When Purchasing Distressed Assets, Protect Yourself Against Possible Fraudulent Transfer Litigation

April 25, 2015

As most of you know, parties can acquire assets in bankruptcy at a significant discount. Those types of sales (section 363 bankruptcy sales) are blessed by a court order which provides the purchaser with the protections to insulate the transaction from any future challenges.[1] However, if you are purchasing distressed assets outside of a bankruptcy case, don't do so with blind faith!

A party who acquires distressed assets from a person or company outside of the bankruptcy process does so at the risk the transaction could be later considered a fraudulent transfer under the Bankruptcy Code or applicable state law. When a purchaser or transferee receives assets in excess of the value it provided to the seller or transferor from whom it acquired the assets, a bankruptcy trustee (or other party in interest) could seek to unwind the transfer and/or require the transferee to return the assets or give back the difference between the amount it received and the value it provided.

There are two types of fraudulent transfers in which a trustee may seek to recover in a bankruptcy proceeding - actual fraud and constructive fraud. Actual fraud involves the actual intent to defraud creditors. Actual fraud requires proof of fraudulent intent. Fraudulent intent is determined on a case-by-case basis. Typically, one would need to prove the debtor transferred its assets to hide them from creditors.

Constructive fraud involves a transfer made in exchange for less than reasonably equivalent value. In determining whether a transfer was constructively fraudulent, intent is irrelevant. Courts look at whether the transfer was made for less than reasonably equivalent value at a time when the debtor was insolvent or whether such transfer would render the debtor insolvent. While there are several different tests for insolvency, insolvency is usually determined by whether the debtor is able to pay its debts when they become due. Value, on the other hand, can be the subject of protracted and costly litigation.

Unlike the fair consideration standard for fraudulent conveyances under certain state fraudulent conveyance laws, good faith is not a requirement for reasonably equivalent value under the Bankruptcy Code. This does not mean that good faith is irrelevant in determining whether a transfer is fraudulent in the bankruptcy context. The good faith of the transferee of assets is one of the defenses to a fraudulent transfer in bankruptcy.

Good faith is not defined in the Bankruptcy Code. Courts have analyzed a transferee's good faith by looking at what the transferee knew or should have known, whether the transfer was part of an arm's length transaction and the relationship between the parties. Good faith is generally viewed by many courts as: (1) an honest belief in the propriety of the activities in question; (2) no intent to take unconscionable advantage of others; and (3) no intent, or knowledge of the fact that the activities in question will hinder, delay or defraud others.

In addition to the subjective good faith tests, the good faith defense under the Bankruptcy Code also requires that the transferee gave value for the property it received from the debtor. Thus, if a party is seeking to transfer assets for little or nothing in return, it is imperative the purchaser / transferee inquire further as to whether the transfer may be later avoided as a fraudulent transfer. While "value" as a defense does not mean "reasonably equivalent value", the value given and circumstances surrounding the transaction when a trustee is seeking to recover value for the bankruptcy estate. A current appraisal of the assets and ensuring the debtor does not retain control over the assets after the transfer can be helpful in proving the good faith of the transferee. It is generally presumed that a transferee could not have acted in good faith if it had sufficient knowledge to place it on inquiry notice of the debtor's possible insolvency and did not provide the debtor with reasonably equivalent value for the assets it purchased.

When purchasing distressed assets, it is very important to protect yourself against the risk of possible fraudulent transfer litigation. Therefore, it is imperative a purchaser of assets conducts proper due diligence in consultation with counsel well versed in bankruptcy as well as other relevant areas of law to protect yourself from the risks and complexities inherent in fraudulent conveyance litigation.

This article appeared on the April 25th, 2015 inforuptcy blog. Inforuptcy is a comprehensive resource for bankruptcy case information, bankruptcy assets for sale and leading bankruptcy news.

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