ComplianceLegalFinanceSeptember 23, 2020

Actual fraud always voids asset transfers

Aggressive use of asset protection strategies is not illegal. However, crossing the line into fraud is illegal. If you want your transfers to hold up, you must avoid a finding of constructive or actual fraud. A finding of actual fraud often hinges on your motive, your financial condition and your attempts to conceal the transfer.

In seeking to avoid challenges to asset transfers--whether in an overall asset exemption plan or in the strategic funding plan for your business--you must be careful of the provisions of the Uniform Fraudulent Transfers Act (UFTA). Not only does UFTA prohibit constructive fraud, it also outlaws actual fraud--that is, transfers made with the intent, or motive, of avoiding a debt. You should be most concerned with this type of claim.

Both the UFTA itself and the courts have identified factors that tend to establish fraud. With the exception of the first factor (motive or intent), which must be proved in every case based on actual fraud, no one factor is necessarily more important than the others. Factors are weighed by the particular court, and the relative importance of a given factor varies on a case-by-case basis.

Notwithstanding that, the most important factors, in most cases, are as follows:

  • the motive or intent of the debtor
  • whether the debtor was insolvent at the time of the transfer, or could reasonably anticipate becoming insolvent thereafter
  • whether the transfer was concealed from the creditor
  • whether, at the time the transfer was made, the debtor had been sued, was threatened with a lawsuit or was otherwise in the midst of a financial crisis
  • whether the debtor received adequate consideration in return for the transfer
  • whether, at the time the transfer occurred, the debtor had incurred a substantial debt

Other factors that are given some weight include:

  • whether the transfer was of all or substantially all of the debtor's assets
  • whether the transfer was to an insider (i.e., family member or controlled entity)
  • whether the debtor fled the vicinity or tried to hide assets
  • whether the debtor transferred assets to a lienholder, who then transferred the assets to an insider of the debtor

Fraud established by intent to avoid creditors' claims

In a creditor's challenge of asset transfers under the Uniform Fraudulent Transfers Act (UFTA), actual fraud is predicated on a court's finding that the debtor intentionally transferred assets to avoid a creditor's claim. Absent proof of such an intent, or motive, the creditor's challenge fails.

Simply put, to avoid actual fraud, the debtor must be able to convince the court that the transfer was motivated by some legitimate reason, unrelated to the desire to place the asset out of the reach of creditors.

Explanations are derived from common sense and will vary depending on the nature of the transfer. For example, you might pay down a home mortgage to avoid interest charges, which, over the life of a mortgage, can double or even triple the cost of a home. You might take out a second mortgage on a home to invest the funds in a new business, make improvements in your family's home, enable the family to take a vacation or invest the proceeds, etc.

With respect to payments to the business entity, courts have sometimes ruled that payments were not fraudulent when they were made for legitimate business expenses, including payments to the owner for services actually rendered to the entity, or capital leased or loaned to the entity.

Payments from the business entity to the owner can be legitimized if services and capital are actually provided to the entity. Here, it is essential that these payments be regular and supported by written agreements between the owner and the entity.

Payments that occur only when a financial crisis arises, or that are not supported by written agreements, have the appearance of being fraudulent.

Frequently, a debtor incurs a debt when he or she does not have the resources to pay it back. Courts have ruled that if, at the time the debt was incurred or a transfer was made, the debtor had a reasonable expectation of receiving future resources, there is no fraudulent intent in the transaction. After all, that's the nature of taking on debt--you borrow money now with the intention of paying it back later when you have greater resources.

Using this theory, it is possible to sustain a purchase on an unsecured credit card, or an asset transfer, at a time when the debtor was insolvent. You could show, for example, that you reasonably anticipated receiving a bonus or a raise, or perhaps an inheritance.

A business entity could show that it anticipated excellent results from a new marketing plan or contacts the owner had made. That the results were not achieved is not important, provided that the expectation had some basis in fact.

Similarly, an individual or a business entity that is solvent at the time of a transfer, but becomes unable to pay a debt, can disprove fraudulent intent by establishing that it could not reasonably anticipate the events that led to the insolvency. For example, fraudulent intent is disproved by an unexpected loss of a job; pay cut; loss of a major customer, client or contract; or default on receivables of significant value.

In these ways, you can preserve the validity of a transfer even in the face of a finding of insolvency, at least in an actual fraud case.

Another effective strategy, of course, is to establish that these other factors do not apply to the case (e.g., the debtor was actually solvent at all relevant times).

Motive, insolvency key to proving fraud

The timing of a transfer can reveal the real intent behind it. In fact, UFTA specifically provides that motive can be inferred from the timing of transfer. Thus, fraudulent intent can be inferred if a transfer occurs when a lawsuit is threatened or initiated, or if it takes place at the time a substantial debt is incurred.

