When Business Planning Triggers the Fraudulent Transfer Law

This article is adapted from The Fraudulent Transfer of Wealth: Unwound and Explained by David J. Slenn, available from the American Bar Association Business Law Section. Check out the related Book Chat video for more information.

Business Planning

Typical business planning transactions often can trigger fraudulent transfer law. Evidence of intent with respect to transactions involving an entity can be gleaned from direct evidence, but, like transactions involving individuals, is often gleaned from facts and circumstances. Resorting to the use of a business entity to hinder or delay creditors may result in avoidance under fraudulent transfer law.

In 1932, the Supreme Court decided a case involving a Pennsylvania lumber dealer who was unable to pay his debts as they came due and whose creditors were seeking payment. The dealer believed he could retain assets if a receiver was appointed. However, Pennsylvania did not permit the appointment of a receiver for a business conducted by an individual as distinguished from one conducted by a corporation. Consequently, the Pennsylvania dealer formed a Delaware corporation, then transferred all his assets in exchange for all the stock. The new corporation also assumed all the dealer’s debts. The dealer then sued in conjunction with a creditor against the new corporation.

Justice Cardozo noted the transfer to the corporation was fraudulent as well as the resulting receivership because it was part and parcel of a scheme whereby the form of a judicial remedy was to supply a protective cover for a fraudulent design. “A conveyance is illegal if made with an intent to defraud the creditors of the grantor, but equally it is illegal if made with an intent to hinder and delay them. Many an embarrassed debtor holds the genuine belief that, if suits can be staved off for a season, he will weather a financial storm, and pay his debts in full. Means v. Dowd, 128 U.S. 273, 281, 9 S.Ct. 65, 32 L.Ed. 429. The belief even though well founded, does not clothe him with a privilege to build up obstructions that will hold his creditors at bay.”

Limited liability companies

Because the asset protection trust is laced with evidence of intent to hinder creditors ab initio, the use of a limited liability company is tempting because it enjoys a disguise as a valid business entity unrelated to the owner’s personal creditor issues. However, if a creditor can show a debtor fraudulently transferred assets to an LLC (e.g., through a contribution of capital), the transfer to the LLC may be voided, just as a fraudulent transfer to a trustee of a trust may be voided. To the surprise of some planners, a contribution of capital in exchange for membership interests does not necessarily equate to “reasonably equivalent value.”

The limited liability company, and its charging order protection preventing creditors from reaching a member’s distribution until the LLC makes a distribution, is expressly permitted by most state laws. In a minority of states, an LLC need not have more than one member but still provide charging order protection. With an LLC, a veil of protection is created so that a business owner’s individual assets are protected from the claims of creditors of the business (inside creditors). This protection helps promote entrepreneurial spirit and is long recognized by the courts. “After all, there is nothing fraudulent or against public policy in limiting one’s liability by the appropriate use of corporate insulation.” But where the LLC is used as a trust substitute to protect assets from a member’s personal creditors, the member’s concern is not creditors of the business, but rather, the debtor’s personal creditors (outside creditors.)

LLCs as Trust Substitutes

Conceptually, the LLC is developing into a variant of the self-settled trust, where the rights of members and creditors are handled primarily by statutes, which in turn, permit the parties to do as they please under an operating agreement. This contrasts with centuries of developed case law and modern statutes adopting the case law as it applies to the use of trusts. With trust law, certain safeguards developed over time to protect creditors, the most obvious being the centuries old rule against self-settled trusts, which essentially provides one cannot use a trust to have his cake and eat it, too. The LLC and the law of contract, coupled with the benefit of not having to account to beneficiaries, are options for some to sidestep centuries of trust law and its protections for creditors and beneficiaries alike.

Today, some may attempt to enjoy the benefits of a self-settled trust in the form of an LLC. Managers can make decisions instead of trustees. The tax treatment can be replicated as well. A self-settled trust is usually treated as a so-called grantor trust in tax parlance, meaning the settlor pays the income tax on trust income. The LLC achieves the same result where it has a single member. This is because the default classification of a single-member LLC, for federal tax purposes, is to treat the LLC as disregarded (meaning all the tax consequences flow through to the member.)

