Protection of Creditors: The Rules of Fraudulent Conveyances

Fraudulent Conveyances

Asset protection constitutes one of the most common legal tasks that attorneys are asked to assist with. While many people can go their whole lives without being subject to the criminal justice system or to lawsuits, everybody with assets wants to protect them to preserve them for future use and eventual distribution to their heirs. Common estate planning procedures are replete with nuances that help protect assets from vulnerability to potential creditors. Devices such as trusts, retirement accounts and life insurance policies, aside from their main functions, can often serve asset protection purposes.

Still, it is common for people concerned with potential liability (especially professionals whose professions makes them susceptible to lawsuits) to want to consider transferring assets to protect them from possible creditors. In determining whether such a transfer is advisable or effective, the first rule that must be considered is the fraudulent conveyance (or fraudulent transfer) rule.

The fraudulent conveyance rule prevents people from gifting away assets to avoid existing creditors. The general rule of thumb is that if the client already has creditor problems before a transfer is made, there’s probably little that can be done to shield assets from those creditors.[1] Family obligations such as equitable distribution, alimony and especially child support, are similarly difficult or impossible to evade by transferring the assets in question.[2]

The rules regarding fraudulent transfers come from case law, the Uniform Fraudulent Transfer Act[3] and the United States Bankruptcy Code for cases that involve bankruptcy filings.[4]

 There are two types of fraudulent transfers:

-              - “Actual” fraudulent transfers; and

-              - “Constructive” fraudulent transfers.

Actual Fraudulent Transfers

The most common types of actual fraudulent transfers occur when the person who owes money (the “debtor”) transfers assets after the debt arises with the purpose of frustrating the abilities of the creditors to get at those assets.

Let’s look at a few examples. Imagine that Joe owes Bank of America $25,000 in credit card debt. He has only $5,000 in his bank accounts. He gifts this $5,000 to his daughter, Jane, and then declares bankruptcy or negotiates with Bank of America, using the (accurate, now) argument that he has no money with which to pay the bank. This is a classic actual fraudulent transfer, and it can be undone by a court.

For these purposes, the creditors need not necessarily have obtained judgments. They need not, in fact, even have brought lawsuits. Any action to frustrate even potential creditors can be actual fraudulent transfers. For example, if a person has possibly committed a tort (such as negligently causing a car accident) or has been involved in a transaction for which she thinks she may be subjected to lawsuits, and then gifts assets to another person, this also would likely be considered a fraudulent conveyance. Even though it is not clear that she will be liable based on the accident or transaction, removing assets due to potential liability for events that have already occurred is considered fraudulent.  

The same thing is true in the case of marital property division. A person who fears losing assets or being subjected to alimony payments in a divorce proceeding and thus gifts assets to another person to avoid having to share those assets, has likewise engaged in a fraudulent conveyance.

Constructive Fraudulent Transfers

The constructive fraudulent transfers rule was established because determining the intent of a debtor who gifts assets is not always possible. A constructive fraudulent transfer occurs when a person transfers assets for no consideration or for less than market value at a time that he or she:

-                  - Is insolvent; or

-                  - Is about to engage or is engaged in a transaction or business venture for which he had an unreasonably small amount of capital; or

-                  -  Intends to incur debts that cannot reasonably be repaid.[5]

Constructive fraudulent transfer rules do vary based on the circumstances, and bankruptcy law has very specific constructive fraudulent transfer rules when the debtor declares bankruptcy after making the transfer, but these general principles apply to all constructive fraudulent transfers. For these purposes, “insolvency” may mean the inability to pay debts as they come due or that the debtor’s debts are greater than the values of its assets.

The Uniform Fraudulent Transfers Act adds that a gift transfer can be considered fraudulent if the donor:

-                      - was engaged or was about to engage in a business or transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction; or

-                      - intended to incur, or believed or reasonably should have believed that he would incur, debts that are beyond his ability to pay as they become due.

While there’s nothing inherently wrong with starting a business venture that is undercapitalized, it must be remembered that constructive fraudulent transfers are not criminal, or even civil, wrongs. They merely describe gift transactions that can be unwound to ensure that creditors are not denied their abilities to collect their just debts due to gifts they were unreasonable under the circumstances.

It’s important to note that it is NOT considered a fraudulent conveyance to transfer property in anticipation of liability, which basis has not yet arisen. A doctor can, for example, convey her house to her husband due to a fear of one day being subjected to a medical malpractice claim. If the malpractice has not already happened, there should be no problem with making this transfer. In fact, this sort of maneuver is quite a common tool among professionals who are at high risk of malpractice lawsuits. It is only once the basis for liability has occurred (in the case of medical malpractice, this would be the treatment gone wrong) that one may no longer gift assets to shield them from potential creditors.

While asset protection is an import goal of many estate plans, it is important to understand that there are limitations on the types of debts that can be avoided. The fraudulent transfer rules are an excellent first place to look for these limitations.