Similarly, transfers that suddenly occur on the eve of a bankruptcy filing, when the debtor receives notice of a lawsuit, or is in the midst of a financial crisis will only rarely succeed, because the courts can infer fraudulent intent from the circumstances and, in particular, the timing of the transfers. This is why transfers from the business entity to the owner must be ongoing and supported by written agreements.

It is essential that the debtor be able to prove that the transfer was motivated by legitimate reasons unrelated to a desire to protect the asset from a creditor.

Some bankruptcy courts recognize the validity of asset exemption planning, in general. However, the majority of courts do not follow this same rationale.

Most transfers can be explained in a rational way unrelated to asset exemption planning. Of course, this is a lot easier if the transfers occur well in advance of a bankruptcy filing or, for example, notice of a lawsuit.

Within the business, a record proving that payments to the owner have been ongoing, regular and supported by written agreements will be important in convincing a court that the transfers are legitimate.

Salary, lease and loan payments from the entity to the owner that meet these requirements can be sustained in the face of creditor challenges even when other factors, such as insolvency, work in the creditor's favor.

UFTA considers motive regarding future creditors

The UFTA outlaws fraud as to existing and futurecreditors. In other words, to make a claim based on a fraudulent transfer, a creditor does not have to prove his or her claim existed at the time of the transfer.

Some courts have narrowly construed this provision to require proof that the debtor had that particular future creditor in mind when he made the transfer. However, most courts simply require that any future creditor must prove that he or she could have made a claim based on the law that existed at the time of the transfer.

Thus, absent some new enactment of law after the transfer that, for the first time, creates a right to sue, generally you will not be able to defeat a claim based on the fact that the creditor did not exist at the time of the transfer.

Nevertheless, a transfer made to protect assets from existing creditor, or in anticipation of a specific future creditor, is much more likely to be ruled fraudulent because intent can be inferred from the circumstances.

Insolvency is key indicator of fraudulent intent

When battling creditor's challenges to asset transfers, insolvency is a key factor in establishing fraudulent intent in many actual fraud cases, and one of two determining factors in constructive fraud cases.

Tip: Although insolvency is defined in the same way in both actual and constructive fraud cases, the effect of a finding of insolvency is very different in each case. It's important not to confuse the purpose of a finding of insolvency in a constructive fraud case with a finding of insolvency in an actual fraud case.

In a constructive fraud case, insolvency, coupled with a lack of adequate consideration in return for the transfer, automatically renders the transfer fraudulent, regardless of motive or intent. In contrast, in an actual fraud case, insolvency is only one of the factors weighed by the courts.

Because a finding of insolvency will control the outcome of a constructive fraud case, whenever there is an absence of adequate return consideration, the business owner who is, or anticipates becoming, insolvent, must ensure that transfers are either supported by adequate return consideration or that they do not qualify as "transfers" covered under the UFTA.

Proving solvency negates actual fraud

Because insolvency can be an important factor in asset transfers, you should be familiar with the two different ways to gauge insolvency. Specifically, the Uniform Fraudulent Transfers Act (UFTA) provides that you are insolvent if:

  • Balance sheet method: your liabilities exceed your assets (i.e., a balance sheet analysis shows a negative owner's equity, or net worth), or
  • Cash flow analysis: you cannot pay your debts as they come due (i.e., a cash flow statement shows the debtor has a negative cash flow)

Although either version can be important, the cash flow analysis will usually carry more weight.

When making transfers, you should prepare a balance sheet that indicates your financial position (assets minus liabilities) and cash flow statement that shows your liquidity as of the date of that transfer. However, UFTA applies to existing and future creditors. 

Accordingly, any analysis of insolvency also must project your financial position and cash flow (for you and your business) for at least the next three months after a transfer, and preferably for the next year as well. Thus, a second balance sheet and a second cash flow statement should be prepared based on these projections. A finding of insolvency based on either the financial situation on the date of the transaction or under the projections can be significant.

Separate determinations must be made for owner and business entity

Determinations of insolvency (or, hopefully, the lack of it) will have to be made for you as an individual, based on your individual financial situation when you make a transfer, as in the case of asset exemption planning. They also may have to be made for the business entity, as in the case of liens placed on the entity's assets in favor of the owner or payments from the entity to the owner.

Great care must be taken to separate the owner's personal finances from those of the business entity. If the small business follows our advice, this separation will already exist in the recordkeeping system for the business. This separation is essential if you are to preserve your limited liability for the business's debts.

