Fraudulent transfer laws can create problems for many financiers — even those with the best of intentions. Ken Weinberg discusses why transactions of this nature should be considered carefully and seen as having inherent risk. He points out that even a lender that eventually defeats a fraudulent conveyance claim will probably feel like a loser upon receiving the legal bill.
“Fraudulent transfers” sound like the sleazy types of transactions generally associated with the likes of Bernie Madoff and Enron. Notwithstanding the nefarious-sounding name, fraudulent transfer laws can create problems for financiers who have nothing but honest intentions. This edition of Dispatches from the Trenches discusses these laws and what prudent financiers should know.
General Background & Sources of Fraudulent Transfer Laws
Modern fraudulent transfer laws had their genesis way back in jolly ol’ England with the Statute of 13 Elizabeth, passed by the English Parliament in 1571. Concepts rooted in that English law formed part of the common law of the United States for many years and were eventually codified in the majority of States pursuant to the Uniform Fraudulent Conveyance Act. In 1984, the UFCA was revised and renamed the Uniform Fraudulent Transfer Act (UFTA) in part to address changes under federal law with respect to fraudulent transfers set forth in the Bankruptcy Reform Act of 1978. The UFTA is a self-described “modernization” of the fraudulent transfer laws in the United States and is currently in effect in more than 40 states and in the District of Columbia.
Although the UFTA differs some from the fraudulent conveyance laws comprising a portion of the Federal Bankruptcy Code, it is sufficiently similar in many respects that the remainder of this edition of Dispatches from the Trenches focuses on the tests and rules within the Bankruptcy Code. One key difference which needs to be illuminated, however, relates to the applicable statutes of limitations. The UFTA contains its own statute of limitations which extinguishes any claim not brought “within four years after the transfer was made or the obligation was incurred,” unless the fraud was intentional and was not discovered until a later time, in which event the limitations period is extended for an additional year after such discovery “was or could reasonably have been discovered by the claimant.”1 In at least one state, the initial limitation period is six years instead of four.2 The statute of limitations in the applicable section of the Bankruptcy Code, §548, is expressed as being two years. However, a trustee or debtor-in-possession can assert state law claims and benefit from the longer statute of limitations in the UFTA.3
Section 548(a) of the Federal Bankruptcy Code (labeled “fraudulent transfers and obligations”) provides, “[t]he trustee may avoid any transfer… of an interest of the debtor in property, or any obligation… incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily:
(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or
(B) received less than a reasonably equivalent value in exchange for such transfer or obligation; and [either] (I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation [the Insolvency Test]; (II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital [the Capitalization Test]; or (III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured [the Excessive Debts Test].4
Although the law is often referred to as the law of fraudulent transfers, it is important to understand that §548 of the Bankruptcy Code considers the incurrence of an obligation (such as agreeing to guarantee the debt owed by another) to be covered by the scope of the fraudulent transfer laws.
It is also important to understand that the term “transfer” is broadly defined in the Bankruptcy Code to include the creation of a lien, the retention of title as a security interest, the foreclosure of a debtor’s equity of redemption; or each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or an interest in property.5
The key point is that even non-recourse pledges such as those accomplished pursuant to intercompany cross-collateralization provisions are included. For example, it is not uncommon for lenders to require transactions among affiliates to be cross-defaulted and cross-collateralized. The net result of the cross-collateralization is that a brother-sister company may pledge its assets “side-stream” as security for the obligations of its sibling. Similarly, a subsidiary may pledge its assets “up-stream” as security for the obligations of its parent. These transactions all constitute “transfer” subject to fraudulent transfer analysis under the Bankruptcy Code.
Actual Fraud Versus Construction Fraud
Modern fraudulent transfer law protects both against “actual fraud” and “constructive fraud.” The type of fraudulent transfer described in subsection (A) above requires focus on the actual intent of the transferor/debtor, not the adequacy of consideration or such party’s solvency. Proving actual intent can be extremely difficult. As a result, actual intent to defraud need not be shown by direct evidence, but may be inferred from the circumstances surrounding the conveyance. These indications are sometimes referred to as the “badges of fraud” and include the following: (a) a lack or inadequacy of consideration; (b) the existence of a family, friendship, or special relationship between parties; (c) an attempt by the debtor to keep the transfer secret; (d) the financial condition of the debtor both before and after the transaction; (e) the existence or cumulative effect of a pattern or series of transactions or course of conduct after the incurrence of debt, onset of financial difficulties, or pendency or threat of suits by creditors; and (f) the overall chronology of events and transactions.6
A fraudulent transfer described in subsection (B) above is a type of constructive fraud. Rather than requiring a showing of actual intent, fraud is constructively imputed under the circumstances. The test for constructive fraud can be best understood as a two-pronged test: (1) At the time of fraudulent transfer, the transferor/debtor must have failed one of three specified financial tests (the “Financial Tests”); and (2) such party must have received less than a reasonably equivalent value in exchange for such transfer or obligation (the “Reasonably Equivalent Value Test”).
