A look at scenarios and possible defenses related to a bankruptcy debtors’ transfers

Bankruptcy filings have increased drastically in recent years. To the dismay of creditors, such filings often signal only the very beginning of their difficulties.Bankruptcy debtors (or their appointed bankruptcy trustees) can file “turnover actions” — lawsuits in which a debtor seeks the return of past payments to creditors based on “preference” or “fraudulent transfer” causes of action.Although in preference suits a debtor may usually only seek the refund of payments made in the 90 days prior to bankruptcy, in fraudulent transfer actions the debtor may pursue payments made years before.A few examples will be helpful: • A debtor in dire need of immediate cash to pay her many creditors raises funds by selling her home for far less than fair market value. The debtor is rendered insolvent by the sale and is unable to pay most of her creditors, but she does pay the debt owed an aggressive unsecured creditor whose hard-nosed collection efforts and demands forced the debtor to sell her home. The debtor then files bankruptcy 1 1/2 years later. • At a time when a debtor is insolvent but continuing to do business, an under-secured creditor demands and receives additional collateral of essentially all of the debtor’s assets, without providing any additional consideration, such as loans or trade credit. The debtor then files for bankruptcy relief six months later. • Corporation A, a closely held corporation that has been threatened with a lawsuit for breach of contract by a vendor, secretly transfers all of its assets to its affiliate, Corporation B (both A and B have identical ownership) for nominal value. The vendor then prevails in its lawsuit only to find that Corporation A is insolvent. Corporation A subsequently files for bankruptcy relief three years later.In any of the above situations, the transferee is at risk of suit for a “fraudulent transfer.” A bankruptcy debtor may bring a fraudulent transfer claim under the Bankruptcy Code or applicable state law. The elements of these actions are very similar.It’s important to remember that the term “fraudulent transfers,” as used by these statutes, is misleading because actual fraud is not necessarily a required element of a fraudulent transfer claim.Rather, under both the code and state law, a plaintiff in such a case need only show that the transferor received less than reasonably equivalent value and was insolvent or became insolvent as a result of the transfer while it was engaged in or was about to engage in a business or a transaction with remaining property that constituted unreasonably small capital or the transferor intended to incur or believed that it would incur debts beyond its ability to pay.In short, a transferee faces two possible scenarios in which a payment may be challenged under fraudulent transfer laws — challenges to transfers involving actual fraudulent intent and challenges to transfers where no fraudulent intent was necessarily present but the transfer was for less than fair value during the debtor’s insolvency, or it rendered the debtor insolvent (as in the first two examples above).Act quicklyThere are limitations on the power to avoid such transfers. For example, the Bankruptcy Code only allows for the avoidance of transfers made in the two years prior to the bankruptcy filing. This would mean that under the third example, the transfer could not be avoided under the code.However, debtor plaintiffs or their trustees may also assert fraudulent transfer actions based on state fraudulent transfer statutes, which generally permit such claims years after the challenged transfer.Another limitation in the code provides that the debtor cannot bring suit more than two years after the filing of bankruptcy or one year after the appointment of the first bankruptcy trustee, whichever is later.That raises a more difficult question: How do you avoid these lawsuits altogether? The answer is that several measures may be helpful, but there is no cure-all.You may: • Secure payment of amounts due your business, since secured creditors generally have a protected position, even in bankruptcy. Assuming that any security provided by the debtor is given prior to insolvency and is not, itself, vulnerable to fraudulent transfers litigation or any other attack, this can be a very powerful tool and should substantially diminish the risk of litigation. • Obtain guarantees of your customer’s debt from its affiliates, subsidiaries, owners and officers. In short, the idea is to be in a position to compel a separate party to pay the bankruptcy debtor’s debt to your business, regardless of whether the debtor has filed for bankruptcy protection. • Insure for nonpayment or disgorged payments. Though perhaps expensive, where particularly risky ventures are involved the unusual option of “credit” insurance, also called “accounts receivables” insurance, may be a useful hedge that can save your business from disastrous financial loss.Finally, if compelled to repay sums, you also may be able to recoup some part of the repayment through the prompt filing of a proof of claim in the bankruptcy proceeding.The most important rule to remember, however, is to act quickly when you know that you are a target of fraudulent transfer litigation and always seek advice of competent bankruptcy counsel.Charles R. Powell III, a shareholder and chair of the Bankruptcy and Creditors’ Rights Practice Group at Devine, Millimet & Branch, can be reached at 603-695-8736 or cpowell@devinemillimet.com.