Balance sheet analysis can demonstrate solvency

This analysis involves subtracting liabilities from assets. Assets should be valued at fair market value, and not original cost, for purposes of this projection. Note that, in a conventional accounting system, most assets will remain in the accounting records at historical cost. For our purposes here, these assets must be adjusted to fair market value. Thus, an adjustment may be necessary for an asset such as an office building, which has appreciated significantly in value. The fair market value of depreciated assets should be used and not the book value, as an estimate of fair market value already includes adjustments for depreciation.

Liabilities should normally be subtracted at face value. This includes any liens established on the assets by the owner, which should always be recorded on the entity's books as liabilities in any event.

Exempt assets must be excluded from the balance sheet equation. In the business entity, this will not affect the calculation because asset exemptions are available only to natural persons.

For an individual, exempt assets are excluded because they are not available to the creditors. However, exempt assets can be reached by holders of consensual and statutory liens on exempt assets. Thus, when exempt assets are excluded, the corresponding consensual and statutory liens on the exempt assets also should be excluded.

This will make a significant difference in an individual's balance sheet calculation. Among the assets that must be excluded are the  homestead to the extent of its exemption ERISA-qualified retirement plan assets and, in many states, IRAs.

When the face value of a liability insurance policy would be available to a particular creditor, this amount should be included as an asset in the balance sheet calculation. This would be appropriate when, for example, a claim was made by an injured party in the form of a negligence lawsuit, and the plaintiff, after securing a judgment, alleged that a transfer from the defendant was fraudulent. This can make a dramatic difference in the calculation results, turning the results into a finding of solvency.

It would be inappropriate to include the face value of the policy in the calculation when the policy could not be paid to the creditor in question (e.g., a breach of contract claim). Thus, the calculation should initially be made without inclusion of the face value. A second determination, made by plugging this amount into the equation, should also be made. This determination will be relevant only with respect to those creditors who could make claims covered by the policy (i.e., usually claims based on the commission of a tort, such as negligence).

Balance sheets, cash-flow projections can refute fraud

Ultimately, the effect of the exclusion of exempt assets will mean that, in many cases, individuals will be deemed insolvent. Similarly, financing the business entity with leases and loans and encumbering the entity's assets with liens in favor of the owner, all of which are extremely effective asset protection strategies, will also mean that in many cases the business entity will be insolvent, according to the calculation.

In these situations, it is essential to exchange adequate consideration when making transfers, to avoid application of the constructive fraud theory. Then, actual fraud can be avoided through proof that the debtor is not insolvent from a cash flow perspective, plus proof that the transfer was motivated by a legitimate reason, as explained above. In addition, the absence of findings on the other factors can help to disprove an allegation of actual fraud.

The forward-looking (sometimes called projected, or pro forma) balance sheet should include any assets and liabilities (subject to the rules discussed above) that the individual or business, as the case may be, can reasonably expect to materialize. As discussed above, this projected statement should be in addition to a balance sheet based on the individual's or business entity's existing financial position.

The forward-looking balance sheet is important because an anticipated change in circumstances can be used to prove or disprove insolvency. A debtor who is solvent at the time a debt was incurred can be ruled insolvent at a future date, when he or she fails to pay the debt. If it can be shown that the debtor could have reasonably anticipated this result, this can be important evidence of fraudulent intent.

Conversely, a debtor who is insolvent at the time a debt is incurred can disprove intent of fraud by proving that he or she reasonably anticipated being able to pay the debt through future earnings. This strategy is discussed in more detail above.

Cash flow analysis can establish solvency

Measuring cash flow for an individual amounts to adding up the individual's monthly sources of income, and then subtracting the monthly expenses. A home finance program such as Intuit's "Quicken" or Microsoft's "Money" will be helpful here. A cash flow statement is a standard feature in every business accounting software program. Thus, for the business entity, you can generally rely on the business entity's accounting software to make such calculations.

Tip: Ratios can be used to quickly gauge an entity's current and future solvency from a cash flow perspective.

The current ratio is calculated by dividing the entity's current assets by its current liabilities. Current assets are those that will be converted to cash or used up within one year. Current assets include cash, receivables, marketable securities, inventory and prepaid expenses. Similarly, current liabilities are those that will be paid within the next year. This should include the next 12 monthly payments for any installment loans (such as mortgages, or car loans).

A result of 2:1, or better, is desirable. A ratio of 1:1 means the entity is solvent, but on the border of being insolvent in the sense of being unable to pay its debts as they come due.

A different version of the ratio, called the quick ratio or acid test ratio, excludes inventory and prepaid expenses from the definition of current assets, on the grounds that inventory can be difficult to quickly convert to cash. This ratio should normally be 1:1 or better.