The concept of a charging order has roots in trust law. At its core, a charging order is a lien on a debtor’s interest where a creditor has to wait for distributions to be made from a third party to the debtor before seizing the distributed property. In the trust setting, generally a court does not refer to this lien as a “charging order” but instead enters an order permitting a creditor to attach present and future mandatory distributions due to a trust beneficiary. If the trust is discretionary, a court may enter an order permitting garnishment of distributions when made in the discretion of a trustee.

According to section 736.0504(2), a former spouse may not compel a distribution that is subject to the trustee’s discretion or attach or otherwise reach the interest, if any, which the beneficiary may have. The section does not expressly prohibit a former spouse from obtaining a writ of garnishment against discretionary disbursements made by a trustee exercising its discretion. As a result, it makes no difference that the instant trusts are discretionary. Casselberry is not seeking an order compelling a distribution that is subject to the trustee’s discretion or attaching the beneficiary’s interest. Instead, she obtained an order granting writs of garnishment against discretionary disbursements made by a trustee exercising its discretion.

Where the trust is self-settled, generally, a creditor may reach the maximum amount that could be distributed to the settlor. Where a debtor does not contribute assets to a trustee but is merely a discretionary beneficiary of the trust (referred to as a third-party trust), the beneficiary’s interest generally is protected from creditors, at least until distributions are made.

Contrast with the LLC, which essentially takes a best of both worlds approach; the debtor-member may contribute assets to the LLC much like the debtor would a self-settled trust, however, the debtor-member is essentially treated as a beneficiary of a third-party trust because the LLC charging order statutes permit a creditor to reach distributions only if made by the LLC. If the LLC was treated like the self-settled trust, a creditor could, like a creditor of a beneficiary of a self-settled trust, take the maximum amount distributable to the member. With an LLC, this would mean foreclosing on the member’s interest, voting the member’s interest, etc.

But the LLC is not a trust; the LLC is a business entity. The charging order for purposes of trust law was meant to ensure a beneficiary could not thwart a creditor by enjoying the benefits of a trust despite an obligation to creditors. For LLCs (and partnerships), the charging order is justified on the grounds that a creditor should not step into the debtor’s shoes as a member of the LLC. Instead, the creditor may receive the same economic benefits the debtor member enjoyed. The goal with the LLC charging order is to prevent the creditor from interrupting other members of the LLC in conducting LLC business. But if there is no business other than dodging creditors, the public policy supporting the charging order weakens.

The law in some jurisdictions is written in a way that makes it difficult to disregard public policy. Like choice of law disputes in the trust context, debtors also attempt to hardwire the governing law of an operating agreement to force creditors to play by the rules of debtor-friendly states or countries.

In sum, the LLC is increasingly being used as a quasi-trust with the goal of protecting a member’s assets from the member’s personal creditors. Consequently, creditors who engage in discovery will look for evidence of the LLC serving as a personal use vehicle. This may lead to a court viewing the LLC as an alter ego or sham, permitting the creditor to reach the assets. Not only can general creditors rely on personal use evidence to reach assets, but the lack of a true business purpose can have negative consequences for federal tax law purposes.

Capital Contributions

In some cases, the contribution of an asset to a business entity is not meant to assist with business operations but instead intended to help the owner insulate the transferred asset from the claims of the owner’s creditors. Fraudulent transfer law provides a creditor with an opportunity to challenge the transfer of assets to a business entity.

In Firmani v. Firmani, the court reviewed debtor’s argument that the transfers to an LLC were made not to hinder a creditor, but for estate planning purposes. The court did not buy the excuse and found the transfer to the LLC to be fraudulent under an actual fraud analysis.

Defendants failed to present any substantial evidence to counter the strong inference of fraudulent intent established by these badges of fraud. Firmani submitted a certification which asserted that he established the Family Partnership and conveyed the Haddonfield property to this entity for “estate planning purposes.” However, we are unable to discern from Firmani’s certification how the transaction could have served any estate planning purposes, except by increasing the total amount of his estate by the $25,000 he seeks to avoid paying plaintiff and by the amounts of the judgments that certain casinos have against him. In any event, N.J.S.A. 25:2–25(a) does not require that an intent to hinder, delay, or defraud a creditor be the exclusive motivation behind a transfer in order for the transfer to be deemed fraudulent.

