Financial strain often leads businesses and individuals to sell certain assets or the entire business operation to obtain funds. Purchasers have an opportunity to acquire these assets on favorable terms due to the distressed situation. But distressed transactions also present risks that should evaluated. It is likely that many transactions taking place during this COVID period have some element of these risks which could lead to lawsuits against the purchaser by the seller’s creditors or bankruptcy trustee should the seller file for bankruptcy post-sale.
Knowledge of risks in distressed sales assists with negotiations, due diligence, and preparation of deal documents. In this first post of a series we discuss the fraudulent transfer risk of a distressed sale.
When a person hears the word “fraud” images of schemes and theft jump to mind. But under Florida law and in many other states, a purchaser may become subject to fraudulent transfer liability without any bad intent from the purchaser. Fla. Stat. 726.105 addresses fraudulent transfers in Florida. There are two types: actual and constructive fraudulent transfers.
To establish actual fraudulent transfer claim a creditor must prove: (i) the existence of a creditor of the debtor/seller; (ii) a transfer of property available to pay debts; and (iii) the debtor/seller intended a fraud. Rarely does a debtor admit to committing fraud. Therefore, the intent element is determined by evaluating the “badges of fraud” which include:
(a) The transfer or obligation was to an insider.
(b) The debtor retained possession or control of the property transferred after the transfer.
(c) The transfer or obligation was disclosed or concealed.
(d) Before the transfer was made or obligation was incurred, the debtor had been sued or threatened with suit.
(e) The transfer was of substantially all the debtor’s assets.
(f) The debtor absconded.
(g) The debtor removed or concealed assets.
(h) 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.
(i) The debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred.
(j) The transfer occurred shortly before or shortly after a substantial debt was incurred.
(k) The debtor transferred the essential assets of the business to a lienor who transferred the assets to an insider of the debtor.
The risk to a purchaser of assets in this scenario is a lawsuit from a creditor of the debtor/seller who sells assets to obtain funds before assets are executed upon by creditors.
The second type of fraudulent transfer, a constructive fraudulent transfer, is less concerned with the intent of the transferor and instead focuses on the financials of the deal and the debtor/seller. A creditor of the seller suing a purchaser for constructive fraudulent transfers would have to establish that:
(1) the seller did not receive “reasonably equivalent value” in exchange for the transfer; and (2) the seller:
(a) 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;
(b) 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 (often referred to as “Cash Flow Insolvency”); or
(c) was insolvent at that time or the debtor became insolvent as a result of the transfer or obligation (known as “Balance Sheet Insolvency”).
Fla. Stat. 726.105.
This scenario may arise when a seller is attempting to sell at below market prices while insolvent or close to insolvency.
If a purchaser is found liable for a fraudulent transfer, then the seller’s creditor or bankruptcy trustee may obtain either: (i) return the asset or property fraudulently transferred; or (ii) a money judgment against the purchaser for the amount fraudulently transferred. This leaves the purchaser to pursue the seller who is likely defunct or without the ability to provide recovery to the purchaser.
Due diligence in a distressed transaction is important to address, among other things, liens or other encumbrances on the assets. It is also an opportunity to identify potential creditors by: (i) searching for filed lawsuits; (ii) review accounts payable for potential creditors; (iii) inquire into known creditors; and (iv) include representations regarding potential creditors in the transaction documents. This knowledge is helpful to understand the extent of exposure to litigation.
Additionally, valuation is important. Purchasing for less than “reasonably equivalent value” is one of the elements for a constructive fraudulent transfer. Appraisals or other approaches to determining value help to support the transaction. Further, its possible to value contingent liabilities to help determine solvency, a key element to element fraudulent transfer case.
Distressed sales offer substantial value to purchasers, particularly those who are aware of the risks and use this information to mitigate exposure or to negotiate further discounts. Due diligence, thoughtful transaction documents, and careful execution can help mitigate these risks. In the part 2 we discuss the different sales processes for distressed sales.
The information provided on this website is for informational purposes only and is intended as a public service. Any questions of a legal nature should be directed to an attorney, and the information on this website is not intended to replace legal advice from a licensed attorney in your state. By using this website, you acknowledge that you may not rely upon or refer to the contents as being legal advice or guidance provided by BMU Law, without its prior written consent.