After a break for the holidays, this is the third of an expected five-part series on fraudulent transfers. In my first blog, I laid out the basic statutory framework, as well as a described generally the difference between actual and constructively fraudulent transfer. In the second blog, we took a detailed look at the elements of a fraudulent transfer under both the Bankruptcy Code as well as Texas law. In this third installment, we will take a deeper dive into the badges of fraud that courts use to analyze the existence of actual fraudulent intent.
As we discussed in the last installment, one of the elements of an actual fraudulent transfer under either the Bankruptcy Code or the Texas Uniform Fraudulent Transfer Act ("TUFTA") is that the debtor transferred assets with actual intent to hinder, delay, or defraud any of the debtor's creditors. Whether a transfer was made with actual fraudulent intent is a fact question. Given that direct evidence of actual intent is rarely available (no one is going to readily admit that they intended to defraud their creditors), courts typically rely on circumstantial evidence, known as badges of fraud, to infer intent. Badges of fraud have been described as bridges that connect "questionable acts commonly associated with fraud to findings of actual fraudulent intent." 5 Collier on Bankruptcy ¶ 548.04(1)(b) (16th 2022).
The Bankruptcy Code does not explicitly list badges of fraud, but the Fifth Circuit has recognized the following badges of fraud in analyzing actual fraud under the Bankruptcy Code:
- the lack or inadequacy of consideration;
- the family, friendship or close associate relationship between the parties;
- the retention of possession, benefit or use of the property in question;
- the financial condition of the party sought to be charged both before and after the transaction in question;
- the existence or cumulative effect of the pattern or series of transactions or course of conduct after the incurring of debt, onset of financial difficulties, or pendency or threat of suits by creditors; and
- the general chronology of events and transactions under inquiry.
See Soza v. Hill (In re Soza), 542 F.3d 1060, 1067 (5th Cir. 2008) (quoting Chastant v. Chestnut (In re Chastant), 873 F.2d 89, 91 (5th Cir. 1989)). Other circuits have found used similar badges of fraud in their analysis of actual intent.
Under Texas law, TUFTA provides a non-exclusive list of badges of fraud that may be considered to find actual intent on the part of a debtor. The badges of fraud listed in the statute include:
- the transfer or obligation was to an insider;
- the retained possession or control of the property transferred after the transfer;
- the transfer or obligation was concealed;
- before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit;
- the transfer was of substantially all of the debtor's assets;
- the debtor absconded;
- the debtor removed or concealed assets;
- the value of consideration received by the debtor was less than reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred;
- the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred;
- the transfer occurred shortly before or shortly after a substantial debt was incurred; and
- the debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor.
Tex. Bus. & Comm. C. §24.005(b). Note that these badges of fraud derive from the Uniform Fraudulent Transfer Act, a form of which is in place in most states. Therefore, the analysis herein can be used in any state adopting or mirroring the Uniform Fraudulent Transfer Act.
Hereinbelow, we will take a closer look at these badges of fraud.
Badges of Fraud Under the Bankruptcy Code
Lack or inadequacy of consideration
The lack of consideration is a fairly straightforward badge. If a debtor transfers property for an amount that bears no reasonably resemblance to the value of that property, that is strong evidence that the debtor had ulterior motives in transferring that property. Trust arrangements can often run afoul of necessary consideration based on the fact that property is typically gifted to a trust.
Relationship between the parties
Although it's fairly common business practice for someone to transfer property to a business they control, such an LLC, other transfers to insiders can represent clear fraudulent intent. For example, a transfer of property to a brother-in-law shortly before filing bankruptcy or shortly before a lawsuit goes to trial could very well be challenged as a fraudulent transfer.
Retention of possession, benefit or use of the property in question
When a transferor of property retains effective control over the property despite a transfer of ownership, fraudulent intent may be inferred. For example, if a debtor puts a piece of property into an international trust, but then continues to live in it rent-free, that transaction could be viewed as having fraudulent intent.
Financial condition of the party sought to be charged both before and after the transaction in question
Transfers are considered suspect when the transferor had serious financial problems leading up to the transfer. Of course, some transfers are a normal part of business, but unusual transfers that are not considered made in the ordinary course of business will draw scrutiny when the transferor is struggling financially.
The existence or cumulative effect of the pattern or series of transactions or course of conduct after the incurring of debt, onset of financial difficulties, or pendency or threat of suits by creditors
This badge allows a court to take a bigger picture look at a series of transactions or other conduct that, although innocent enough in a vacuum, when viewed in combination reveals a clear pattern of fraudulent intent. It also incorporates a look at the threat of suits by creditors, which is its own badge of fraud under Texas law.
