally, parties rely on TUFTA since it is more generous. It is important to note that governmental creditors are not bound by the SOL and courts will sometimes allow an equitable tolling of the Bankruptcy Code limitations period.

Practice Pointers

  1. Carefully document the transaction and clearly identify the consideration given and received.
  2. Watch for statute of limitations defenses under State law and Bankruptcy Code.
  3. If you do not want to be in bankruptcy court, say so at the beginning. The bankruptcy court’s power to hear fraudulent transfer actions is uncertain at this time.
  4. If you are handling a company sale, do not let your client(s) get too greedy. Exiting shareholders who take too much give rise to fraudulent transfer actions.

Judge Hale has been a bankruptcy judge in Dallas since 2002. Andrew Edson is an associate with Strasburger & Price, LLP, and can be reached at andrew.edson@strasburger.com. This article was written in part and edited by Maria G. Fernandez and Moira Chapman, law students at Southern Methodist University and judicial externs for Judge Hale.

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