When a financially distressed company is having difficulty restructuring its debt through such means as seeking forbearance or other agreements from its creditors, it may proceed to the more significant step of attempting to sell off some of its assets or businesses.
Such a move can happen for a variety of strategic reasons, from simply raising much-needed cash to eliminating the distractions that non-core businesses may be causing company management. An asset sale may even be a requirement by the company’s lenders before certain amendments to the company’s credit agreement will be granted.
What is a fraudulent transfer?
The origins of fraudulent transfer can be traced back as far as the 16th century, when the Statute of 13 Elizabeth was introduced under British law. The statute was a response to the practice, common amongst overburdened debtors, of handing over assets to friendly parties in order to escape creditors’ collection attempts, and then reclaiming the assets after the creditors had abandoned their efforts.
How does actual fraud differ from constructive fraud?
An actually fraudulent transfer is exactly what it sounds like: a transfer made with premeditated intent to hinder, delay, or defraud any of the debtor’s creditors. As it can be very difficult to prove such deliberate intent on the part of the transferor, however, the courts have developed a list of what are known as “badges of fraud,” or circumstances which can be construed as intent to commit fraud. These include secretive transactions, transactions where a price far below fair value is paid for the transfer, transactions which occur during collection efforts by creditors, and an agreement not to record a transaction.
In a constructively fraudulent transfer, on the other hand, fraudulent intent does not necessarily have to be present. Rather, constructive fraud occurs when a company voluntarily or involuntarily received less than what is known as “reasonably equivalent value” for a transfer made while the company was either insolvent, engaged in business for which its remaining capital after the transfer would be unreasonably small, or under the belief that it would incur more debt than it could pay, or for a transfer benefitting an insider.
How do fraudulent transfer claims affect investors
In other words, in the case of a fraudulent transfer, the assets will be recovered from the transferee and reapplied to the debtor’s estate, in order to provide fair access for creditors. Under federal law, the recovery period for fraudulent transfers is two years prior to the bankruptcy filing date, but in some states the period can be as long as six years.
What are risk mitigation strategies to protect against fraudulent transfer?
One is for all parties to a transaction to ensure that proper records are kept, documenting that a reasonable sale process was conducted in good faith and that arm’s-length terms resulted.
It may further be helpful for either the distressed company or a counterparty to seek a valuation opinion, solvency, or capital adequacy from a third-party expert. Such an opinion may be very useful in defending the transaction in the event that it is later challenged as having been made for less than reasonably equivalent value or for having undermined the company’s solvency.
Investors should also make all attempts possible to consider and document such factors as the trading prices of the company’s equity and debt, in order to provide as many details as possible on contemporaneous market evidence of value.
Finally, for investors who seek maximum protection, it is a reasonably common practice among purchasers of assets from distressed companies to insist that the company file for bankruptcy first, and then condition the purchase on approval from the courts. In this situation, the purchaser is insulated from any subsequent contention that the transfer was undervalued.