Source: https://www.monitordaily.com/article-posts/fraudulent-transfer-laws-tread-carefully/
Timestamp: 2019-04-26 11:37:12+00:00

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Fraudulent transfer laws can create problems for many financiers — even those with the best of intentions. Ken Weinberg discusses why transactions of this nature should be considered carefully and seen as having inherent risk. He points out that even a lender that eventually defeats a fraudulent conveyance claim will probably feel like a loser upon receiving the legal bill.
“Fraudulent transfers” sound like the sleazy types of transactions generally associated with the likes of Bernie Madoff and Enron. Notwithstanding the nefarious-sounding name, fraudulent transfer laws can create problems for financiers who have nothing but honest intentions. This edition of Dispatches from the Trenches discusses these laws and what prudent financiers should know.
Modern fraudulent transfer laws had their genesis way back in jolly ol’ England with the Statute of 13 Elizabeth, passed by the English Parliament in 1571. Concepts rooted in that English law formed part of the common law of the United States for many years and were eventually codified in the majority of States pursuant to the Uniform Fraudulent Conveyance Act. In 1984, the UFCA was revised and renamed the Uniform Fraudulent Transfer Act (UFTA) in part to address changes under federal law with respect to fraudulent transfers set forth in the Bankruptcy Reform Act of 1978. The UFTA is a self-described “modernization” of the fraudulent transfer laws in the United States and is currently in effect in more than 40 states and in the District of Columbia.
Although the law is often referred to as the law of fraudulent transfers, it is important to understand that §548 of the Bankruptcy Code considers the incurrence of an obligation (such as agreeing to guarantee the debt owed by another) to be covered by the scope of the fraudulent transfer laws.
The key point is that even non-recourse pledges such as those accomplished pursuant to intercompany cross-collateralization provisions are included. For example, it is not uncommon for lenders to require transactions among affiliates to be cross-defaulted and cross-collateralized. The net result of the cross-collateralization is that a brother-sister company may pledge its assets “side-stream” as security for the obligations of its sibling. Similarly, a subsidiary may pledge its assets “up-stream” as security for the obligations of its parent. These transactions all constitute “transfer” subject to fraudulent transfer analysis under the Bankruptcy Code.
A fraudulent transfer described in subsection (B) above is a type of constructive fraud. Rather than requiring a showing of actual intent, fraud is constructively imputed under the circumstances. The test for constructive fraud can be best understood as a two-pronged test: (1) At the time of fraudulent transfer, the transferor/debtor must have failed one of three specified financial tests (the “Financial Tests”); and (2) such party must have received less than a reasonably equivalent value in exchange for such transfer or obligation (the “Reasonably Equivalent Value Test”).
If any of the three Financial Tests described below is met,7 the first prong of the fraudulent transfer analysis has been met.
The first of the Financial Tests, the Insolvency Test, involves an analysis of whether the transferor/debtor was insolvent at the time of, or became insolvent as a result of, the transfer or obligation. Although the Bankruptcy Code and the UFTA have slightly different insolvency criteria, the concepts are generally the same — a test of insolvency requires a comparison of the debts of the transferor/debtor versus its assets. For this reason, this test is sometimes described as the Balance Sheet Test. Although a court is not required to apply generally accepted accounting principles in making its determination, it often considers the testimony of professional accountants. Appraisers and business-valuation experts are also important sources often used to establish the fair value of the debtor’s assets and liabilities at the time of the challenged transaction.
The third, Excessive Debts Test is a subjective test analyzing whether the transferor/debtor intended to incur, or believed that it would incur, debts that would be beyond the transferor/debtor’s ability to pay as such debts matured. Of course, a lender who lends funds depending on a transfer that the transferor/debtor believed would render it unable to repay its debts as they matured has bigger problems than those resulting from fraudulent transfer laws.
In considering the second prong of the fraudulent transfer analysis, lenders should understand that Reasonably Equivalent Value does not have the same meaning as consideration. Rather, a determination that a transaction resulted in reasonably equivalent value sufficient to defeat a fraudulent transfer claim requires more consideration that the proverbial “peppercorn” or other amounts that would generally support the enforceability of a contract.
The Bankruptcy Code does not define the term “reasonably equivalent value,” and both federal and state courts have held that it is to be determined on a case-by-case basis. Courts have steered away from using a hard-line or mathematically precise determination of reasonably equivalent value, and as one court has said, “[t]he issue of the reasonable equivalence of value is a question of fact [and t]he inquiry on this element is fundamentally one of common sense, measured against market reality.”8 The crux of reasonably equivalent value is whether the value transferred by the transferor/debtor is disproportionately small compared to the value it actually receives.
Unfortunately, common sense and market reality are more difficult to determine in the context of the type of multi-party transactions at issue when fraudulent transfers are alleged with respect to the execution of a guaranty or an accommodation pledge of collateral. In such circumstances, the proceeds of the loan flow to the borrower in exchange for the guaranty/pledge by the third party. In other words, the value given by the lender does not necessarily flow to the transferor/debtor.
