30: Constructive fraud

© Charles Tabb 2010

proof of certain specified facts conclusively establishes that transfer is fraudulent◦ irrespective of DR’s actual subjective intention

strict liability -- redress inherent creditor injury

What is “constructive” fraud?

1) useful surrogate for actual fraud

2) some transfers by their very nature injure creditors of the debtor

focus of constructive fraud on the victims – the creditors – rather than on Dr

rationales

2 parts:

1) lack of “reasonably equivalent value”◦ Or “fair consideration” UFCA

PLUS

2) sign of financial distress:◦ A) insolvent or rendered insolvent *MOST important◦ B) unreasonably small capital◦ C) incur debts beyond ability to pay as mature

Structure of constructive fraud

“be just before you are generous”

maxim

Constructive fraud?

(1) – debtor (Generation) was insolvent at time it sold the customer lists

(2) was sale to McGraw-Hill for “reasonably equivalent value”?◦ Sold for $150K, not know value – but originally

asked for $500K

Alan Drey, reprise

If were under UFCA (i.e., in New York), the value comparison prong is “fair consideration”

Defined as 2 facets:◦ Fair equivalentand◦ Good faith – meaning of the transferee (e.g., McGraw-

Hill)

So if were a UFCA case, EVEN IF said the value was equivalent, if find that transferee not in good faith, find ≠ “fair consideration”

“fair consideration”

Constructive fraud?

Again, Farmer Jones was insolvent

However, transfer of mortgages to brother-in-law Dean was for reasonably equivalent value, b/c made the mortgage transfer in exchange for a loan (Dean “took up” Jones’ defaulted & forged bank notes)◦ Caveat - might not be “fair” consideration UFCA

Dean v Davis, reprise

Facts:◦ Debtor owes 10 creditors $50K; in default on 7 debts◦ Five creditors bring lawsuits against the Debtor ◦ Debtor’s only nonexempt asset is a valuable painting

she inherited from her father, worth $40K ◦ Debtor sells the painting to Art Mann, a wealthy

collector, for $38K ◦ Art Mann knows nothing of Debtor’s financial situation◦ Debtor deposits the cash in her bank, wire transfers

the money to a Swiss bank, and disappears ◦ Two months later, an involuntary chapter 7 order for

relief is entered against Debtor

9.5(a)

Dr insolvent?◦ YES – debts = 50, assets = 40

Less than “reasonably equivalent value”?◦ NO ◦ Art paid 38, that is “reasonably equivalent” tp the

painting’s value of 40

◦ SO – NOT avoid as constructive fraud

Analysis 9.5(a)

Same facts, but sell painting for $20K, not $38K, and is worth $40K

Now IS constructive fraud:◦ Insolvent, yes, 50 v 40 {indeed, is even worse, b/c

is “rendered” even more insolvent – after sale, has only 20 in assets (cash) vs 50 in debts}

◦ Less than Reasonably equivalent value?, Yes, 40 v 20

9.5(b)

Sells for $38K to Mom

Under Bk Code and UFTA, NOT constructive fraud, b/c = REV (40 v 38)

Under UFCA, possible is = constructive fraud, b/c not “fair consideration” – require fair equivalent in value (ok, 40 v 38) AND “good faith” of transferee (Mom) – whose good faith might be called into question

9.5(c)

Gives painting to Mom

Obviously = constructive fraud

1) insolvent 2) no REV – a gift

9.5(d)

Donate to Art Institute

Constructive fraud -- yes 1) insolvent - yes 2) no REV – yes, gift

What about safe harbor for charitable contributions in 548(a)(2), which applies to constructive fraud under 548(a)(1)(B)?

• Art Institute is a qualifying charity, 548(d)(4)

• But safe harbor n/a -- transfer must be cash or a financial instrument, 548(d)(3)(B) – not a painting!

9.5(e)

Facts of Durrett – mortgage sold at foreclosure for $115K, allegedly worth $200K, while Dr insolvent, within one-year reachback period (now is 2 years)

Issue- was foreclosure for 115 “REV” to estimated value of 200?◦ Policy – foreclosure deprived estate of $85K

5th Circuit, 1980,held NOT REV and thus = constructive fraud

Mortgage foreclosures

Before Durrett, no one had thought to set aside a mortgage foreclosure as FT ◦ Instead, only challenge under mortgage law – if

price so low as to “shock the conscience”

◦ Threw real estate law, & securityof land titles, into shock

watershed

Some debated issues:◦ 1) does foreclosure even qualify as transfer? Argued not:

