By: Edward D. Brown, Esq., CPA, LL.M
When a creditor is looming, the debtor may be tempted to give away assets to friendly parties so that the creditor will not have recourse to seize as many assets. This was the impetus behind our laws today that hold such actions as voidable transactions (also known as fraudulent transfers) when the intent behind such actions is motivated by the goal of depriving the creditor of reachable assets, or when such actions render the debtor insolvent or the debtor was already insolvent. In these cases, a creditor can argue this to be a failed attempt at asset protection and therefore be afforded the remedy of clawing back the assets that were transferred by the debtor.
The idea here is that a debtor should not be allowed to diminish his net worth as a defensive maneuver in a creditor situation. This raises the issue of whether a sale of assets by the debtor for a promissory note (that has an adequate interest rate provision and a face value equal to the value of the assets being sold by the debtor) will escape the fraudulent transfer trap. At first blush, the debtor’s net worth appears to have remained unchanged, so how can that ever be a voidable transaction?
Courts have considered the creditors’ viewpoint in scenarios involving a transfer by a debtor, with the debtor arguing he received reasonable fair value for the transfer, and as such, no fraudulent transfer claim can be successfully asserted by a creditor. A creditor can however be hindered by such a transaction as a result of no longer having access to “reasonably equivalent value.” For example, a sale of a highly marketable asset in exchange for an installment note could delay a creditor’s ability to collect on a judgment because the debtor holds only a promissory note that necessarily (by design) defers any receipt of funds over perhaps many years (e.g., a thirty year installment sale note) as opposed to an asset that can be easily converted to immediate cash.
In the 2017 case of Fifth Third Bank v. Morales , a debtor sold Colorado real estate to her daughters for a promissory note with a face amount equal to the fair market value of the Colorado property. The note however accrued no interest. The court determined that the note was not sufficient value from the creditor’s standpoint. For one, the note delayed any payments for fifteen years. Two, the purchasers were to inherit the note receivable at some point, so the purchasers had no real economic incentive or obligation in paying the note. Furthermore, the timing of the sale for the note (in the midst of litigation) made the entire sale suspect and therefore prone to being perceived as a fraudulent transfer. Besides, if the face value (the initial principal amount) of the note approximates the value of the real estate sold, but the note has no interest requirement and is unsecured and the payor has no reason to repay the note, the fair market value of the note is actually much lower than the payable amount stated on the face of the note.
Other cases in which a debtor transferred funds in exchange for value (to the debtor) that nevertheless was challenged as a fraudulent transfer include: (i) Interpool Limited v. Patterson , et. al, in which a debtor placed funds into a limited partnership in exchange for a capital interest in that partnership, which cloaked those funds with certain “charging order” restrictions that can stem a creditor’s rights to access those funds, and (ii) Janvey v. Golf Channel, Inc. , in which the debtor who was engaging in a Ponzi scheme paid millions in advertising expenses for air-time on the Golf Channel. In these cases, what the debtor received in these transactions had less value to creditors than what the debtor owned immediately prior to these transactions. It should be noted here though that the Golf Channel did have a good faith defense in that it was not aware of the debtor’s schemes.
In light of cases such as these, a debtor is well advised to not rely on the fact that simply because an asset is exchanged for value during a creditor threat, that such transfer will withstand scrutiny in a court setting.
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