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This article is written by Aashish Mittal, pursuing Diploma in US Intellectual Property Law and Paralegal Studies from Lawsikho.

This article has been published by Abanti Bose.

Introduction

Fraudulent Conveyance has its origin from the Bankruptcy laws where debtors usually sold, concealed, or tried to set aside the creditors’ claim over their assets or other transferable properties when they are on the brink of insolvency. Uniform Fraudulent Transfers Act (hereinafter referred to as the Act) is one such legislation which governs fraudulent transfers in USA and state laws are also modelled in line with this legislation to give uniform effect.

Debtors aggressively sell the company’s assets at little or at very minimal cost right before the bankruptcy proceedings, or before any due date of the loan to avoid their assets being transferred or sold for the purpose of creditors’ claim.

In this article, firstly a brief introduction as to fraudulent conveyance is given, following with their types, further the elements which constitute actual fraud which is the key highlight of the article along with elements constituting such fraudulent transfers. Further a brief highlight over the actual fraud and the 11 badges of fraud that were added in the Code.  In the later part the defences are available to the transferee. In the subsequent chapters, the principle of tracing is discussed with the lines of fraudulent conveyance claims in which the courts’ act is to trace the transferred property or the amount accumulated with it, in order to prove the debtor’s intent behind such transfer in cases of actual fraud and lastly concluding remarks.

What is fraudulent conveyance?

Fraudulent Conveyance as explained above is creating hindrance by any way possible by the debtor against the creditors claim over the assets and properties of the debtors which were used as collateral to securitize the loans. Section 548 of the Federal Bankruptcy Code deals with the Fraudulent Transfers and Obligations, a provision which is only for the debtors perspective which indicates that where the debtor had engaged in a transaction to hinder, delay, prejudice the bankruptcy proceedings the Trustee so appointed by the court can set aside such transfer as void. The lookback period of such a transaction is stated as 2 years before the filing of the bankruptcy petition.

The trustee so appointed by the bankruptcy court has some duties which are specified in Section 704 of the Code of Bankruptcy. Some of the duties state that the trustee shall:

  1. be accountable for all property received;
  2. ensure the debtor shall perform his intention related to the property securing consumer (creditor’s) debt; 
  3. investigate the financial affairs of the debtor;
  4. and any other duty as specified in the given section.

Now it has been stated that Sec 548 is only for debtors, it is because the bankruptcy petition according to this provision is filed by the debtor voluntarily or involuntarily to initiate the bankruptcy proceedings. 

The Fraudulent Conveyance Law is based on the two important factors which are essential in establishing the transfer as fraudulent first is the cost, and the second is the timing. Any of the two factors if proved by the other party can constitute the claim against the debtor for being a party to the Fraudulent transfer. 

Cost implies that the amount received out of the transferable property either can be equivalent to the market value of the asset or it can be lower which shows that there is a clear intent of the debtor to not allow the creditors to gain out of such property in case there occurs the events of insolvency.

Types of fraudulent transfers

There are two types of fraudulent transfers:

  1. Actual Fraud–  In this type of fraud, the debtor intentionally tries to hinder, delay, or defraud creditors. The intent is an essential element to prove the existence of actual fraud. This type of fraud is dealt with under Section 548(a)(1)(A) of the Code.
  2. Constructive Fraud– when the debtor receives reasonably equivalent value in return at a time he was in financial distress. The intent of the debtor in cases of constructive fraud is immaterial (the centre of attraction of this article is related only to actual fraud so Constructive fraud will not be elaborated further).

Elements constituting a fraudulent conveyance

As per our understanding and the discussion above there are two types of fraud. In both cases, a two-year “look-back period” and a two-year statutory limitation is prescribed which means that cause of action arises against the transactions/transfers which had taken place within two years preceding the date of initiation of proceedings against the debtor. So, in short, if the transfer to be considered fraudulent it must have occurred within two years immediately before a bankruptcy petition filing, either by the debtor voluntarily or involuntarily or by the creditor(s) against the debtor. 

As per 11 U.S.C. Section 548(a)(1), the plaintiff has to prove the following four elements:

  1. the transfer was made,
  2. of interest of the debtor in any transferable property or any obligation incurred by the debtor,
  3. made or incurred within two years of the filing of the bankruptcy petition, 
  4. the petition was filed by the debtor whether voluntary or involuntary.

The above shall not suffice the claim of actual fraud against the debtor until the claimant shows the actual intent of the debtor behind such transfer, which was to hinder, delay or defraud the creditor(s).

