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Fraudulent Conveyance Actions Provide a Tool for Asset Recoveries

Fraudulent conveyance is a legal concept involving the transfer of property for less than equivalent value to defeat a creditor’s ability to collect from its debtor. Whether a fraudulent conveyance has occurred is highly dependent on the facts and circumstances of the case.

For example, if someone sold his $500,000 house to his daughter for $100,000, he might be considered generous or senile, but not necessarily fraudulent. However, if the person perfected that same transaction right after losing a million-dollar lawsuit, then that transaction most likely would be considered a fraudulent conveyance that a judge could undo. The significance of the transaction being voided is that it puts the assets back into the hands of the debtor to make them available to the debtor’s creditors.

Fraud is defined as “deception intended to result in financial or personal gain.” The elements of fraud are clear: deception, intent, and gain to the perpetrator. All three must exist for fraud to have occurred. The victim’s loss must result from having relied on the intentional deception of the fraudster. A false statement made out of ignorance by a person who believed it to be true or an immaterial statement that the victim did not rely on, for example, does not constitute fraud. Having to prove all three elements of fraud sets a high standard that is sometimes difficult to meet. Especially in the chaos that typically envelops insolvency cases, the distinction of what was known or what was intended can become particularly murky.

Fraudulent conveyances fall under a related concept, constructive fraud, which eliminates intent as a consideration but adds a different element—breach of fiduciary duty that causes harm to another. A debtor’s violation of its fiduciary duty to a creditor is treated as fraud even if the debtor did not intend to deceive anyone and even if they were not aware of what they were doing.

While there is no published research regarding such trends, anecdotal experiences suggest that fraudulent conveyance laws are being used with both broader reach and greater frequency. Debtors need to be aware that transfers they make that are later deemed to be fraudulent conveyances can be undone. Creditors need to be aware that assets they relied on as collateral or evidence of ability to pay may be recovered even after they’ve been transferred to a non-debtor.

Pinpointing Insolvency 

There are many types of fraudulent conveyance beyond selling assets below market value. Estates of bankrupt debtors have recovered funds that the debtor had paid to insurance companies and credit card issuers that benefited the debtor’s officers or owners personally, but not the debtor. Excessive salaries, bonuses, and perks well in excess of market value that were paid to officers or relatives of debtors have been recovered. Mortgages that far exceeded a property’s market value have been voided, and payments on those mortgages recovered. 

Fraudulent conveyance is statutorily based in the U.S. Bankruptcy Code and in state law under the Uniform Fraudulent Transfer Act (recently refined by the Uniform Voidable Transactions Act). The law varies from one jurisdiction to another. 

The elements of a fraudulent conveyance are the transfer of an interest in property or the incurrence of an obligation for which the debtor received less than reasonable equivalent value in exchange. Further, the debtor was insolvent at the time of the transfer or incurrence, or was rendered insolvent as a result of the transaction, was left with unreasonably small capital, or incurred debts beyond its ability to pay. 

The concept of unreasonably small capital tests whether a company is likely to become insolvent at some future time based on likely business conditions. The key issue is: will or did the business have sufficient cash flow to execute its business plan? Arguments regarding unreasonably small capital usually center on the reasonableness of management’s plans and projections, and is therefore significantly more qualitative than the other solvency tests.

For purposes of measuring solvency, the date of the transaction being voided is the relevant date. The Bankruptcy Code assumes that, for general creditors, debtors were insolvent for 90 days prior to the filing of the case. The code also provides for a one-year look-back period for insiders. For fraudulent conveyances, the look-back period varies from two to six years, depending on the jurisdiction. Any transaction that occurred during the applicable look-back period is potentially voidable if it can be shown that the debtor was insolvent when the transaction took place.

Transfers of property or the incurrence of obligations is usually the easiest element to prove in fraudulent conveyance cases. There is no strict definition of “reasonable equivalent value,” which depends on circumstances such as fair market value and prevailing economic forces. The measurement is viewed from the creditor’s perspective as of the date of transaction.

