1 29: Fraudulent transfers – overview, actual fraud © Charles Tabb 2010

2 Purpose of fraudulent transfer law Protect body of CREDITORS from unfair actions by the Dr that harm the Cr groups’ financial interests Creditors debtor Hide assets

3 Driving norms 1 st – NAUGHTY debtor – misbehavior by Dr – actual, subjective fraudulent intent, to hinder, delay, or defraud her creditors 2 nd – 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

4 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

5 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

6 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

7 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

8 Primary issues 1 st – set aside the transfer? I.e., voidable?  i.e., was the transfer either actually or constructively fraudulent? 2 nd -- if set aside – what remedy?  From whom (if anyone) can Cr or Trustee recover, and  What (how much) can they recover?

9 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

10 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

11 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”

12 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

13 Issue? Issue in Costas:  did Dr make a transfer of an interest in property when she disclaimed the trust interest?

14 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!

15 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

16 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

17 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)

18 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

19 Debtor’s disclaiming “transfer" disclaims Debtor Siblings Dad dies, Trust Property

20 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

21 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

22 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 1 st place  Any arguments - logic is fallacious??  Is “property” in pre-bk period (for purposes FT law) any different than “property of estate”

23 Drye distinction # 2 Tax liens are just different Policy of federal tax law is to grab EVERYTHING  Even if Crs normally could not reach Whereas bankruptcy law norm is to respect & honor property under non-bankruptcy law -> the Butner norm against “windfall by reason of happenstance of bankruptcy”

24 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)

25 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??)

26 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

27 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

28 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”

29 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’s sheep, but Twyne’s  C sued Twyne to set aside the transfer

30 Twyne Pierce ₤400 Twyne ₤300 “C”

31 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.

32 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

33 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 TrustDr as Beneficiary Creditors

34 548(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

35 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

36 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?

37 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.

38 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?

39 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?

40 9.4(b) Facts:  Same as a., except:  Dr sells to Art for $20K, not $38K  Art then gives painting to his daughter DR ArtDaughter $20K Gift

41 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

42 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

43 9.4(b) protection, cont. 2 nd, 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

44 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!

45 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

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

47 9.4(c) Facts:  Same as a., except Dr sells to her mother, not Art DR MOM $38K

48 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

49 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

50 9.4(d) Facts:  Same as a., except Dr gives painting to her mother DR MOM Gift

51 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

52 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

53 9.4(e) Facts:  Same as a, except Dr donates painting to Art Institute DR Art Institute Gift

54 Analysis 9.4(e) Fraud?  Same badges as before, plus outright gift

55 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)

56 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.

57 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

58 9.5(a) What arguments would you make that Dr DID have actual fraudulent intent? What arguments did NOT have such intent?

59 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?

60 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

61 Facts, cont. Generation, through Pres. (Handler) offered to M-H for $500K M-H knew of judgment for Drey M-H called Drey, confirmed judgment in effect Drey called G, asked “what’s up,” & G lied – said not going out of business or selling G agree to sell lists to M-H for $150K Sale put G out of business M-H requested indemnity; knew G in financial straits G asked M-H to keep sale confidential No 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

62 issues Issues in Alan Drey? 1 st – was it an actually fraudulent transfer?  i.e., did Generation have an actual intent to hinder, delay or defraud Drey? 2 nd, if so, is McGraw-Hill a protected innocent purchaser for valuable consideration, w/o knowledge of the fraud?

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

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

65 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?

66 Dean v Davis Facts:  Farmer Jonesowed 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

67 Dean v Davis JonesBank Dean take on $1600 $1600, notes Claim - $1600 mortgage Other creditors

68 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

69 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)?

70 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