General chronology of events and transactions under inquiry
This final badge recognized by the Fifth Circuit, similar to the "pattern or serios of transactions," gives broad authority to courts to view a broad scope of conduct in identifying fraudulent activity that, standing along, might not rise to the level of fraud.
Note that, in the Fifth Circuit, numerous cases have found that a trustee can avoid the burden of proving actual fraudulent intent—or laboriously establishing different badges of fraud—in one situation: when there was a Ponzi scheme (the "Ponzi-Scheme Presumption"). The Fifth Circuit defines a Ponzi scheme as a "fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger investments. Janvey v. Alguire, 647 F.3d 585, 597 (5th Cir. 2011) (quoting BLACK'S LAW DICTIONARY 1198 (8th ed. 2004)). The Fifth Circuit reasoned that a Ponzi scheme is, "as a matter of law, insolvent from its inception." Warfield v. Byron, 436 F.3d 551, 558 (5th Cir. 2006). Generally, the Fifth Circuit has only applied the Ponzi-Scheme Presumption—meaning actual fraudulent intent is presumed, relieving a plaintiff from the usual burden of proof requirement—where it has expressly found the debtor or transferor operated a classic Ponzi scheme. See Warfield, 436 F.3d at 558–559; Janvey v. Alguire, 647 F.3d at 597–98; Janvey v. Brown, 767 F.3d 430, 439 (5th Cir. 2014); Sec. & Exch. Comm'n v. Res. Dev. Int'l, LLC, 487 F.3d 295, 301 (5th Cir. 2007); Quilling v. Schonsky, 247 F. App'x 583, 586 (5th Cir. 2007).
Badges of Fraud Under Texas Law
Unlike the Bankruptcy Code, Texas law actually identifies a non-exclusive list of badges of fraud. Each of these will be analyzed in turn:
Transfer to an insider
This badge of fraud, similar to the "Relationship between the parties" badge note above, focuses on the relationship between the transferor and transferee of property. The Bankruptcy Code and Texas law have virtually identical definitions of "insider" (compare11 U.S.C. §101(31) with Tex. Bus. & Comm. C. §24.002(7). Despite these definitions, the badges of fraud are generally flexible enough to expand these close relationships where necessary given the right set of facts.
Retention of possession or control of the property transferred after the transfer
This badge of fraud is similar to the retention of possession badge noted above.
Transfer or obligation was concealed
Concealing of a transfer is considered a badge of fraud. Although there can be many reasons to protect one's financial privacy, when a debtor is threatened or is under pressure from one or more creditors, concealing of transactions appears more suspect.
Recent Suit or Threatened Suit
Transfers occurring after a creditor threat has arisen are inherently more subject to challenge. Transferors should be prepared to provide plausible explanations for transfers occurring in such situations
Transfer was of substantially all of the debtor's assets
A transfer that leaves the transferor with little to no assets is wide open to challenge by a creditor. Establishing a business purpose other than protecting assets and avoiding creditors becomes more difficult when the transferor has few or nominal value in remaining assets.
The Debtor Absconded
This is somewhat of an obvious badge of fraud – when a debtor skips town immediately after making a transfer of assets. Usually this badge will be accompanied by other badges and should be viewed in context. Obviously, going out of town on a business trip is not the same as skipping town and taking all valuable assets that could be used to satisfy creditors with you.
The Debtor Removed or Concealed Assets
Similar to the concealing of the transfer itself, concealment of assets will similarly draw scrutiny from a fraudulent transfer perspective. Debtors facing lawsuits or other liabilities should avoid any drastic removal of assets so as to avoid this badge.
Receipt of Less Than Reasonably Equivalent Value
Many fraudulent transfer cases turn on an analysis of "reasonably equivalent value." While some of the other badges of fraud are more obvious, comparing the relative value of what was transferred with what was received often involves a very technical analysis. Sometimes, experts must be retained to provide valuation comparisons of property transferred.
Similar to the financial condition badge noted above, establishing the insolvency of the transferor is one badge of fraud. However, at least one court has concluded that insolvency, along with the existence of pending litigation, is one of the least probative badges of fraud, as they are present in the majority of cases. See e.g., Yaquinto v. CBS Radio, et al., Adv. Proc. No. 19-03226-sgj (Bankr. N.D. Tex., July 13, 2022).
Transfer occurred shortly before or shortly after a substantial debt was incurred
Occasionally, transferors will make anticipatory fraudulent transfers – recognizing that they are about to take on debt that they will not be able to satisfy. Therefore, an additional badge of fraud is the existence of a substantial debt taken on by the transferor shortly before or shortly after the transfer.
Debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor
This badge is basically a combination of other badges to capture a situation where a debtor ultimately accomplishes the result of a transfer of property to an insider or close associate. In this scenario, it occurs by way of a transfer first to a person or entity with a lien on the assets but ultimately to an insider.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.