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Transcript of proof of certain specified facts conclusively establishes that transfer is fraudulent ◦...
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?