Financial Tests for Constructive Fraud
If any of the three Financial Tests described below is met,7 the first prong of the fraudulent transfer analysis has been met.
The first of the Financial Tests, the Insolvency Test, involves an analysis of whether the transferor/debtor was insolvent at the time of, or became insolvent as a result of, the transfer or obligation. Although the Bankruptcy Code and the UFTA have slightly different insolvency criteria, the concepts are generally the same — a test of insolvency requires a comparison of the debts of the transferor/debtor versus its assets. For this reason, this test is sometimes described as the Balance Sheet Test. Although a court is not required to apply generally accepted accounting principles in making its determination, it often considers the testimony of professional accountants. Appraisers and business-valuation experts are also important sources often used to establish the fair value of the debtor’s assets and liabilities at the time of the challenged transaction.
Even if a transferor/debtor was not insolvent at the time of the transaction in question, or rendered insolvent thereby, it could be left with too little capital to continue its business. In this respect, the Capitalization Test (the second of the Financial Tests) indicates a condition short of insolvency. This test is naturally fuzzier than the Insolvency Test and, generally speaking, involves an analysis of the future needs of the company and whether it has sufficient cash-flow, liquidity and assets to satisfy those needs. In other words, the Capitalization Test considers whether, in light of the transfer, the transferor/debtor’s business is able to generate sufficient profits to sustain operations on a continuing basis taking into consideration a variety of factors such as (A) the sources of operating capital and the availability of credit; (B) the transferor/debtor’s historical data and cash-flow needs; (C) the reasonableness of its cash-flow projections, including monthly analyses of the debtor’s balance sheet, income statement, net sales, gross profit margins, and net profits and losses; (D) adjustments for difficulties that could reasonably be anticipated, such as interest rate fluctuations and general economic downturns and the incorporation of some margin for error; and (E) whether the transferor/debtor’s assets exceed its liabilities by a sufficient margin to provide an adequate “equity cushion.”
The third, Excessive Debts Test is a subjective test analyzing whether the transferor/debtor intended to incur, or believed that it would incur, debts that would be beyond the transferor/debtor’s ability to pay as such debts matured. Of course, a lender who lends funds depending on a transfer that the transferor/debtor believed would render it unable to repay its debts as they matured has bigger problems than those resulting from fraudulent transfer laws.
Reasonably Equivalent Value Test
In considering the second prong of the fraudulent transfer analysis, lenders should understand that Reasonably Equivalent Value does not have the same meaning as consideration. Rather, a determination that a transaction resulted in reasonably equivalent value sufficient to defeat a fraudulent transfer claim requires more consideration that the proverbial “peppercorn” or other amounts that would generally support the enforceability of a contract.
The Bankruptcy Code does not define the term “reasonably equivalent value,” and both federal and state courts have held that it is to be determined on a case-by-case basis. Courts have steered away from using a hard-line or mathematically precise determination of reasonably equivalent value, and as one court has said, “[t]he issue of the reasonable equivalence of value is a question of fact [and t]he inquiry on this element is fundamentally one of common sense, measured against market reality.”8 The crux of reasonably equivalent value is whether the value transferred by the transferor/debtor is disproportionately small compared to the value it actually receives.
Unfortunately, common sense and market reality are more difficult to determine in the context of the type of multi-party transactions at issue when fraudulent transfers are alleged with respect to the execution of a guaranty or an accommodation pledge of collateral. In such circumstances, the proceeds of the loan flow to the borrower in exchange for the guaranty/pledge by the third party. In other words, the value given by the lender does not necessarily flow to the transferor/debtor.
1. Direct Benefits
In the case of a Downstream Guaranty or accommodation pledge by a Parent in support of obligations owed by its subsidiary, common sense readily reveals the presence of reasonably equivalent value. The benefit to the guarantor/pledgor is derived from the fact that its stock or other ownership interest in the borrower is increased by the infusion of capital made by the lender into the borrower.