In certain circumstances, the debtor tends to find the two-year lookback period as a loophole (defence), so it is the duty of the other party to prove the transfer as fraudulent and also the duty of the trustee appointed by the court to conduct the bankruptcy proceedings in such a manner so that he can provide a remedy against such transactions which had taken longer than the two-year time frame, but the same is upon the complete discretion of the trustee.

What is known as actual fraud?

In actual fraud, the main factor which the court considers is whether the debtor made the transfer (which is in question) with the intent to hinder, delay, or defraud its existing creditor(s). It is not easy to identify the intent of the debtor so courts rely on circumstantial evidence in order to prove the intent. 

In 2014 the Uniform Voidable Transactions Act codified 11 badges of fraud which were used by the courts as a tool to determine the intent of the alleged defaulters. the list is as follows:

  1. The transfer or obligation was to an insider like family members, relatives, business partners, etc. 
  2. The debtor transferred the property but the possession still rests with the debtor
  3. The debtor has concealed or has not disclosed the transfer.
  4. The debtor had been sued or had threatened to be sued before the transfer.
  5. The debtor’s assets that were transferred constitute a full or substantial portion for a value that is very little.
  6. The debtor absconded after the transfer, i.e., the debtor made the transfer secretly and hurriedly.
  7. The debtor moved the assets out of the plaintiff’s sight or had hidden them
  8. Consideration received for transfer of property was not reasonably equivalent to the value of the property transferred, or the amount due.
  9. The debtor became insolvent or was insolvent shortly after the assets were transferred or when the time the amount became due.
  10. The transfer of property/assets was made shortly before or after the substantial amount of debt was incurred.
  11. The debtor transferred the secured assets to a lienor that further transferred the same assets to the insider of the debtor.

The above list is not an exhaustive list of badges of fraud. However, the courts from time to time promote and update the list to further bring the complex transactions under the umbrella of actual fraud.

As far as the above understanding of the badges of fraud, it is pertinent to note that the timing of the transfer is an important part that has to be determined as to when the transfer had occurred. Certain types of transferable property require the involvement of multiple steps in the perfection of the title to the transferor by the transferee. 

‘Perfection’ occurs when the buyer of the transferable property from the debtor cannot acquire any superior interest than the debtor himself, that is when the transfer has been perfected under the law. 

Defences available to the debtor against fraudulent conveyance claims

The defences which are available to the debtor against the fraudulent conveyance actions can be classified into two categories, firstly where the debtor challenges elements of fraudulent conveyance as mentioned above, secondly certain other defences are separate from these elements, which depends on the facts and circumstances of the case, the debtor can challenge the claim of the creditor.

It is pertinent to note that the first category of defences is self-explanatory which means that out of the four given elements of fraudulent conveyance if the debtor disproves the very element, then it will be counted as a defence for the debtor. For instance- the transfer did not occur within the look-back period i.e., within 2 years.

However, it is important to note that the fourth element generally in no way can be countered as the bankruptcy proceedings are initiated one way or another.

Now, the second category of defences are as follows:

  • The debtor was solvent at the time of the transfer,
  • The statute of limitations has tolled,
  • The transferee was a good-faith purchaser,
  • The transferee repaired, improved, or preserved the property,
  • The transferee was a “mere conduit,” meaning that they had no real control over the property. A financial intermediary is a typical example.
  • The transfer was a settlement payment. For example, in a divorce settlement, a debtor may not be able to get “reasonably equivalent value.”

Principles of tracing

Tracing is the process of identifying a new asset as a substitute for the old one. For instance, if the money to be traced is used to purchase a new car then the money can potentially be traced into the car.

The law of tracing is a practice that enables an owner to recover the property in the event the property is taken from them involuntarily. Here the word “involuntarily” means that the owner has not agreed to any transfer in that process to the defendant. 

Tracing of property operates at 3 different levels which are as follows:

  1. Owner seeking to recover the original property from the defendant,
  2. Owner seeking to recover the original property as well as the gains/profits made thereunder, and
  3. The owner not seeking to recover the original property, but the property had been mixed with other property, or the original property is not found. (example- person purchased in good faith).

In the third category of tracing above, the owner may seek to establish the proprietary right in some other property that the defendant has acquired using the original property.

Therefore, the claimant is seeking to assert a title on substitute property which might take the form of sale proceeds. Now the word “substitute property” here means the traceable proceeds which means the claimant’s rights are traced in such property as the original property is not identifiable.

Now let’s look back and recall what we have understood, tracing is a process whereby the claimant can establish a proprietary claim. A successful tracing claim means that the claimant can recover their property, and take priority over other claimants in the event of insolvency. The claimant may also be able to take advantage of any increase in the value of any property to which they made a successful claim.