Take into account any source of income that can reasonably be expected to materialize. As was suggested above, courts generally hold that, if such sources do not materialize, there is no fraud, as long as the original projections had some basis in fact. Here, again, offering a reasonable explanation, with supporting proof, can be an effective strategy.

Example: Linda Jones had a reasonable expectation, based on past experience, that she would receive a sizable bonus in the last quarter of the year. Accordingly, in anticipation of this bonus, she makes substantial charges on her credit card, even though at the time of the purchases she is insolvent. Here, the future projection of solvency, if reasonable, would negate any finding of fraudulent intent.

Similar conclusions are warranted when a business incurs debt or makes transfers at a time when it is insolvent. If such transactions are based on reasonable projections that the entity would be solvent in the future (e.g., from increased sales, decreased operating expenses, etc.), these projections can negate a finding of fraudulent intent even if the projections do not materialize.

Conversely, debts incurred on a date when the individual or business was solvent can be shown to be the result of fraudulent conduct, when reasonable projections would have indicated future insolvency.

Cash-flow insolvency can establish fraud

Proof that the debtor was not insolvent from a cash flow analysis can negate a finding of insolvency from a balance sheet analysis, as illustrated in the example below.

Example: John Smith, a Florida resident, owns a home worth $180,000, which is subject to a mortgage in the amount of $100,000. He also has an ERISA-qualified retirement plan with assets worth $140,000.

His only nonexempt asset is cash in a savings account of $19,000. His only other liability is for several credit cards that total $20,000. Smith makes mortgage payments with his credit card, totaling $4,000. This leaves Smith with a balance on his credit cards of $24,000.

Smith is insolvent under the balance sheet analysis ($19,000 less $24,000). The home and the retirement plan must be excluded from the calculation because both are completely exempt. The corresponding mortgage loan on the exempt home must also be excluded.

If Smith is paying his monthly bills as they come due, he will not be insolvent from a cash flow perspective. For example, Smith earns $4,000 per month, has monthly expenses of $2,000 and he has been paying his bills each month.

Smith is not insolvent, despite the results from the balance sheet analysis. The cash flow analysis makes more sense in this case, and it should, accordingly, bear more weight in any court proceeding.

Regardless of whether you're planning to make a transfer in the near future, you should periodically make separate determinations of solvency for yourself personally and for your business, being careful to separate your resources from those of the business entity.

Your personal analysis will be relevant for asset exemption planning and personal borrowing, while the business entity's analysis will be relevant when the entity makes payments to, and creates liens in favor of, you, and otherwise engages in borrowing.

Concealing assets and transfers may point to fraud

When creditors challenge asset transfers, court rulings indicate that concealment can be an extremely important factor in proving fraudulent intent in an actual fraud case, although motive and insolvency are more important factors in determining actual fraud cases. Lying on a loan application or in a bankruptcy petition is usually conclusive proof of fraud. Worse, yet, of course, it also is a crime that is taken very seriously by the courts.

Conversely, the opposite of concealment - disclosure - can negate a finding of fraud. Actual disclosure will almost always defeat a creditor's claim, absent some specific act of fraud on the part of the debtor.

Example: If a bank or other lender provides a 125-percent mortgage loan, by definition, the liability created exceeds the asset that secures the loan. Because many of the debtor's other assets may be exempt, the debtor technically, from a balance sheet analysis, may be insolvent at the time of the loan.

However, the debtor's financial situation would be fully disclosed to the creditor before the loan was granted, on the loan application, tax returns, credit report, etc. Of course, the lender will charge an especially high rate of interest in this situation to cover the additional risks it knows it is taking. Here, the creditor cannot complain later that it was defrauded, as it knew exactly what it was doing at the time of the loan.

In addition, constructive notice of a debtor's financial situation can negate any allegation of fraud. "Constructive notice" means information that the creditor received or could have received. If a debtor's credit report, income tax records and home finance reports were available to the creditor, or even obtainable by the creditor, the debtor can show that the creditor knew or should have known about the debtor's financial situation. Thus, the creditor cannot now claim that he or she was defrauded.

Use your business's accounting software program to generate monthly financial statements. These statements and the entity's income tax returns can serve as constructive notice of the entity's financial condition to the creditors of the entity.

A creditor may not be able to mount a claim of fraud later if it could have accessed this information at the time credit was extended.

Similarly, an individual could use a finance software program that allows the tracking of income and expenses. These records, along with the individual's tax returns, can serve as constructive notice to creditors who extend credit to the individual.

Note that this argument is more likely to be acceptable when a one-time extension of credit is made, such as a loan, as opposed to the use of a credit card or other open account.

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