However, consider the application of the Reasonably Equivalent Value Test in the context of an Upstream Guaranty where the guarantor (SubCo) guarantees the obligations of its parent (ParentCo) in connection with a loan made by Lender to ParentCo. In this case, SubCo is liable for the obligations of ParentCo but did not benefit from the infusion of capital into ParentCo by way of any sort of ownership interest.
In some situations, the funds eventually flow to SubCo — for example where ParentCo is a holding company for a larger corporate group and the loan proceeds are intended to finance the acquisition of equipment or other property by SubCo and other subsidiaries of ParentCo which guarantee the loan. In such cases, prudent lenders sometimes trace the flow of funds. For example, the loan documents could require ParentCo to lend the money to SubCo pursuant to a promissory note or other financial arrangement.
2. Indirect Benefits
Although not uniformly accepted, courts applying fraudulent transfer analysis are often willing to consider “indirect benefits” even if the loan proceeds cannot be traced directly to SubCo.
Courts adopting the “indirect benefit doctrine” have noted that requiring a transferor/debtor to receive a direct flow of capital would be “inhibitory of contemporary financing practices, which recognize that cross-guarantees are often needed because of the unequal abilities of interrelated corporate entities to collateralize loans [and that even] when there has been no direct economic benefit to a [transferor/debtor], some courts performing a fraudulent transfer analysis have been increasingly willing to look at whether a [transferor/debtor] received indirect benefits from the [transfer/guaranty]. . . .”9 However, such courts generally “will not recognize an indirect benefit unless it is fairly concrete.”10
Consider the classic example where ParentCo manufactures goods sold by SubCo. A loan made to ParentCo to enable it increase its production of goods indirectly benefits SubCo by providing it more goods to sell and therefore increased profits.
Another type of indirect benefit sometimes accepted is the benefit resulting when various companies, although separate and distinct legal entities, operate as a single enterprise. This rationale is sometimes referred to as the “identity of interest rule,” which recognizes that if the debtor and the third party are so related or situated that they share an ‘identity of interests,” then “what benefits one will, in such case, benefit the other to some degree.”11
This type of rationale is prevalent in non-recourse project financings where the borrower is a holding company owning multiple subsidiaries that each constitute a separate project (a renewable energy project, shopping center, toll road, etc.). Each subsidiary executes Upstream Guaranties and pledges all of its assets as collateral for the loan made to the parent/borrower and all other subsidiary project companies comprising a portion of the single portfolio. The financial covenants, cash-flow, pricing and related aspects of the transaction are structured on a “portfolio” level taking into account all projects as a consolidated business.
3. What “Value” has the Transferor/Debtor Given?
As noted above, the value received by a transferor/debtor that is a guarantor or pledgor in a multi-party transaction can be difficult to measure. Similarly, the value it provides pursuant to the guaranty/pledge can be difficult to ascertain.
Indeed, as long as the borrower performs its obligations, the lender will not need to call upon the guarantor/pledgor. Accordingly, a strong argument can be made that the value given by the guarantor/pledgor is less than the amount of the obligations owed by the borrower (which should be discounted by the probability of the borrower’s default).12
In addition, in the context of co-guarantors, a right of contribution may be meaningful.13
Practitioners should hear bells-and-whistles (or, even better, Darth Vader’s theme song) whenever they encounter Upstream Guaranties, Side-Stream Guaranties or cross-collateralization among affiliates. Any time the amount of the loan is sufficiently large, when compared to the financial wherewithal of the guarantor/pledgor, there is a potential fraudulent transfer issue.
Even if the lender prevails in court, the application of the Financial Tests and the Reasonably Equivalent Value Test can be uncertain, complex and expensive to litigate. Over the years, lenders have pulled a variety of arrows from their quivers in an attempt to address these concerns, including savings clauses, affidavits or other evidence of business synergies, minimum net worth guaranties, solvency opinions, lease-sublease structures and heavily documented transactions tracing the flow of funds to any subsidiaries that guarantee the obligations of their parent/borrower. However, none of these approaches should be viewed as a panacea.
Transactions of this nature should be considered carefully, and viewed as having inherent risk. Even a lender that eventually defeats a fraudulent conveyance claim probably feels like a loser when it receives its legal bill.
Kenneth P. Weinberg is a shareholder at Baker, Donelson, Bearman, Caldwell & Berkowitz and practices in the area of commercial finance, focusing on equipment leasing, equipment finance and renewable energy project finance. He has penned Dispatches from the Trenches since 2002.
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