A) involuntary by DR

B) the “transfer” made back when mortgage granted & recorded, not when mortgage foreclosed

◦ 2) presumptively valid if follow state procedures? A) rebuttable presumption is ok – but can still look at value B) conclusive validity if follow state procedures – UFTA 3(b)

“a person gives a reasonably equivalent value if the person acquires an interest of the debtor in an asset pursuant to a regularly conducted, noncollusive foreclosure sale” - 1984

Interim sparring, 1980-1994

1) Congress amended Bk Code -> FT does include involuntary transfers – including foreclosures:

548(a)(1) -- “if the debtor voluntarily or involuntarily-” 101(54) dfn “transfer”: “means– …

(C) the foreclosure of a debtor's equity of redemption; or

(D) each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.

2) changes Congress did NOT make –>considered, but then did NOT adopt, provision ~ UFTA 3(b), which makes following regular procedures per se = REV

1984 amendments

Facts:◦ 1987: DR (BFP) borrow money from Imperial to

buy house, grant Imperial deed of trust, recorded◦ July 1989: foreclosure, for $433K (to Osborne)◦ October 1989: Dr filed ch. 11◦ Dr as DIP sued to set aside under 548

Allege property worth $725K, thus not = REV

BFP

1) transfer of interest of Dr in property w/in one year* of bankruptcy [* now two years]◦ Court not dispute that 1984 amendment made the

1989 foreclosure the “transfer” – not 1987 original transfer of deed of trust & recordation

2) while Dr insolvent ◦ conceded

3) less than “reasonably equivalent value”◦ DIP argued that 433 not REV to 725◦ Δ argue since followed state law process, per se = REV

Elements constructive fraud

foreclosure sale price must conclusively be deemed to constitute "reasonably equivalent value,“ if sale was noncollusive and regularly conducted in compliance with state law

◦ =

◦ i.e., irrebuttable presumption:whatever $ receive at proper foreclosure = REV

Value comparison of price received at foreclosure sale vs alleged FMV is irrelevant

SCOTUS holding

Justifications 1) Value comparison meaningless in

foreclosure context ◦ “simply worth less”

◦ “very antithesis” ≠

2) federalism◦ Security of land titles◦ “ancient harmony” … “400 years of peaceful

coexistence”

1st – effect of decision is to immunize mortgage foreclosures from attack as a fraudulent transfer, which is directly at odds with what Congress did in 1984 amendments

Dissent?

2nd, “ordinary speaker of English” – “Reasonably equivalent value” mandates a value comparison between something◦ But under majority view isn’t a question even

worth asking, b/c will always be satisfied

Dissent, cont.

Policy: federal bankruptcy policy – maximize estate

Net effect of decision is to cause estate to lose $292K in value

Dissent, cont.

In constructive fraud cases, the decisive issue often is whether the Dr received less than “reasonably equivalent value” in exchange for the transfer

Assuming can prove the requisite financial distress, typically that Dr = insolvent

What is “reasonably equivalent value”?

Why does the value issue matter?

Because if Dr was insolvent, and transferred assets and got less back, her crs are worse off – recoverable asset pool depleted

good bad

Justification?

transfer

Creditors

Often said that value must be measured from the perspective of the creditors of the Dr, not from the Dr's perspective◦ E.g., Comment to UFTA: "'Value' is to be

determined in light of the purpose of the Act to protect a debtor's estate from being depleted to the prejudice of the debtor's unsecured creditors. Consideration having no utility from a creditor's viewpoint does not satisfy the statutory definition.”

Creditor’s perspective

REV ≠ “Consideration” Thus, REV for FT purposes is not the same

as “consideration” for K law purposes

Hypo: ◦ Sell Blackacre (worth $100K) to Fred for $40K◦ Would = “consideration” under K law◦ But ≠ “REV” for fraudulent transfer law

transfer drains $60K out of the Dr’s asset pool

Must be careful not to view “REV” as a pure “how deep is the pool before vs after” Q

Hypo:◦ Dr has $1000 in cash, only asset, and $20K debts◦ Dr goes to opening day for Cubs, pays $100 for

ticket◦ Now has only $900 left – Crs are worse off, right?

so, is the purchase of the Cubs ticket a constructively fraudulent transfer?

What about consumption?