In the case of a Downstream Guaranty or accommodation pledge by a Parent in support of obligations owed by its subsidiary, common sense readily reveals the presence of reasonably equivalent value. The benefit to the guarantor/pledgor is derived from the fact that its stock or other ownership interest in the borrower is increased by the infusion of capital made by the lender into the borrower.
However, consider the application of the Reasonably Equivalent Value Test in the context of an Upstream Guaranty where the guarantor (SubCo) guarantees the obligations of its parent (ParentCo) in connection with a loan made by Lender to ParentCo. In this case, SubCo is liable for the obligations of ParentCo but did not benefit from the infusion of capital into ParentCo by way of any sort of ownership interest.
In some situations, the funds eventually flow to SubCo — for example where ParentCo is a holding company for a larger corporate group and the loan proceeds are intended to finance the acquisition of equipment or other property by SubCo and other subsidiaries of ParentCo which guarantee the loan. In such cases, prudent lenders sometimes trace the flow of funds. For example, the loan documents could require ParentCo to lend the money to SubCo pursuant to a promissory note or other financial arrangement.
Although not uniformly accepted, courts applying fraudulent transfer analysis are often willing to consider “indirect benefits” even if the loan proceeds cannot be traced directly to SubCo.
Consider the classic example where ParentCo manufactures goods sold by SubCo. A loan made to ParentCo to enable it increase its production of goods indirectly benefits SubCo by providing it more goods to sell and therefore increased profits.
This type of rationale is prevalent in non-recourse project financings where the borrower is a holding company owning multiple subsidiaries that each constitute a separate project (a renewable energy project, shopping center, toll road, etc.). Each subsidiary executes Upstream Guaranties and pledges all of its assets as collateral for the loan made to the parent/borrower and all other subsidiary project companies comprising a portion of the single portfolio. The financial covenants, cash-flow, pricing and related aspects of the transaction are structured on a “portfolio” level taking into account all projects as a consolidated business.
3. What “Value” has the Transferor/Debtor Given?
As noted above, the value received by a transferor/debtor that is a guarantor or pledgor in a multi-party transaction can be difficult to measure. Similarly, the value it provides pursuant to the guaranty/pledge can be difficult to ascertain.
Practitioners should hear bells-and-whistles (or, even better, Darth Vader’s theme song) whenever they encounter Upstream Guaranties, Side-Stream Guaranties or cross-collateralization among affiliates. Any time the amount of the loan is sufficiently large, when compared to the financial wherewithal of the guarantor/pledgor, there is a potential fraudulent transfer issue.
Even if the lender prevails in court, the application of the Financial Tests and the Reasonably Equivalent Value Test can be uncertain, complex and expensive to litigate. Over the years, lenders have pulled a variety of arrows from their quivers in an attempt to address these concerns, including savings clauses, affidavits or other evidence of business synergies, minimum net worth guaranties, solvency opinions, lease-sublease structures and heavily documented transactions tracing the flow of funds to any subsidiaries that guarantee the obligations of their parent/borrower. However, none of these approaches should be viewed as a panacea.
Transactions of this nature should be considered carefully, and viewed as having inherent risk. Even a lender that eventually defeats a fraudulent conveyance claim probably feels like a loser when it receives its legal bill.
See Orr v. Kinderhill Corp., 991 F.2d 31, 35 (2d Cir. 1993) (applying a six-year limitation under New York Consolidated Law Service, §213).
Section 544(a) of the Bankruptcy Code gives the trustee the status of a hypothetical lien creditor whose lien was perfected as of the date of the filing of the bankruptcy petition. Section 544(b)(1) incorporates state law into the bankruptcy process and enables the trustee to exercise the rights of creditors under state fraudulent transfer laws to void any transfer of an interest of the debtor in property that is avoidable under applicable state law.
11 U.S.C. §548(a) (emphasis added).
Gullickson v. Brown (In re Brown), 108 F.3d 1290, 1293 (10th Cir. 1997).
See 548(a)(1)(B) for the statutory description of such tests.
Leonard v. Mylex Corp. (In re Northgate Computer Sys.), 240 B.R. 328, 365 (Bankr. D. Minn. 1999).
In re Image Worldwide Ltd., 139 F.3d. 574, 578 (7th Cir. 1998).
Garrett v. Falkner (In re Royal Crown Bottlers, Inc.), 23 B.R. 28, 30 (Bankr. N.D. Ala. 1982); See also In re Tryit Enterprises, 121 B.R. 217 (Bankr. S.D. Tex. 1990)(holding that because the debtors held themselves out as a single business enterprise and availed themselves of the financial benefits derived from their consolidated financial condition, the transferor/debtor did in fact receive reasonably equivalent value sufficient to defeat a fraudulent transfer claim).
See In re Chase & Sanborn Corp., 904 F.2d 588 (11th Cir. 1990).
See In re Central States Resources Corp., 922 F.2d 490 (8th Cir. 1991).

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