Most controversy in fraudulent conveyance cases swirls around whether a debtor was insolvent at the time of a conveyance. The Bankruptcy Code defines insolvency as “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors.” Fair value, therefore, becomes one of the items of contention in determining insolvency. Fair valuation in a solvency analysis generally contemplates a going concern value rather than liquidation or distressed value, and is intended to estimate asset values based on the price that a willing buyer would pay in an arm’s-length transaction for the debtor’s entire package of assets and liabilities.

When determining the value of assets and liabilities, the balance sheet is the starting point, not the end point, of the analysis. Book value does not equal fair value. Archaic accounting rules often keep significant value, such as intellectual property—e.g., Coke’s secret formula—off the balance sheet. Incompetent or fraudulent accounting practices can make a balance sheet look much healthier than it actually is. Defendants in avoidance actions often see value that is highly subjective as to both existence and amount. Every element of the balance sheet, including assets or liabilities not recorded or improperly stated, must be adjusted to reflect fair value for every time period under consideration. 

The valuation of assets and liabilities at fair value often depends on the value of the company as a whole, and the valuation of distressed companies presents particular problems. The value of a company depends on the assets in place and the benefit streams being generated at the time of the valuation. In distressed companies, those assets likely are not generating enough cash to pay the liabilities that are encumbering them.

In healthy companies, a large component of the value is often a company’s growth prospects and anticipated profitability. In a distressed company, growth and profitability are often nonexistent or negative. The valuation of a company should be premised on its future earning capacity, free of the impact of specific distress or past mismanagement. However, the more speculation as to future results a valuation contains, the more it needs to be discounted (i.e., given a lower valuation) and the more likely the speculative valuation is to be ruled inadmissible by a court.

The risks potentially impacting a company’s anticipated benefit stream are evaluated by considering such factors as the quality of the management team and operations; the company’s ability to execute on its business plans; its financial strength and ability to finance its planned activities; the probability of survival; political, industry, and competitive factors; the longevity of its customers; and the size of the market. These often include factors that led to the company’s distress. To the extent that success factors are missing or impaired, the company’s value will be lower.

Making a Case

One example in which valuation of the company, and hence valuation of the specific assets and the evaluation of solvency, was pivotal involved a specialty medical practice. There were two competing expert valuations of the practice based on the exact same set of facts. One side’s expert valued the practice at $80,000 using the asset method, and the other side valued it in excess of $5 million using the income method.

The points of contention were whether significant goodwill existed—it did—and whether that goodwill belonged to the debtor corporation or to the doctor personally. Key valuation factors were determining what drove the income and the value of the practice and who benefited from the resulting income streams and value. Was it the practice alone or the doctor’s personal reputation that generated the income?

During his deposition, the doctor hurt his side’s contention that the practice’s value was minimal by clearly describing the goodwill as his own, unrelated to the bankrupt medical practice. He argued strongly that patients came to the practice specifically to see him and that the strength of his reputation generated referrals, not the practice’s name, location, equipment, etc. Without the doctor’s goodwill, the only value remaining in a practice grossing more than $2.5 million a year was from the small amount of furniture that was not leased, and the practice was deemed to be insolvent at the time of key transactions. As a result, $500,000 of a $2 million transfer was recovered for the estate, enough to help the secured lender recover 100 percent of its loan.

Another example of balance sheet insolvency was a retail company whose book value was negative for 18 months prior to its bankruptcy filing but which was arguably insolvent for 30 months before the filing. There were inaccuracies in the financial statements—store costs that should have been expensed were capitalized, and inventory was improperly accounted for and overstated. The defendants claimed there was considerable unrecorded goodwill in the stores’ name and even more unrecorded value in the company’s store leases, which they claimed were all at below market rates.

