Avoiding avoidance actions in bankruptcy | Flaster Greenberg PC
For most non-bankruptcy attorneys, their first experience in bankruptcy court could most likely begin with a call from an agitated and bewildered client asking for help in figuring out why he was being sued by a trustee in a bankruptcy case. bankruptcy filed by one of his clients. Worse still, the customer’s disbelief can only be exacerbated by the fact that that same customer still owes your customer money! This is when a basic working knowledge of avoidance actions in bankruptcy cases would be extremely helpful.
For trustees in bankruptcy and debtors in possession of Chapter 11 (and for the purposes of this article we will only refer to trustees as the terms in this context are interchangeable) an important aspect of any bankruptcy case – indeed a primary source recovery for any bankruptcy estate – is the availability for the trustee of actions for annulment. These are legal actions to recover money or property that was transferred by the debtor before filing for bankruptcy. There are several types of annulment actions which are covered by the Bankruptcy Code and which can be brought by a trustee. The most common are preferences and fraudulent transfers. In this article, we will provide a high-level summary of the legal standards for recovering rescission actions, as well as the defenses and strategies available to businesses or individuals who are the unfortunate targets of such litigation.
Section 547 of the Bankruptcy Code allows a trustee to recover or recover a preference, which is generally a payment made by the debtor to any party within 90 days of filing for bankruptcy that was made due to an existing debt. These actions target creditors who have been paid, partially or in full, before the start of the bankruptcy.
While the look-back period for preferred stock is 90 days for most creditors, this period is extended to one year for any creditor considered an “insider” of the debtor. In the case of an individual debtor, insiders include a relative of the debtor or a partnership or corporation of which the debtor is an owner, partner, director or officer. Where the debtor is a corporation, insiders normally include the owners, directors, officers or persons deemed to control the debtor. The Bankruptcy Code defines a “relative” as a “person related by affinity or consanguinity in the third degree as determined by the common law”. This also includes stage or adoption relationships.
The objective behind preference is to level the playing field so that one creditor is not paid in preference to another. Understandably, many preference defendants feel they are being unfairly targeted and struggle to overcome the reality that they have done absolutely nothing wrong. It is important to note that in a preferential action, there is no implication of wrongdoing. Rather, the goal is to put all creditors back in the same position they would have been in if payment had not been made.
There are three commonly invoked defenses against preferential action. Significantly, the only defenses available are those provided in Section 547(c) of the Bankruptcy Code.
First, a defendant may argue that a transfer was not related to an existing debt, but rather a contemporaneous exchange for new value. The most common illustrations of this type of transaction are store purchases or cash on delivery vouchers. The payment is not considered a preference since it is not made to satisfy a pre-existing debt.
In addition, a “new value” defense may be available to the preferred defendant, where, after receiving the allegedly preferential payment, the creditor has provided additional services and/or products to the debtor for which the creditor was not paid. This new value defense may serve to offset the defendant’s exposure or, in some cases, completely shield a defendant from liability if the new value exceeds the amount of the disputed transfers. For example, if your customer receives a “preferential” payment from a debtor in the amount of $1,000 and then ships goods to the debtor worth $800 for which no payment is received, the exposure to your client’s preference is limited to $200.
Finally, an important and often used defense against a preference is commonly referred to as the normal course defense — where a payment has been made in the normal course of the debtor’s business and financial affairs and of the assignee. In order to successfully assert the defense in the normal course of business, your preferred defendant will need to show either that the disputed payments were made in accordance with the parties’ commercial terms, or that the payment history between the parties has been consistent with the times before and during the 90 -day preference period. For example, if your customer’s invoice states that payment is due in 30 days, payments made within 30 days are entirely defensible. On the other hand, if your customer can establish that, despite the 30-day deadlines, payments have been made consistently between, for example, 45 and 60 days throughout the commercial relationship with the debtor, then it is also a defensible position.
So what if your client is faced with a preference claim? First, consider trying to fix the problem quickly. Know that approximately 99% of all preference cases are settled before trial. However, to obtain a favorable result, ask your client to gather his transactional history with the debtor going back at least one year and more, if available. This will help determine if any of the legal defenses are available to your client and can be helpful in determining the strength of your negotiating position.
A second common avoidance action is a fraudulent conveyance, which is set forth in Section 548 of the Bankruptcy Code. The wording of Section 548 closely mirrors New Jersey state law and New Jersey’s Uniform Fraudulent Transfers Act (UFTA).
To succeed under Section 548, a trustee must establish that the debtor: (a) made a conveyance with the actual intent to obstruct, delay, or defraud a creditor; or (b) received less than the equivalent value or the transfer, and the obligor was insolvent at the time of the transfer, became insolvent as a result, incurred or intended to incur debts which it would not be able to to repay, or made the transfer for the benefit of an insider.
Because a debtor will rarely, if ever, admit to having transferred property with the actual intent to defraud its creditors, the actual fraud will often be proven by circumstantial evidence. New Jersey courts consider several factors to determine whether a debtor acted with fraudulent intent. Some of these factors are the relationship between the debtor and the beneficiary, whether the debtor retains possession of the property that has been transferred, whether the transfer was concealed from its creditors, whether the transfer constituted substantially all of the debtor’s assets and whether the debtor was sued or threatened with suit before the transfer. Not all factors need to be proven for a court to find fraudulent intent.
In most cases, however, a fiduciary will attempt to establish that a fraudulent conveyance was not intentional, but rather fraudulent by construction due to the circumstances. For example, generally avoidable fraudulent transfers in the case of an individual debtor include prior transfers at the request of a debtor to his or her spouse or children for nominal consideration. In the corporate context, trustees generally seek to recover payments made by the debtor company on behalf of its owners and managers. For example, does the agent have a corporate credit card that is used for non-corporate purchases, but for which the company pays the bill?
While the Bankruptcy Code specifically provides for a two-year fraudulent conveyance lookback period, a trustee may avail itself of the longer four-year lookback period permitted under New Jersey’s UFTA.
The best defense against a fraudulent conveyance claim is that reasonably equivalent value has been given in exchange for the transferred property. To determine whether the consideration was reasonably equivalent, the courts will engage in a two-step process to assess all of the circumstances. First, did the debtor receive value? Transferring the deed to a property for a dollar or paying for your company’s treasurer’s vacation does not constitute value. However, if the value is received, was it “reasonably” equivalent? Given the circumstances surrounding the transfer, was the value received by the transferee reasonably equal to the value given by the debtor? Yes, the debtor paid the company treasurer’s credit card bill, but the charges on the credit card were all business related.
Fraudulent transfers can and do happen, inadvertently and quite frequently, especially with small businesses or family businesses. It is important to be on the lookout for some common scenarios in which they occur and advise clients accordingly. Identifying these issues allows corrective action to be taken. For example, minimize exposure to your company’s treasurer by having them reimburse the company for any credit card usage that is personal in nature. Additionally, where the client operates more than one entity and one of the entities regularly pays the debts of another due to cash flow issues, encourage a reconciliation of these payments when cash is available. Finally, it is obviously preferable to dissuade an insolvent client from transferring property to a relative simply to keep it out of the reach of creditors.
Whether your client has been sued for a preference or a fraudulent transfer in a bankruptcy case, it is indeed advisable to consult a bankruptcy professional who can offer you experienced advice to minimize your client’s liability.