Avoiding Fraudulent Transfer Claims from Loan Workouts

By Hanna Lahr and James Roberts

During and after an economic downturn, an increase in fraudulent transfer actions is almost inevitable. Economic instability leads to an increase in troubled borrowers who, in turn, have troubled loans that banks and financial institutions must work out or restructure.

Managing troubled loans can take many forms, including forbearance agreements, orderly wind-downs and, where a consensual resolution is not possible, litigation or often bankruptcy. Workouts may also involve the lender protecting its interests by requiring pledges of additional collateral or guaranties, including from affiliates of the borrower. These transactions can make lenders more vulnerable to fraudulent transfer claims—a special breed of federal and state laws that requires a lender, under certain circumstances, to give back what it received in a challenged transaction, with interest.

The basics of fraudulent transfers

The majority of state fraudulent-transfer laws are based on the adoption of the Uniform Fraudulent Transfer Act, or the revised Uniform Voidable Transactions Act. Federal law has similar fraudulent transfer statutes that are applicable in bankruptcy cases. In a bankruptcy case, the bankruptcy trustee or the debtor can make fraudulent transfer claims under both federal and applicable state law, which is often preferable due to longer timeframes during which transfers can be recovered.

There are two types of fraudulent transfers: actual fraudulent transfers, and constructive fraudulent transfers.

An actual fraudulent transfer occurs when the debtor makes a transfer with the intent to defraud its creditors (such as transferring assets for little or no consideration in an attempt to prevent the creditor from going after such assets). Because intent is generally difficult to prove, it can be shown circumstantially through certain “badges of fraud,” including, but not limited to: transfer to an insider, concealment of the transfer, pending lawsuits against the debtor, less than reasonably equivalent value received for the transfer and the debtor’s insolvency. A transferee can defend against an actual fraudulent transfer claim by showing that it acted in good faith (for example, without knowledge of the debtor’s fraudulent intent) and that it provided “reasonably equivalent value” for the transfer, as discussed below.

A constructive fraudulent transfer occurs when the debtor makes a transfer without receiving reasonably equivalent value for the property transferred during a time when the debtor is insolvent or in financial distress, or when the transfer itself causes the debtor to become insolvent.

The value given does not have to be dollar-for-dollar to be considered “reasonably equivalent,” and courts will look at both direct benefits (including a debtor’s payment on a loan reducing the amount of debt owed by that debtor) and indirect benefits (such as financing that allows the corporate enterprise to bridge to a sale) when considering whether reasonably equivalent value was given.

A transferee can defend against a constructive fraudulent transfer claim by showing that it acted in good faith such as without knowledge of the debtor’s insolvency or fraudulent purpose.

Five tips to guard against fraudulent transfer claims

A lender cannot prevent a borrower from having an intent to defraud its creditors or from being insolvent. The lender should, however, be aware of the risk for fraudulent transfer liability and take steps to help minimize fraudulent transfer exposure and to prepare the lender in the event there is an avoidance claim in the future. Here are five actions banks can take to avoid trouble:

1. Do your due diligence. Courts are not inclined to protect lenders who appear to have turned a blind eye to a debtor’s fraudulent intent or insolvency. If a lender, therefore, has no knowledge of a debtor’s fraudulent intent or insolvency because the lender purposely failed to do its due diligence, the good faith defense will likely be unavailable to protect the lender from fraudulent transfer liability. The due diligence should be tailored to the proposed transaction at issue, but will generally include getting updated financial records from all parties involved, particularly for any new parties to the deal, and analyzing the collateral, including through field exams and updated valuations. Through this process, the lender will also be able to better analyze whether reasonably equivalent value is arguably being exchanged.

2. Follow the policies for reporting suspicious activity. As noted above, sometimes fraudulent transfer situations involve actual fraudulent activity by the debtor. If there are suspicions regarding the debtor’s activities, follow internal policies for reporting such suspicions.

3. If suspicions are confirmed, exit the relationship. Exiting the relationship may look different in each situation. Exiting immediately may not be possible or sensible depending on the circumstances, so the lender may, for example, put the loan in default, refuse to extend further funds to the debtor and/or begin liquidating collateral. Regardless of the path ultimately deemed appropriate, evaluation of the options should consider the potential for fraudulent transfer liability if the exit is not immediate and the lender continues to work with the debtor.

4. Be careful with non-obligors. Adding new guaranties or collateral from non-obligors are common ways to further secure a lender’s position when a loan becomes troubled. If the non-obligor is in financial distress itself and is not receiving reasonably equivalent value in the deal, fraudulent transfer liability can arise. Reasonably equivalent value can include indirect benefits, such as where the non-obligor receives the benefit of the goods or services for which the debt is incurred by the obligor.

5. Document your process. In the event that a fraudulent transfer action is brought, it is important that the due diligence and actions taken in connection with the actions above be well-documented so that the lender can prove its efforts to determine whether the debtor had a fraudulent intent or was in financial distress. If the investigation was diligently undertaken but the debtor’s fraudulent intent or financial distress was not uncovered, the good faith defense will still be available.

Hanna Lahr is a partner and James Roberts is an associate in the creditors’ rights and bankruptcy group at Burr and Forman LLP.