If more than one person transfers assets to an LLC, but only one person is a debtor, such that his transfer is voidable by a creditor, it should not matter if the transaction involved a non-debtor; one cannot insulate a fraudulent transfer by arguing the avoidance would complicate matters or affect another person’s interest. Such was the case in First Citizens Bank & Trust Co., Inc. v. Park at Durbin Creek, LLC, where the debtor transferred his 50 percent interest in real property, together with the other 50 percent owner (Whiteman), to PDC, LLC. It should be noted that debtor offered evidence of his intent, which included legitimate business planning, to no avail. Despite the complications of unwinding a transfer to an LLC where some members do not have fraudulent intent, the court ruled in favor of the creditor:

Accordingly, we find the conveyances of Whiteman’s 50 percent interest and Clifton’s 50 percent interest to PDC were each distinct transfers that Whiteman and Clifton merely chose to accomplish in a single deed. The fact they utilized one instrument to transfer their separate interests does not negate the distinct ownership interest each person possessed in the Property. As mutually exclusive conveyances, we also find that the invalidity of one does not necessarily invalidate the other. To that end, Whiteman’s intent in transferring her share of the Property to PDC is irrelevant to the circuit court’s finding of fraudulent intent as to Clifton. Clifton’s proportional interest is subject to the claims of his creditors, and he cannot legitimize the fraudulent transfer of his interest by lumping it together with Whiteman’s presumably valid transfer of her interest. Regardless of the parties’ choice of instrument to convey the Property, we find the circuit court properly set aside the conveyance pursuant to the Statute of Elizabeth.

The transfer of assets to an LLC may be viewed as a badge of fraud where the debtor removed assets by transferring to an LLC to enjoy charging order protection. The Official Comments to the UVTA also address the intersection between charging order protection and fraudulent transfer law.

In Interpool, the debtor, Cuneo, transferred non-exempt assets to an LLC (RMC). The RMC interests were then transferred to a trust (RAC). The court examined the transfers under both New York and Florida fraudulent transfer law, finding their holding would have been the same, regardless of the applicable law because there was no conflict between the state laws. As is typical in wealth transfer transactions challenged under fraudulent transfer law, the debtor argued he was motivated by non-creditor reasons. This did not persuade the court to find in the debtor’s favor.

Cuneo was deposed in March 1995 in connection with the proceedings to enforce the judgment. His explanation for the challenged transfers was un-illuminating. He was unable, or chose not, to explain how he and his wife determined what property to transfer into RMC and RAC or why the transfers were made other than to say that he “picked stuff that [he] thought had a worth to it” and that he did so on the advice of counsel for “estate planning” reasons. He testified that he did what [Attorney] suggested and that he “assume[d] that it had to do with tax purposes if [he] die[d].” But he did not articulate any specific reasons why he believed the transfers to be advantageous.

As to whether the membership interests received in exchange for non-exempt assets constituted reasonably equivalent value, the court did not focus on the LLC’s value, and thus, the potential value of the LLC interests Cuneo received in exchange for his assets. Instead, the court focused on a creditor’s rights to the property that was transferred. In other words, the court examined a creditor’s rights before and after the transaction in determining the value of the debtor’s asset from the creditor’s perspective.

The contribution by Cuneo of all or substantially all of his non-exempt assets to RMC in exchange for general and limited *266 partnership interests in an entity of which he and his wife are the sole partners, even disregarding the subsequent transfer of the limited partnership interest that the Court already has set aside, left him substantially judgment proof. A judgment creditor can do no more than levy upon Cuneo’s interest in the partnership, which is defined by statute as his right to receive distributions, the amount and timing of which would remain in control of Cuneo and his wife, from the entity. Thus, the judgment creditor would be entitled to sell at auction the right to receive such sums as Cuneo and his wife might choose to distribute to the successful purchaser. This makes the transfer constructively fraudulent as to Interpool irrespective of the law applied.