Except from the point of view of St. Louis Cardinals fans, Dr got “value” when bought Cubs ticket◦ Even though depleted her recoverable asset pool

Why? The ticket conveyed the right to attend the baseball game – a fair market transaction◦ Can see this from fact Dr could have resold the

ticket (e.g., StubHub) instead of actually going to the “friendly confines”

Cubs ticket = “Value”

For same reason, would be “value” for FT purposes if DR ate dinner at a fancy restaurant (comparison court used in Chomakos) – even though after dinner Dr had fewer leviable assets◦ Dr has to pay for dinner!

A present debt that must be satisfied, = “value”

Dinner also “REV”

Can justify the consumption cases as not violating the rights of creditors and as obtaining a “REV” for Dr’s transfer if insist on compliance with an objective market determinant of value

If Creditors worry that Dr is “consuming” too much (e.g., too many Cubs games, too many fancy dinners), the recourse is for Crs to commence an involuntary bk case – strip Dr of power to decide how to deploy her assets

Objective market determinant

Church contribution cases Series of cases in 1990s (prior to 1998)

raised issue of whether = FT for insolvent Dr to tithe to his church in year before bk

Only question was whether the donations to church were for “REV”◦ If not, then indisputably = FT

What arguments on value issue in church cases?* is this the same as going to Cubs game or not?

Specific result in charitable contribution cases was changed in 1998 when Congress created a safe harbor for charitable contributions◦ Not change the theory in FT law, just a political

deal

Limits:◦ Only if constructive fraud◦ Up to 15% dr’s income◦ Note must be cash or financial instrument

1998 safe harbor

Before filed bankruptcy, George & Nikki Chomakos gambled a lot at the

Flamingo Hilton Net, came up $7,710 in the hole Were insolvent the whole time

Trustee sought to recover the losses as constructively fraudulent◦ Insolvent -- conceded◦ No “REV” – this is the issue

Gambling cases - Chomakos

Trustee’s arguments why ≠ REV? Lost more than they won, which hurt Crs

House advantage – casino bound to win over time – odds are stacked

If church loses, surely casino must too!

vs

Have to measure at the time of the transfer, when the bet is made – BEFORE the outcome of the bet is determined

Here, there was a mathematical chance would come up as 24

When measure value?

Remember our discussion of the valuation fallacy, using the shell game

Dr placed a $3 bet on the pea being under shell # 1 – if wins, gets $9 (i.e., no house advantage)

When placed bet, had a 1/3 chance of being right

So ex ante, value of chance = 1/3 x $9 = $3 For FT, argue got exact value in exchange

for $3 bet

Valuation fallacy

In prior hypo, what if shell entrepreneur would only pay $3.33 on a winning $3 bet?

Now of course value Dr receives ex ante = 1/3 x $3.33 = $1.11

Which arguably is not “reasonably equivalent” to the $3 bet the Dr placed

Stack the odds?

assume Dr has debts of $12K, assets of $10K◦ i.e, is insolvent

Dr risks her entire $10K on a 50-50 bet (a flip of a coin)

payoff if the Debtor wins is $20,000 (i.e., no house advantage).  Of course, if she loses the bet, the payoff is zero.

Question: calculate the projected payout – before the coin is flipped --  from the perspective of (i) Creditors and (ii) Debtor.

Valuing risk?

Value of bet -> Perspective of Creditors:

.5 (12) + .5 (0) = 6[win–pay in full] + [lose – get nothing]

* If no bet, Crs get 10 (i.e., all Dr’s assets)

Value of bet –> Perspective of D

.5 (8) + .5 (0) = 4* If no bet, Dr gets nothing (insolvent, Crs get

everything)

Risk & value

From perspective of Creditor group, then, this is a bad bet – even though the Dr had a 50-50 chance, and even though there were no house odds – the payoff to the Creditors was way less than the value transferred

The reason is that the Creditors enjoy little of the upside from a winning bet (only 2 grand), and all of the downside from a losing bet

in short, the Dr is gambling entirely with the Crs’ money! Dr gets all the upside, no downside

other people’s $

The risk/reward calculus for insolvent or almost insolvent Drs has led to a perception of the proper role of FT law as a means of regulating Drs from taking excessive risk when fall into or would become insolvent

Do we want Dr who has become insolvent to be able to bet all of their assets on # 24?

FT law as regulating excessive risk

compare gambling as “value” to:

Cubs

Dinner

Church donation

Is gambling like going to see Cubs? Dinner? Church?

Are there any limits on the “it was fun for me” theory of value?

What if DR’s favorite form of entertainment, from which he derived unspeakable joy, was to light his money on fire and watch it burn?◦ assume this Dr was insolvent

How far does “psychic” value go?