What is Fraudulent Conveyance?
Fraudulent Conveyance refers to the preferential transfer of an asset under the intent to defraud other existing claim holders.
A closely related concept based on a similar legal basis is termed “voidable preferences,” which is when the debtor made a transfer to a creditor right before filing for bankruptcy that was determined to be “unfair” and neglectful of the claims structure.
Fraudulent Conveyance Introduction
Management Fiduciary Duties
In the case of non-distressed companies, the fiduciary duties of management are owed to the equity shareholders (i.e., to maximize the firm value).
But once the corporation approaches or enters the “zone of insolvency,” the interests of creditors must become the priority for management. Pre-petition debt holders participating in the reorganization often become the post-emergence shareholders – thereby, the protection of their interests must be prioritized.
The debt holders, as part of the restructuring process, often become the post-bankruptcy equity shareholders as their debt was converted into equity as part of the recovery and form of consideration.
This is not only because of their higher placement in the capital structure but also because many of the creditors could become the new shareholders post-restructuring. For example, part of the POR could be a debt/equity swap.
This changing fiduciary duty is an important consideration when it comes to legal risks because actions indicating preferential treatment and not abiding by the priority of claims waterfall is a direct violation of their legal obligation to look out for the interests of the debt holders.
Trustee Appointee Justifications
If the debtor conducts fraud, gross mismanagement, or fails to comply with the required disclosure requirements, a Chapter 11 Trustee can be appointed.
That being said, a Chapter 11 Trustee is appointed to take charge of the bankruptcy process only if the management team of the debtor has shown fraudulent behavior or gross negligence.
There are two rationales by which the appointee of a Chapter 11 Trustee could be justified:
- “Cause” Basis: The presence of any form of fraud, dishonesty, incompetence, or gross mismanagement
- “Best Interests” Test: If the appointment would be in the best interests of creditors, equity security holders, and other claim holders, the trustee can be appointed
However, creditors should carefully consider the situation before requesting the management team to be replaced. The independent trustee is not familiar with the troubled company yet would take charge of all business affairs (and data has shown that most end up becoming liquidated).
Excluding fraud or gross ineptitude that caused complete erosion of trust in management’s integrity (and judgment), it is usually preferred for the existing management team to remain on board.
Benefits of Existing Management Leading Reorganization
The existing management team is preferred to lead the reorganization because the management team has pre-existing relationships with the creditors and key stakeholders, although the relationships may have deteriorated in recent months.
Assuming there is some degree of trust (or at least familiarity) amongst the management team and stakeholders from prior interactions, their existing history with the relevant claim holders could potentially lead to a more favorable outcome.
At the very least, their judgment stemming from their years of experience could be more reliable than a complete stranger running the operations of a company, in which they lack any real working knowledge in running nor in which they have industry expertise.
No group of people knows the “ins and outs” of a faltering company better (and the specific Catalysts of Distress explaining its lackluster financial performance) than those that caused the problems in the first place and/or made mistakes repeatedly.
But to tie this concept back to the previous section, if the decision-making of the management team is in doubt (i.e., the duty to act in the best interests of creditors), then it might be best for a Chapter 11 Trustee to be appointed despite not being ideal.
Fraudulent Conveyance Definition
Fraudulent conveyance is the illegal transfer of property or an asset to another party proven to have been made with the intent to hurt existing creditors and reduce their recoveries.
Creditors can litigate a transfer made by the debtor with the actual intent to hinder and defraud its creditors.
If proven to be true, the legal provision requires the transaction to be reversed.
To receive approval from the Court for a transaction to be considered fraudulent conveyance, the following conditions must be proven:
- The transfer must be proven to have intentionally been done to damage the creditors
- A less than equivalent value was received in exchange (i.e., confirming the transfer was unfair, yet completed to hurt the creditors)
- The debtor was already insolvent at that time (or became insolvent soon afterward)
The first condition of fraudulent conveyance can be the most challenging to prove. For that reason, successful litigation is uncommon given the difficulty of proving the intent to harm.
If the Court determines the transfer to have been of fraudulent nature, the recipient of the asset can be legally required to return those assets or provide monetary value in the equivalent amount to the class of relevant creditors.
Learn More → Fraudulent Conveyance Legal Definition (Cornell LII)
Actual vs. Constructive Fraudulent Conveyance
There are two types of fraudulent conveyance:
|Actual Fraud||Constructive Fraud|
In either case, the management team would have made a transfer that breached their legal obligation to look out for the best interests of creditors.
