Facing financial distress, businesses may resort to various strategies to mitigate losses, including filing for bankruptcy.
However, bankruptcy law is complex, and improper actions taken by businesses and their owners to shield assets can lead to serious consequences. If you intend to file Chapter 11 bankruptcy and reorganize, you need to be wary of crucial mistakes – including fraudulent conveyance.
What is fraudulent conveyance?
In bankruptcy law, fraudulent conveyance occurs when a debtor transfers assets to some other party in a way that hinders, delays or defrauds their creditors. It’s illegal because it ultimately undermines the bankruptcy process and the principle of equitable distribution of assets among the debtor’s creditors. A fraudulent conveyance can generally either be considered an act of actual fraud or constructive fraud.
What is actual fraud in fraudulent conveyance?
Actual fraud involves a deliberate transfer of assets with the actual intention to defraud creditors. This can include transferring property or funds to a family member, friend or even another business entity for the sole purpose of avoiding payment to creditors during the impending bankruptcy. It’s a method of asset diversion that’s wholly illegal.
For example, imagine a business owner who anticipates an upcoming bankruptcy. Worried about what assets they may lose in the bankruptcy, they transfer a valuable piece of real estate to a family member for significantly less than its fair market value, intending to recover the property after the bankruptcy proceedings.
What is constructive fraud in fraudulent conveyance?
Constructive fraud, by comparison, lacks the same deliberateness. It occurs when a transfer lacks proper consideration and the debtor was either already insolvent or became insolvent as a result of the transfer. (The intent to defraud is not a necessary element; rather, it focuses on the consequences of the transfer.)
For example, imagine a struggling business sells its entire inventory to a related party for a token amount without receiving fair market value. It was an impulsive move because they were already in financial distress, but the temporary influx of cash still makes it impossible for them to repay their creditors.
What about paying for ordinary business expenses during bankruptcy?
This is not the same as a fraudulent conveyance. While the concept of fraudulent conveyance aims to prevent dishonest asset transfers, businesses are not prohibited from continuing to pay for ordinary business expenses and supplies during periods of financial distress and while in bankruptcy proceedings. The key is to ensure that these transactions are made in the ordinary course of business and for fair consideration.
Payments for regular, ongoing business expenses such as rent, utilities, employee salaries and necessary inventory or supplies are typically considered in the ordinary course of business. These transactions are less likely to be challenged as fraudulent conveyances by creditors or the bankruptcy trustee.
The payment for goods or services must also be fair and reasonable relative to their market value. Continuing to make payments for necessary and legitimate business expenses ensures that the transactions are not flagged as attempts to defraud.
When businesses face financial challenges, it is crucial to uphold ethical practices and abide by bankruptcy laws. By continuing to pay for ordinary business expenses and supplies fairly and transparently, businesses can navigate financial distress while avoiding problematic repercussions. Legal guidance before and during the bankruptcy process can make compliance with the law a lot easier.