Interpool can be contrasted with United States v. Holland, where the debtor transferred assets to a limited liability company but remained the sole member. The transfer of assets to a single-member LLC, where the governing law does not provide single-member charging order protection, is akin to the transfer of assets to a revocable trust.

The US contests this characterization, contending that, when compared to the prospect of garnishing the Royalty Assets, the 1998 Transaction left Holland’s creditors with “the far less appealing recourse of seizing [Holland’s] partnership interest (which is subject to major partnership-level debts).” (Doc. 310, p. 7). In this connection, the US asserts that “a conveyance is not an exchange for equivalent value when it makes the debtor ‘execution proof.’” (Id.). In support, the US cites Interpool Ltd. v. Patterson, 890 F.Supp. 259 (S.D.N.Y. 1995), in which a debtor-husband transferred assets to a partnership jointly owned by his wife, and Dunn v. Minnema, 323 Mich. 687, 36 N.W.2d 182, 184 (1949), in which a debtor-husband “invest [ed] of $9,600 of his personal assets in property to which he and his wife held title by the entireties.”

Under the particular facts of this case, the transfer to EHLP did not make Holland “execution proof” because, unlike the debtors at issue in Interpool and Dunn, Holland was the sole owner of the assignee entity, EHLP. Accordingly, seizing Holland’s partnership shares would, apparently, enable a creditor to reach the Royalty Assets. The US is correct that, under this scenario, the Royalty Assets would be subject to “partnership-level debts.” However, because Holland received the benefit of such partnership-level debts in the form of the Note proceeds, this factor is of no avail to the US. If Holland had simply left the Note proceeds in his bank account, his creditors would have been no worse off—they could garnish the cash and recover the remaining value of the Royalty Assets upon repayment of the Notes.

In view of these factors, the 1998 Transaction and 2005 Transaction did not significantly hinder Holland’s creditors. Accordingly, the transfer did not result in the type of “wrong” that would support a finding that (i) that EHLP held title to the Royalty Assets as Holland’s nominee, (ii) that Holland fraudulently conveyed the Royalty Assets to EHLP, or (iii) that EHLP is the alter ego of Holland. Because the US demonstrates no basis for attaching property held by EHLP, the Court must deny its motion for summary judgment.

United States v. Holland illustrates why some states have enacted statutes providing charging order protection for a single-member limited liability company. The LLC becomes a quasi-exemption debtors may use to avoid paying their personal creditors. Like the asset protection trust, the single-member LLC offering charging order protection presents public policy issues relevant to fraudulent transfer law and choice of law for debtors attempting to import protections into their own state against their personal creditors.

Although avoiding a transfer to a business entity has an impact on the business and its owners, this is of no consequence if the transfer is fraudulent. As previously addressed, some have argued that it is unfair to other business entity owners if a creditor may void a transfer to the business entity by a debtor. This argument has also been used in the trust context, where some maintain it is not fair to void a transfer to a trust if the debtor created rights in third parties (via beneficial interest.) Like the choice of law in a trust agreement, or avoidance of a transfer to a self-settled trust, a creditor who has been injured and seeks relief under fraudulent transfer law is not always held subject to rules created in advance by a debtor. Stated differently, a debtor cannot transfer assets to an entity or trustee, muddy the ownership rights to such property by creating rights in third parties (often insiders), and then expect these third-party interests will automatically defeat a creditor.

If business entities are utilized to effectuate a fraudulent transfer, there is a risk that the court will disregard the business entity. This could have the effect of rendering the individual who controls the business entity liable as transferee. For example, In re Pace featured an attorney who helped his client (the debtor) transfer assets to an LLC controlled by the attorney. This was done to avoid the debtor’s creditors. The court held the LLC was the initial transferee, and further found that the attorney, due to his participation, was jointly liable and might have been considered the person for whose benefit the transfer was made. As discussed in the civil liability section of this book, lawyers must be careful as to their degree of involvement in fraudulent transfers.