Rather, the management team is acting in their own best interests, which in these cases means that they are making sure that creditors do not receive a full recovery.
Distressed M&A Legal Issues
Under the Bankruptcy Code, the Trustee can recover any assets that were fraudulently transferred if still within the two-year “look back” period before petition filing.
Fraudulent conveyance is when the debtor, who was already “insolvent,” made a cash, property, or other asset transfer with the clear intent to defraud its creditors.
The lienholder that claims a fraudulent transfer occurred must prove the company was insolvent when making the sale and that the sale was made to delay or avoid its due obligation to its creditors. If successful, the lien holder can claw back some proceeds. In out-of-court scenarios, buyers of distressed assets or companies must be aware of the potential threat of litigation risk from Debt Lenders, equity holders, Suppliers/Vendors, and any impaired claim holder.
The claim holder that brought on the allegations must provide proof that the debtor was:
- Insolvent: Debtor was insolvent at the time of the transfer (or shortly became insolvent due to the transfer)
- Preferential Treatment: The transfer was made for the benefit of the insider/buyer at the expense of more senior claim holders
- Failed “Best Interests”: The transfer was not in the “best interests” of the ordinary course of the business
- Intent to Defraud: The most difficult to prove, it must be shown that the transfer was a deliberate attempt to hurt creditors
The odds of facing litigation related to fraudulent transfer increase if the assets were purchased at a discount – as this means the creditors received less recovery on their claims (i.e., making their claim more credible). If the criterion is met, the transaction could be classified as “voidable,” meaning the funds would have to be returned.
Rule of Successor Non-Liability
The most common structure for the acquisition of a distressed company is for the purchaser to pay cash for the seller’s assets, but not assume all of the seller’s liabilities.
Based on the rule of successor non-liability, the buyer of a distressed company will often look to structure the deal as an asset sale to avoid inheriting contingent or unknown liabilities.
However, in certain circumstances, the Court can make the buyer responsible for the liabilities of the seller under one of the four exceptions listed below:
- Assumed Liabilities: The buyer explicitly agreed to assume the liabilities of the predecessor or implied it would agree to do so
- De Facto Merger: The M&A transaction, despite not being structured as a merger, is actually a merger between the buyer and seller in substance – this doctrine prevents buyers from avoiding the assumption of the target’s liabilities while benefiting from the “merger”
- “Mere Continuation”: The buyer is a mere continuation of the predecessor (i.e., the seller, only with a different company name)
- Fraudulent Transfer: As explained in the previous section, the transfer was fraudulent, and intent to defraud creditors was proven
The purchaser of the assets expects to be free from liabilities of the target, as this is unlike stock purchases where the liabilities were retained – but this can be flipped by the Court’s ruling if one of the above exceptions is met.
So, while the buyer can take advantage of the seller, doing so puts it at risk of future litigation if the company enters bankruptcy protection.
Over the long run, it may be in the best interests of the buyer to decrease litigation risks by paying a fair value for the assets and acting in an ethical manner.
If a debtor made payments to certain creditors based on preferential treatment, a complaint can be filed regarding the payment.
The Court can review the specific payment in question and has the right to force the creditor to return the funds if it was out-of-order – this is called a “voidable preference.”
To qualify as a “voidable preference”, the following conditions must be met:
- The payment must have benefited a lower-priority creditor based on the personal preference of the debtor (i.e., debtor disregarded the priority waterfall schedule)
- The date of the payment must have preceded 90 days of the petition filing date – but in the case that the receiver of the funds was an “insider” (e.g., director of the company), the “look back” period extends to two years
- The debtor must have been insolvent at the time of payout
- Creditor(s) in question (i.e., the receiver of the funds) retrieved more proceeds than if the debtor had been liquidated
Again, preferential treatment was given to certain creditors while breaching the correct order of payouts.
Not only is the debtor required to prioritize the interests of creditors over the interests of equity holders (and their own), but management also cannot breach the claims waterfall without the prior consent of senior claim holders.
On the flip side, in an extreme case, secured creditors can be unilaterally equalized in a process called “equitable subordination”.
Equitable subordination can be invoked by the misconduct of secured creditors with proof of wrongdoing (i.e., “acting in bad faith” and intentionally attempting to cause the detriment of the debtor).
Similar to how a breach of fiduciary duty by the debtor could bring negative consequences, the same standards apply to creditors that take actions in “bad faith” with the intent to harm the debtor.