BEYOND DISSIPATION: THE EFFECTIVE USE OF ILLINOIS’ FRAUDULENT TRANSFER ACT IN DIVORCE LITIGATION
By Andrew R. Schwartz, Thomas J. Kanyock and Karen Jeffreys
Consider the following scenario: A marriage breaks down when Wife discovers Husband having an extramarital affair. In anticipation of Wife filing for divorce, Husband makes a gift of joint funds to a bank account in his girlfriend’s name to defeat Wife’s interest. As the matrimonial lawyer for Wife, you would likely make a dissipation claim, asking the court to include the amount transferred in the marital estate, and adjust the distribution of assets to give Wife credit for some or all of the transferred funds.
Now change the scenario slightly to reflect that Husband gave everything to his girlfriend, leaving no marital estate, so that a dissipation claim will not adequately compensate Wife. What recourse do you have?
The Illinois Uniform Fraudulent Transfer Act (“UFTA”)1 can provide a potent weapon in a matrimonial litigator’s arsenal. This article, which distills our 2010 ISBA Family Law Section presentation, discusses the nature of fraudulent transfers and the remedies available to the matrimonial litigator under UFTA. Matrimonial litigators usually find UFTA concepts easy to use because matrimonial law employs the related concepts of “estates” and “dissipation.”
II. WHAT IS A “FRAUDULENT TRANSFER”?
“Fraudulent transfer” and “fraudulent conveyance” refer to a debtor’s dissipation of assets to frustrate a creditor’s ability to collect on a debt. For example, consider the following scenario: On day one, A has a net worth of $100,000, which he holds in a bank account. On day two, Creditor takes a $75,000 judgment against A. On day three, A gives his wife the $100,000 cash. After giving away all his valuable property, A claims he cannot pay Creditor’s judgment because he has insufficient assets. Illinois considers such dissipation by a debtor a fraud on the debtor’s creditors. In Birney v. Solomon,2 our Supreme Court stated the proposition somewhat more eloquently, ruling “[t]he doctrine is firmly declared to be that one must be just before he is generous.”
A ‘transfer’ is a prerequisite to an UFTA claim. Without a transfer, there is nothing to avoid or recover.3 UFTA §2(l) defines “transfer” broadly, to include:
every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an asset, and includes payment of money, release, lease, and creation of a lien or other encumbrance.
The gist of any UFTA suit is the debtor’s voluntary depletion of his own net worth to a point at which he cannot fully repay the claims of creditors. Whenever a debtor claims insolvency as a basis for nonpayment of a judgment or other claim, the alert creditor’s attorney should discover (1) whether the debtor has recently transferred any valuable assets and/or incurred a large debt, (2) the identity of the transferee and/or holder of that recent debt, and (3) the consideration, if any, received for that transfer and/or debt. If the debtor recently transferred property without compensation – by putting it into a trust, giving it away to relatives, paying a suspicious large debt, etc., the creditor’s attorney should immediately investigate whether the transfer can be set aside as a fraud.
The creditor’s attorney cannot lose sight of the “dissipation” concept when analyzing such transactions. A general rule of thumb is that if the debtor received fair value for the divested asset, the transfer probably does not constitute a fraud. For instance, the sale of a debtor’s property for adequate consideration does not constitute a fraudulent conveyance, because it does not deplete the debtor’s net worth; the debtor has merely exchanged one form of value for another (usually cash). Likewise, repayment of a legitimate debt does not deplete the debtor’s net worth; the use of cash to extinguish an existing liability does not affect the debtor’s net worth. However, a transfer for no compensation probably is fraudulent if it leaves the debtor without sufficient assets to repay creditors. Likewise, a debtor’s agreement to obligate himself or herself to pay a liability is probably fraudulent if the debtor derives no benefit from that agreement.
III. PARTIES TO THE FRAUDULENT TRANSFER ACTION
The original creditor and its successors or assigns are the proper plaintiffs in a suit to set aside a fraudulent transfer, but the debtor is not the target defendant. The “real” defendant in a suit to set aside a fraudulent transfer is the recipient of the property. A suit to set aside a fraudulent transfer seeks to divest the transferee of some or all of the property it has received. Once the debtor divests himself of the asset, the debtor no longer has it; therefore the court cannot order the original debtor to turn the asset over to the creditor. The creditor should also name the debtor as a nominal defendant in the lawsuit. As noted below, the issue of fraudulent transfer often turns on the solvency of the debtor after the transfer; moreover, as a practical matter, usually only the debtor possesses the information necessary to prove or disprove this issue.
Two threshold questions in any fraudulent transfer case are whether the party seeking relief qualifies as a creditor and whether the transferor qualifies as a debtor who owes a debt to the creditor.5 To resolve these questions, the creditor’s attorney must look for guidance to the language of UFTA, especially the definitions provided in §2 of the statute. In particular, the UFTA defines a “creditor” as a person who has a claim, including a claim for past-due child support.6 A “debt” is defined as liability on a claim, and a “debtor” is a person who is liable on a claim.7 The existence of a debtor-creditor relationship may generate litigation in state court actions when a plaintiff wishes to enforce its rights under the UFTA before the plaintiff can take a judgment against the transferor who contests the underlying liability. In such a case, the transferee may challenge the plaintiff’s right to relief.