In the general practice and bankruptcy law there exist two types of tracing principles that the court relies upon and carries forward to trace the funds/assets/property in question. They are mentioned below.

Common-law tracing

Common-law tracing is a process of tracing property through clean substitutes of property and it does include that property which is mixed or commingled property.

In cases when the creditor seeks to identify a specific item of property in the hands of the debtor in which the creditor has retained proprietary rights, means that the property is collateral or is held as a trust property for the event of insolvency or bankruptcy.

In cases where the specific item of property is involved the creditor seeks a remedy under common law tracing that requires the return of that specific item of property. Thus in common law, it is required by the claimant that the property claimed is not mixed with any other property.

In the case of Taylor v. Plumer (1815) 3 M. &S. 562, Lord Ellenborough stated that the product of or substitute for the original thing can be followed so long as it can be ascertained to represent the original property. It is also one of the first cases which commenced modern law tracing.

The common law of tracing was not developed for a long period and in FC Jones & Sons v. Jones [1997] CH. 159 in which a partnership firm loaned a sum of money to one of the partners’ wives, and she invested the and got profits out of it. The whole amount was deposited in a separate bank account. The partnership firm committed an act of bankruptcy under the Bankruptcy Act, 1914, and all property was deemed to have passed to the official receiver. The earlier judgements and the law prevailing it would have only recovered the loaned amount from the wife as it was the original property. 

The court of appeal held that all the proceeds (loan amount + profits) were to be paid to the official receiver as part of a common-law tracing claim. 

The nature of common law tracing right was explained by Millet LJ as being a proprietary right to claim whatever was held in the bank account whether the amount at the time was more or less than the original amount deposited, so common law claim is allowed on the basis that the money in this present case was perfectly identifiable in a bank account separate from her own.

Equitable tracing

Equitable tracing comes into play when the claimant is unable to establish his claim through common law. In this type, the claimant has to establish that the property was transferred in breach of fiduciary duty, which need not be fraudulent, i.e., the relationship between the claimant and the defendant is of fiduciary relationship bound by equity.

In cases of equitable tracing, the claimant can trace the property through mixed funds and take the increase in value of the property bought with such funds. So in short equitable tracing is preferred when the funds are mixed or where the specific item of property is not identifiable but is sold or commingled with other property.

Tracing equitable property is considerably more extensive which means that tracing property rights is wider than that is available in the common law.

To have an equitable claim in any property, it is necessary and important to show an equitable interest in the property which is to be traced.

Tracing through the equitable process is a two-stage process:

  1. To detect the property and to carry out the tracing, so that the claimant can identify the property which will further stand as a substitute for the original property in question in which the claimant had an equitable interest.
  2. To identify which equitable remedy should be imposed over that property.

There are three requirements that act as a prerequisite to establishing the equitable claim:

  1. The claim must be based on pre-existing fiduciary relationship;
  2. The property in question must be in a traceable form; and
  3. It must be equitable to trace.

Conclusion and analysis

Creditors in cases of actual fraud have to be often under the mercy of the court(s) where they are required to prove the intent of the debtor which varies from case to case basis, and there is no hard and fast rule to determine whether particular conduct of the debtor frustrates the intent part.

So, in most cases the above 11 badges of fraud are an evolving provision of law that vary from state to state and any conduct in one particular case may prove that the debtor had a fraudulent intent but the same conduct in other cases may not prove that the debtor had the intention to hinder, delay or defraud the creditor.

Fraudulent conveyance acts by the debtor are mostly done in order to evade the liability, which means loopholes in the code of federal bankruptcy is also in play which requires the legislators and the judiciary to provide a strict and improved provision that creates uniform application and better-defined essentials to prove the intentional part uniform for all.

References

  1. https://www.jdsupra.com/legalnews/fraudulent-conveyances-41765/
  2. https://www.wolterskluwer.com/en/expert-insights/actual-fraud-always-voids-asset-transfers
  3. https://content.next.westlaw.com/5-382-3498?__lrTS=20210130024240749&transitionType=Default&contextData=(sc.Default)&firstPage=true
  4. https://www.law.cornell.edu/uscode/text/11/548#
  5. https://www.caddenfuller.com/articles/bankruptcy-law-understanding-fraudulent-conveyances/
  6. https://gleissnerlaw.com/assets/docs/fraud-defenses.pdf
  7. https://jsheld.com/insights/articles/analysis-of-fraudulent-conveyance-actions

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