Proving Insolvency in Fraudulent Transfer Actions

By:  Brandon C. Meadows, Esq. and Frankie Velez, J.D. Candidate 2018

There are two primary types of fraudulent transfers contemplated under Florida’s Uniform Fraudulent Transfer Act (“FUFTA”)—actual fraudulent transfers and constructive fraudulent transfers.  When a debtor makes a transfer with “actual intent to hinder, delay or defraud” a creditor—that is, “actual fraud” under Fla. Stat. 726.105(1)(a)—insolvency of the debtor is largely irrelevant.  However, the drafters of the statute understood the difficulty in proving intent, finding that a transfer could be deemed constructively fraudulent, upon a showing that the debtor was insolvent at the time of the transfer.  In other words, constructive fraud does not hinge on the debtor’s intent, but rather the economic effects of the transfer.

Due to the practical difficulties in proving “actual fraud”, many aggrieved creditors often seek to prove constructive fraudulent transfers, bringing the issue of the debtor’s insolvency to the forefront of fraudulent transfer litigation.  If the economic effects of the transfer were to leave the debtor insolvent, then the creditor may obtain relief.  Whether prosecuting or defending fraudulent transfer claims, practitioners should be aware of the types of insolvency contemplated by FUFTA, and the various ways or proving it.

The Significance of Insolvency in the Various “Types” of Fraudulent Transfers

Under FUFTA, a debtor is considered “insolvent” when the “sum of the debtor’s debts is greater than all of the debtor’s assets at fair valuation.”  Fla. Stat. § 726.103(1).  “Section 726.103(1) provides a definition the courts label the “balance sheet test.”   Balsamo v. Grippe Ceramiche Richetti, S.P.A., 862 So. 2d 812, 814 (Fla. 4th DCA 2003). Additionally, there is a presumption of insolvency when a debtor “is generally not paying his or her debts as they become due.”  Fla. Stat. § 726.103(2).  In other words, “Cash Flow” insolvency gives rise to a presumption of “insolvency” under FUFTA.

Insolvency is not wholly irrelevant in proving actual fraudulent transfers.  In fact, insolvency is among the many factors—“badges of fraud”—that a court may consider in determine whether a debtor possessed the requisite intent to hinder, delay or defraud.  Fla. Stat. 726.105(2)(i).  While the transferor’s insolvency is an indicia of fraudulent intent, it is certainly not dispositive of actual fraud.

Just as fraudulent transfers can be categorized as either actual and constructive, the statute further identifies specific economic effects that may constitute a claim for constructive fraudulent transfers.  Specifically, there are three separate provisions of FUFTA that govern constructive fraud—§§ 726.105(1)(b); 726.106(1) and 726.106(2).

Under § 726.105(1)(b), governing fraudulent transfers as to present and future creditors, the creditor must prove two things:

  1. The debtor made a transfer without receiving reasonably equivalent value;
  2. “[A]nd the debtor” did either of the following:
  • Was engaged or was about to engage in a business or a transaction for which the remaining assets of the debtor were unreasonably small in relation to the business or transaction (“Unreasonably Small Capital”); or
  • Intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due (“Cash Flow Insolvency”).

Fla. Stat. § 726.105(1)(b).

Likewise, constructive fraud under § 726.106(1) governing fraudulent transfers as to present creditors focuses on the economic effect of the transfer—again requiring proof of both reasonably equivalent value and insolvency—and providing the following:

A transfer made or obligation incurred by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made or the obligation was incurred if the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange for the transfer or obligation and the debtor was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation.

Fla. Stat. § 726.106(1) (emphasis added).

Lastly, a transfer to an insider may be deemed constructive fraud under § 726.106(2), which states:

A transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the transfer was made to an insider for an antecedent debt, the debtor was insolvent at that time, and the insider had reasonable cause to believe that the debtor was insolvent.

Fla. Stat. § 726.106(2) (emphasis added).

In sum, FUFTA recognizes two basic types of insolvency: Cash Flow Insolvency and Balance Sheet Insolvency.  Irrespective of actual fraud, it is implicit in FUFTA that a solvent debtor may make transfers with impunity.  If, after the transfer, the transferor is paying debts when due, there is no presumption of insolvency based upon cash flow.  If, after the transfer, the debtor still has a positive net worth, then there is no balance sheet insolvency.  Essentially, if the debtor pays its bills and has sufficient assets to cover liabilities, there is no injury to the creditors under FUFTA.

Balance Sheet Insolvency Test

The Balance Sheet test requires the court to analyze the “comparison of the ‘fair value’ of all of the debtor’s assets with the face or ‘stated’ value of its liabilities on the relevant date.” In re Winstar Comm’ns, Inc., 348 B.R. 234, 247 (Bankr. D. Del. 2005).  The timing of the solvency analysis will play crucial role as well.  Solvency is determined as of the transfer date, not at the time suit is filed.   “For the purpose of a solvency analysis . . . assets and liabilities must be valued based upon information known or knowable as of the date of the challenged transfer.”  In re Commercial Fin. Servs., Inc., 350 B.R. 520, 541 (Bankr. N.D. Okla. 2005).