However, this was the chain’s second bankruptcy, and nobody had bought either the name or the leases in either asset sale. In addition, profitability was less than that of comparable stores in comparable markets, indicating that the company lacked both goodwill and better-than-market advantages. Considerable transfers to insiders that occurred during the 30 months of insolvency were found to be voidable. The settlement payment from the insiders allowed the unsecured creditors to receive a 15-cent distribution when they otherwise would have received nothing.

In determining a debtor’s insolvency for purposes of avoiding a transfer, the inability to pay debts as they mature is redundant if the insolvency is clearly demonstrated under the balance sheet test. However, since balance sheet solvency is often arguable, an inability to pay debts is often used as a supplemental or alternative argument. A company may appear to be solvent on its balance sheet but still not be able to pay its bills as they become due. Evidence of insolvency in this type of analysis includes:

  • Aged accounts payable, consistently overdrawn cash, and checks being held before mailing

     

  • Vendors accepting steep compromises for either more immediate payment or more security

     

  • Churning of vendors

     

  • Difficulty sourcing required materials and being forced to pay COD or cash in advance

     

  • Decreases in gross margin due to higher sourcing costs and  declines in both quality and quantity of inventory due to availability restrictions

     

  • Excess labor costs due to spurts in production when materials arrive sporadically

     

  • Significant delays in routine required payments that generate slow follow-ups to nonpayment, such as trust fund taxes and pension obligations

     

  • Large numbers of canceled customer orders or product returns

     

  • Management acting reactively instead of proactively

     

  • Higher than normal stress levels among employees and significant turnover in management ranks

     

  • Lawsuits filed for nonpayment

     

  • Internal chaos

In another case, a manufacturer was shown to be insolvent during every month of the applicable four-year look-back period under both the balance sheet and inability to pay debts as they become due tests. The debtor was insolvent on a balance sheet basis for four years prior to filing, as evidenced by the following:

  • Accounts receivable and inventory were both consistently overstated on the balance sheet.

     

  • Accounts payable and warranty costs were both consistently understated on the balance sheet.

     

  • Fixed assets never generated a profit in place and were expensive to move, yielding little going concern or liquidation value.

     

  • Capitalized software development costs of $4 million for a customized system that was never implemented sat on the balance sheet as an asset for three years before they were written off. Most of these costs were internal labor charges that were probably ineligible for capitalization under proper accounting procedures.

The company’s inability to pay debts as they became due was evidenced by the following:

  • The company was in workout with its bank continuously for seven years and violated virtually every covenant and restructuring agreement it ever agreed to. Transgressions continued on a quarter-by-quarter basis.

     

  • There was an ongoing pattern of vendor compromises and conversion of short-term payables to long-term notes (which were also not paid). In-between compromises were made as the payables aged significantly.

     

  • There was a continued inability to collect accounts receivable within terms, which generated ongoing liquidity shortfalls.

     

  • The company experienced five consecutive years of large negative EBITDA. Even the income from the cancellation of debt was insufficient to make EBITDA positive.

High Stakes Determination

Whether a transfer of property was a fraudulent conveyance usually comes down to a determination of solvency. Solvency is a matter of judgement decided by the court with the help of valuation experts and restructuring professionals. The stakes can be high, as fraudulent conveyance is often the best or only way that creditors can recover assets that had been spirited away from them.  

This article is a general discussion and is not intended to provide legal advice or define practice in any particular jurisdiction. The particular facts and circumstances of each case should be discussed with an attorney familiar with the applicable statutes in the relevant jurisdictions.

Michael Goldman

Michael Goldman

KCP Advisory Group LLC

Michael Goldman is a senior managing director of KCP Advisory Group LLC. He has been qualified in both state and federal courts as an expert witness in cases involving fraud, solvency, fairness, commercial damages, marital dissolutions, valuation issues, professional malpractice, and bankruptcy issues. He is a CPA, has an MBA, and holds CVA, CFE, and CFF certifications. Previously, Goldman was a professor at the Lake Forest Graduate School of Management and designed courses in the school’s corporate education division.

Topics: 
Fraud
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