A fraudulent transfer or voidable transfer must be avoided if possible when protecting your assets. If you are working out an asset protection plan for yourself, then you should be aware of what you can and cannot do.
Now, it probably won't surprise you to learn that the government places a number of checks on your ability to protect your assets. And chief among these is the limitation on fraudulent transfer.
Fraudulent transfer, also known as fraudulent conveyance, involves moving your assets nominally out of your possession in order to render yourself insolvent, or "judgment proof."
You see, it's an inescapable fact that someone can only successfully be sued if they have the assets to pay the judgment. If they do not, then even if the creditor wins the case, there will be nothing to recover.
People who commit fraudulent transfer are attempting to take advantage of this fact by making themselves appear broke in order to make the courts think that they cannot pay the judgment, while actually retaining their assets.
As you can imagine, courts aren't happy about this, and fraudulent transfer laws are designed to curb the practice. If you are found to have committed a fraudulent transfer, then that transfer will likely be voided, and you might even find yourself in more serious trouble.
So, what makes fraudulent transfer different from legal asset protection? In this article, we will explain.
A Brief History Lesson
Fraudulent transfer has been around for thousands of years. As long as there have been debts, there have been people who attempted to avoid those debts by transferring their assets away from themselves.
Fraudulent transfer laws can be traced back at least to Roman law. However, our modern understanding of the concept dates back to the year 1571.
In England, it was the thirteenth year of the reign of Queen Elizabeth I. During this time, wealthy debtors would frequently hide their assets from creditors by "selling" their property to a co-conspirator for a token amount of money, then taking refuge in a church or other recognized legal sanctuary and waiting out the creditor. Once this was done, the debtor would emerge and once again take control of their assets.
In order to curb these practices, Parliament passed the Statute of 13 Elizabeth. One of the foundational cases which established its authority (Twyne's Case in 1601) involved a shepherd ostensibly selling his sheep to another party in order to avoid a creditor, but continuing to own them in all but name.
Of course, if you find yourself facing bankruptcy today, you likely won't be dealing in sheep. But the underlying legal principles have not changed substantially since the sixteenth century.
In the United States, fraudulent transfer is mostly governed by the Universal Fraudulent Transfer Act, a model legal code adopted by most states, including California, and recently renamed the Universal Voidable Transactions Act. Despite the change of terms, though, the Universal Voidable Transactions Act deals with the same thing.
Fraudulent Transfer in California
As defined by California Civil Code § 3439.04 a fraudulent transfer is:
- Any transfer which is made with the intent to defraud a creditor; or,
- Any transfer which occurs without receiving something of equivalent value in exchange, if this has the effect of making the debtor unable to pay their debts.
Usually, establishing fraudulent transfer involves demonstrating that you had an intent to defraud. The burden of proof for this is on the creditor, and they will have to prove it by a preponderance of the evidence (i.e. more likely than not) standard.
How do courts determine whether you had an intent to defraud? There are a number of considerations, known as badges of fraud, which they take into account in making this determination.
Badges of Fraud
The State of California recognizes 11 badges of fraud. While some of them deal with similar considerations, it's worth listing them all here.
- Whether the transfer or obligation was to an insider.
- Whether the debtor retained possession or control of the property transferred after the transfer.
- Whether the transfer or obligation was disclosed or concealed.
- Whether before the transfer was made or the obligation was incurred, the debtor had been sued or threatened with suit.
- Whether the transfer was of substantially all the debtor's assets.
- Whether the debtor absconded.
- Whether the debtor removed or concealed assets.
- Whether the value of the consideration received by the debtor was reasonably equivalent to the value of the asset transferred or the amount of the obligation incurred.
- Whether the debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred.
- Whether the transfer occurred shortly before or shortly after a substantial debt was incurred.
- Whether the debtor transferred the essential assets of the business to a lienor that transferred the assets to an insider of the debtor.
It's important to note that while these are the enumerated badges of fraud, they are not the only factors that courts can consider. If there are other factors which may be relevant, then they may take these into account as well – which might work for or against you, depending on the case.
How many of these badges of fraud will the court need in order to prove that your transfer was fraudulent? There's no set number, although certainly the more badges there are, the more likely it will be. In the end, it's a holistic decision by the court based on the totality of the evidence.
How to Avoid Badges of Fraud
In steering clear of these badges of fraud, there are a few major considerations.
The first of these is timing (addressed by Badges 4 and 10). This is perhaps the most important consideration which the court take into account. If you were already facing a lawsuit or debt at the time of the transfer, or if there was a lawsuit or debt on the horizon, even if one had not been officially filed yet, then this will make a finding of fraudulent transfer much more likely.
In order to be legally viable, asset protection must be centered around potential future threats to your assets, not specific impending threats. Remember: once you need to protect your assets, it is probably too late to legally protect your assets. Asset protection must be done proactively rather than reactively.
As what point in a case does a transfer become fraudulent for certain? This is not an entirely settled question. One judge may consider a transfer made at a certain time legitimate, while another might consider the same transfer made at the same time to have been fraudulent.