When calculating fair valuation of the debtor’s assets, it is important to understand which assets cannot be included in the analysis.  FUFTA defines “assets” as property of the debtor that does not include (i) property to the extent it is encumbered by a valid lien; (ii) exempt property; and (iii) any interest in property held in tenancy by the entireties to the extent it is not subject to process by a joint creditor.  Fla. Stat. § 726.102(2).  FUFTA further excludes certain assets and contemplates liabilities of the debtor in the solvency analysis.  Specifically, § 726.103(4) excludes the asset that was fraudulently transferred, and § 726.103(5) excludes debts to the extent they are secured by a valid lien.  These exclusions make practical sense, as the aforementioned excluded assets are those that an unsecured creditor could not normally look to in satisfaction of the debt.  For purposes of determining whether a debtor is solvent enough to cover the debts owed to the creditor after a transfer, it is practical to only count those assets that are available to the creditor.

Cash Flow Insolvency Test

The cash flow test requires the court to determine whether a debtor is paying its debts generally as they become due.  In such cases, the court should consider the amounts of the debt and the due dates of the indebtedness.  Comment 2, § 2, UFTA.  “The court should also take into account such factors as the number of the debtor’s debts, the proportion of those debts not being paid, the duration of nonpayment . . . and other special circumstances alleged to constitute an explanation for the stoppage of payments.”  Id.

Notably, Fla. Stat. § 726.105(1)(b)(2) has a subjective element built into the statute, whereas the debtors must have “intended to incur, or believed or reasonably should have believed that he or she would incur, debts beyond his or her ability to pay as they became due.”  Fla. Stat. § 726.105(1)(b)(2).  Due to the subjective nature of the inquiry, this test is rarely litigated.  In re Suburban Motor Freight, Inc., 124 B.R. 984, n.4 (Bankr. S.D. Ohio 1990) (acknowledging few rulings on this test because it “appears to require the court to undergo a subjective, rather than objective, inquiry into a party’s intent.”).  However, courts may infer intent using a reasonable person standard.  In re WRT Energy Corp. 282 B.R. 343, 415 (Bankr. W.D. La. 2001).  Disproving the existence or inference of such intent or belief may be developed through testimony from debtor’s officers and principals based upon the projections of the debtor’s ability to pay debts when due.

Rebuttable Presumption of Insolvency

When a debtor is not generally paying its debts when due, there is a presumption of insolvency.  Fla. Stat. § 726.103(2).  The presumption is established in recognition of the difficulties typically imposed on a creditor in proving solvency—that is, insolvency is often evidenced by a general cessation of payment of debts, and financial information bearing directly on solvency is generally exclusively possessed by a non-cooperative debtor.  See Comment 2, § 2, UFTA.

Proof to rebut the presumption of insolvency, evidence “may include [the fact] that the sum of debtor’s debts are not greater than all of [the] debtor’s assets, or that other debts are being timely paid.”  Balsamo, 862 So. 3d at 814 (reversing summary judgment and recognizing that the Balance Sheet analysis is available to rebut insolvency presumption).

The Unreasonably Small Capital Test

The Unreasonably Small Capital test is considered a financial condition short of insolvency and refers to the “inability to generate sufficient profits to sustain operations,” because such inability must precede an inability to pay obligations as they become due.  Moody v. Security Pacific Business Credit, Inc., 971 F.2d 1056, 1070 (3d Cir. 1992).  An analysis of adequacy of capital should take into account “‘all reasonably anticipated sources of operating funds, which may include new equity infusions, cash from operations, or cash from secured or unsecured loans over the relevant time period.’”  Peltz v. Hatten, 279 B.R. 710, 745 (Bankr. D. Del. 2002).

Access to sufficient credit may be significant evidence of adequate capital.  The Moody court indicated that “it was proper for the district court to consider the availability of credit in determining whether [debtor] was left with an unreasonably small capital.” Moody, 971 F. 2d. at 1056, 1073.  Supporting the Unreasonably Small Capital Test is reasonable foreseeability—that is, “was it reasonably foreseeable on the [transfer] date . . . that [the debtor] would have unreasonably small capital to carry out its business?”  Peltz, 279 B.R. at 744.

Conclusion

In any fraudulent transfer action, a practitioner should know and understand the role that insolvency plays in proving actual and constructive fraud.  Further, when developing an asset protection plan, professionals should consider the economic effects that a particular transfer or transaction will have on the client, to avoid claims of fraudulent transfers in the future.

 

 

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