Just as holiday sale prices this year were tantalizingly low, the current economic environment is creating a buyer’s market for commercial assets with extremely attractive pricing. A word of caution: a deal just might be too good. It might be successfully challenged as a fraudulent transfer, leaving the bargain buyer without the assets and nothing but an unsecured claim against an insolvent seller. A sophisticated buyer needs to know the ground rules.
There are two types of fraudulent transfers; transfers made with an actual intent to hinder, delay or defraud creditors, and transfers that are “constructively” fraudulent, meaning transfers that the law deems fraudulent. Generally, under bankruptcy law and most states’ laws, transfers are constructively fraudulent if the seller (1) receives less than reasonably equivalent value for what is sold and (2) the seller was insolvent, undercapitalized or unable to pay its debt as they came due either at the time of the transfer or as a result of the transfer.
The easiest way to avoid a constructive fraudulent transfer claim is to pay reasonably equivalent value for what you buy. If a company trades one asset for another of equal value, its creditors cannot claim to have been harmed. Its balance sheet stays the same. However, it is not always easy to determine reasonably equivalent value during difficult economic times.
How does the smart purchaser protect itself from fraudulent transfer risk? While there are no failsafe strategies, reasonably equivalent value may be established by:
- appraisals or valuations made by well-recognized experts immediately before a purchase;
- a recent valuation performed on behalf of the seller’s secured lenders accompanied by the lenders’ consent;
- prices for similar assets in a public market; and
- prices secured at properly advertised public sales for comparable assets.
Insider transactions present the greatest fraudulent transfer risks. Insider purchases are highly likely to be challenged as fraudulent transfers if the seller is unable to pay its creditors after the sale. While payment of reasonably equivalent value should offset claims of a fraudulent transfer, insider transactions are often challenged as having been made with actual intent to hinder, delay or defraud creditors. Actual intent is determined by an analysis of the so-called “badges of fraud” described in the Uniform Fraudulent Transfer Act. The typical actual fraudulent transfer is made to a family member for little or no consideration by someone who has been sued or who knows he will soon be sued for monetary damages. The transferee family member allows the transferor to retain possession and use of the “transferred” assets. The transaction is obviously a sham to avoid the suing party’s claims.
Insider relationships can be pervasive in the corporate context. A corporation, its affiliate corporations, the officers and directors of either, and certain shareholders may all be insiders of each other. As a result, transactions between them are likely to be subject to heightened scrutiny because of the risk of a sweetheart, non arms length deal. In assessing actual fraudulent transfer risk, the parties need to consider the transaction from the perspective of the selling entity’s creditors. Does the transaction have the indicia of an arms-length transaction for reasonably equivalent value? Concealed transactions are more likely to raise suspicion than disclosed and transparent transactions. For example, a competitive public sale process is far less likely to be scrutinized for fraudulent conduct, even in today’s economic environment where no competing bidders may participate.
A complicated subject? Yes, but the best test of transactional risk is the gut reaction of a sophisticated and experienced business professional. Does the deal feel too good to be true? If so, it probably is. Buyer beware!