What is Fraudulent Transfer Law? Part I: Below Market Value Transfers

Let's begin the discussion of fraudulent transfer by defining its terms.

1. Dictionary.com defines fraudulent as "characterized by, involving, or proceeding from fraud,  as actions, enterprise, methods, or gains: a fraudulent scheme to evade taxes."  
2. The same site defines fraud as "deceit, trickery, sharp practice, or breach of confidence, perpetrated for profit or to gain some unfair or dishonest advantage."
3. And finally, "transfer is defined as "to convey or remove from one place, person, etc., to another

Putting these three concepts together, we come up with the following definition: a fraudulent transfer is a conveyance of assets that proceeds from, or whose motive is, fraud. 


Let's delve deeper into this concept by looking at a specific type fraudulent transaction -- one where the person selling an asset does so for less than adequate consideration.  When most people sell something, their motive is to make a profit.  Even if they're selling something at a yard sale, they're still trying to get at least something for a particular item.  In contrast, the motive behind a fraudulent transfer is not economic, but to "hinder, defraud or delay" current or potential creditors -- that is, to make it hard if not impossible for someone to whom a person legitimately owes money to collect on their debt.  


This leads into one of the central concepts of fraudulent transfer law: value, which is defined thusly: 

"Value is given for a transfer or an obligation if, in exchange for the transfer or obligation, property is transferred or an antecedent debt is secured or satisfied, but value does not include an unperformed promise made otherwise than in the ordinary course of the promisor’s business to furnish support to the debtor or another person."

This definition must be viewed with the Uniform Fraudulent Transfer Act's primary purpose in mind: 

"Value” is to be determined in light of the purpose of the Act to protect a debtor’s estate from being depleted to the prejudice of the debtor’s unsecured creditors."

Put into practical terms, if a debtor sells assets for less than adequate consideration or below fair market value, the court will at minimum take a deep interest in the sale and will investigate further.  The court will do this to comply with the the Act's stated intention of preventing a debtor from hindering a creditor's efforts to enforce a valid debt.


The act does not define "reasonably equivalent value," but other sections of the law provide a good working definition. The gift tax code defines the price this way: "The value of the property is the price at which such property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell, and both having reasonable knowledge of relevant facts. The value of a particular item of property is not the price that a forced sale of the property would produce. Nor is the fair market value of an item of property the sale price in a market other than that in which such item is most commonly sold to the public, taking into account the location of the item wherever appropriate."


The code breaks down a less than adequate consideration transfer into two types: transfers as to present creditors (the person making the transfer has at least one existing creditor) and transfers as to present and future creditors (this section includes a creditor whose claim arose after the transfer).


The act assumes that a transfer for less than equivalent value is fraudulent as to present creditors: 

A transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation.

As to present or future creditors, a transfer may be fraudulent if the debtor did so with the intent to "hinder, delay or defraud and creditor of the debtor."  To determine intent the court will determine if "the value of consideration received by the debtor was reasonably equivalent to the value of the asset transferred to the amount of the obligation incurred."  The amount of consideration received by the debtor in the transaction can be a "badge of fraud."  Here is how the commentary in the UFTA explains the consideration element:

Whether the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred: Toomay v. Graham, 151 S.W.2d 119 (Mo.App. 1941) (although mere inadequacy of consideration said not to be a badge of fraud, transfer held to be fraudulent when accompanied by badges of fraud); Texas Sand Co. v. Shield, 381 S.W.2d 48 (Tex. 1964) (inadequate consideration said to be an indicator of fraud, and transfer held to be fraudulent because of inadequate consideration, pendency of suit, family relationship of transferee, and fact that all nonexempt property was transferred); Weigel v. Wood, 355 Mo. 11, 194 S.W.2d 40 (1946) (although inadequate consideration said to be a badge of fraud, transfer held not to be fraudulent when inadequacy not gross and not accompanied by any other badge; fact that transfer was from father to son held not sufficient to establish fraud).

Let's put the above mentioned ideas into practice.  Recently, the New York Times reported,"Joe Paterno transferred full ownership of his house to his wife, Sue, for $1 in July, less than four months before a sexual abuse scandal engulfed his Penn State football program and the university."  Let's look at this transfer from the standpoint of both present and potential future creditors.


Let's assume the house has a mortgage on it, the debt has not been paid off, and the loan is in Mr. Paterno's name entirely.  In that case, the bank can rescind the transaction (unless the house is actually worth $1).  One section of the code simply assumes this is a fraudulent transaction because the debtor is attempting to shift assets to a third party at below market value.


Now, let's look at potential future creditors.  Assume that Paterno has a good idea he's about to be sued -- for example, he's been contacted by a third party lawyer requesting an interview, or something similar.  Or, as the story points out, the transfer occurred in close proximity to a serious legal situation.  In that case, the court may rescind the transaction if the creditor or potential creditor can show Paterno's  intent to hinder, delay or defraud.  One way to show this is to demonstrate the transaction was for less than adequate consideration.    In other words, in this scenario, the inadequate consideration is a factor for the court to consider, but is not entirely determinative.  It's a subtle but important difference.  Now, given the incredibly low amount of consideration in the deal, the court will probably rescind the transaction if asked.  


The message of the above situations is clear: any transfer for less than adequate consideration is a very bad idea from a planning perspective.




 




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