Just because a lawsuit has begun does not completely prevent you from engaging in a transfer. Remember, there are several stages of a lawsuit – the hiring of an attorney by the plaintiff, the filing of the lawsuit, discovery, subpoenas and depositions, pretrial motions, and so forth. The longer you wait in the process, the more likely a transfer will be to be seen as fraudulent.
That is why it is so important to be timely in seeking legal help on this matter. The longer you wait to make a transfer, the worse off you will be! If you are in any doubt, then speak to an attorney posthaste.
The second major factor is amount. This applies on two levels: the amount of the assets you transferred (Badges 5 and 9), and the amount you got in return (Badge 8). Regarding the first point, the entire purpose of a fraudulent transfer is to make yourself seemingly insolvent, and so if you transfer all of your assets, or enough to render yourself effectively judgment proof, then this will count against you.
The second point is closely intertwined. If you transferred your assets to another party, and received something in exchange that was far less than the fair market value of the assets that you transferred, the courts will likely see this as a sign that you were attempting to make yourself insolvent rather than to engage in a legitimate transaction.
In essence, don't give up a large portion of your assets, and if you do, then at least make sure that you get something of approximately equal value in return.
The third major factor is proximity to the other party involved in the transfer (Badges 1 and 11). If you transfer your assets to an insider, such as a family member, personal friend, or business associate, then this will make it more likely that you will be seen as having committed a fraudulent transfer. The same applies if you try to get around this by transferring the assets to a third party who then transfers them to an insider.
Remember, the most common fraudulent transfer method involves giving your assets to someone who you can trust to return them to you after you are out of legal trouble, and who will allow you some control of them in the meantime.
That brings us to our fourth factor: control (Badge 2). Remember the shepherd in Twyne's Case who made it seem like he'd sold his sheep but kept possession of them for all practical purposes? The same principle applies here. If you allegedly sell your property to someone, but keep using it, this will count against you.
Finally, there's the issue of transparency (Badges 3 and 7). Don't hide a transaction from the court, and don't hide any of your assets to make it seem like you have less than you actually do. Disclose all of the necessary information to the court. A lie of omission is still a lie, and will hurt you substantially in this regard.
Also, don't flee to another jurisdiction, conceal yourself, or otherwise abscond (Badge 6). Self-explanatory.
Actual versus Constructive Fraud
All of these abovementioned badges of fraud are meant to establish fraudulent intent. This is used to determine whether you have committed actual fraud.
However, there is a whole other category of fraudulent transfer that does not require this establishment of intent. This is known as constructive fraud.
If you sell an asset for less than its fair market value, and if you are insolvent at the time of the sale or become insolvent shortly after this point, then a court may find that you committed constructive fraud even if you had no intention of doing so.
This is covered by California Civil Code § 3439.04(a)(2), which includes transfers "without receiving a reasonably equivalent value in exchange for the transfer or obligation" within the definition of fraudulent transfer.
Fair market value, of course, is somewhat subjective, but not entirely. And in most cases, people want to get as much value as possible out of their assets. If not, then this doesn't mean you did anything morally wrong – perhaps you were simply a poor negotiator, or wanted to cut someone a break, or didn't particularly care about that asset.
Still, courts can void these transfers. So be careful!
What Happens If I Commit Fraudulent Transfer?
Fraud is a crime (and a rather scary-sounding word, too). But fraudulent transfer, at least as we have been discussing it thus far, is a civil offense rather than a criminal one. The California Civil Code gives the court no power to imprison you or impose other criminal penalties.
Most of the time, if a court finds that you have engaged in fraudulent transfer, then your transfer will be voided (as implied by the term "voidable transaction"), and the asset will be given to the creditor. The creditor may also obtain an injunction to prevent you from transferring the asset again.
Fraudulent transfer does have the potential to be treated as a crime, though. According to California Penal Code § 154, fraudulent transfer is a misdemeanor, which rises to the level of felony if more than $250 worth of stocks are involved.
Don't get too worried: this provision of the penal code is rarely enforced, and unless your conduct was particularly egregious, you are extremely unlikely to face criminal penalties. The criminal statutes, however, do give creditors an advantage in that they can allow the creditor to obtain privileged communications between you and your attorneys that they might otherwise have been unable to access.
Not only that, but attorneys who advise their clients to engage in fraudulent transfer, or assist them in doing so, can have very stiff penalties imposed upon them by the State Bar of California.
Finally, it's worth noting here that fraudulent transfer applies on the federal as well as the state level (see §?548 of the U.S. Bankruptcy Code). So this will be a concern even if you are sued in federal court!
Choosing the Right Attorney
While constructing your asset protection plan, it is important to hire an attorney with two main qualifications.
First, your attorney must be competent. This means that they must understand exactly what constitutes fraudulent transfer, and how best to steer clear of it.
Remember, the line between legitimate asset protection and fraudulent transfer is not always a bright one. At times, it can be murky and subjective, contingent upon the whims of the court. That is why you need someone with a good deal of experience to help guide you through this potential minefield.
Second, your attorney must be ethical. They must be someone who will advise you responsibly and not get you into trouble by telling you that a certain strategy is permitted when it actually isn't.
To this end, it is important to shop for attorneys carefully and get as many opinions as possible. In order to protect the assets that you have spent your life acquiring, you should only work with someone you can trust.
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.