All three definitions — “creditor,” “debt,” and “debtor” — depend on the definition of the term “claim,” which UFTA §2(c) defines as “a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.”
UFTA’s definitions are deliberately broad; for example, “claim” includes rights to payment that have not been reduced to a judgment, as well as potential rights. Indeed, UFTA’s definition encompasses virtually every current and potential right to payment.8 The fact that the debtor may dispute liability does not defeat a claim for UFTA purposes; it merely makes the claim “disputed.” Likewise, if the liability has not yet been adjudicated, it is a “right not reduced to judgment.”
IV. THE UNIFORM FRAUDULENT TRANSFER ACT
The Illinois legislature adopted UFTA in 1989 without comment to the statute. However, the official comments to the Uniform Act evince an intent to provide a consistent set of laws throughout the country regarding fraudulent transfers.9 Anyone litigating a suit to set aside a fraudulent transfer should read these comments.
UFTA parallels the fraudulent transfer provision of the U.S. Bankruptcy Code.10 “Because the UFTA parallels Section 548 of the Bankruptcy Code, findings made under the Code are applicable to actions under the UFTA.”11 The Joy Recovery Technology court noted that the material distinction between the Bankruptcy Code and UFTA is the statute of limitations.12 Moreover, because Illinois’ UFTA is a uniform act that derived its terminology from §548, practitioners and courts in Illinois may look to §548 and court cases interpreting other states’ versions of UFTA for assistance.
V. TYPES OF FRAUDULENT TRANSFERS
Illinois recognizes two categories of fraudulent transfers. A debtor commits “fraud in fact” by intentionally engaging in a transaction for which the debtor does not receive reasonable value and either (a) transferring assets with the actual intent to hinder, delay, or defraud any creditor or (b) engaging in a business or transaction for which the remaining assets of the debtor are unreasonably small in relation to the business or transaction. By contrast, a debtor commits “fraud in law” when the transfer of assets has the effect of hindering, delaying, or defrauding any creditor, irrespective of whether the debtor actually intended to hinder, delay, or defraud the creditor.
A. Fraud in Fact
UFTA §5(a)(1) characterizes as “fraudulent” a transfer by a debtor made with the actual intent to hinder, delay, or defraud any creditor of the debtor.15 Such a “fraud-in-fact” claim asks the court to find that the debtor intentionally disturbed, delayed, hindered, or defrauded any creditor.16 To prove its case, the plaintiff must present evidence that the debtor specifically intended to disturb, delay, hinder, or defraud a creditor by the conveyance.17 Actual fraud is not presumed, but must be proved by clear and convincing evidence.
Debtors faced with a suit to set aside a fraudulent transfer will commonly deny the scienter element, recognizing that it is difficult to prove. UFTA §5(b) provides some relief; in the absence of an outright admission by the debtor of an actual intent to thwart creditors, the court may consider a list of objective facts (“badges of fraud”) from which the trial court may infer fraudulent intent.19 However, the statutory list is not exclusive; it specifically leaves open the possibility of “other factors.
B. Fraud in Law
UFTA recognizes two classes of “fraud in law.”21 Under §5(a)(2), a transfer made or obligation incurred by a debtor is fraudulent as to a creditor, whether the creditor’s claim arose before or after the transfer was made or the obligation was incurred, if the debtor made the transfer or incurred the obligation (1) without receiving a reasonably equivalent value in exchange for the transfer or obligation, and the debtor either (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; or (B) intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due.
UFTA §6(a) provides an alternate “fraud in law” claim. Under §6(a), 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.
A major difference between §5(a)(2) and §6(a) actions is timing. Section 6(a) applies only when the creditor’s claim preceded the purportedly fraudulent transfer/obligation. By contrast, a §5(a)(2) “fraud in law” action will lie if the creditor’s claim arose before or after the transfer was made or the obligation was incurred.
A fraud-in-law case is substantially easier to prove and more difficult to defend. A creditor states a prima facie case of fraud in law simply by alleging facts demonstrating (a) that the debtor either made a transfer or incurred an obligation (b) without receiving a reasonably equivalent value in exchange for the transfer/obligation and (c) the debtor either was insolvent at the time of the transfer/obligation or became insolvent as a result of the transfer/obligation. To defend, the debtor must disprove at least one of these allegations. If the debtor fails to do so, the presumption of fraud becomes conclusive and the claim succeeds.
C. Preferential Fraudulent Transfers to Insiders
UFTA §6(b) recognizes a third type of fraudulent transfer claim that is similar to a preference claim in bankruptcy,25 and reads as follows:
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.
We could not find any Illinois cases applying §6(b). However, a Bankruptcy Court provided the following discussion of a §6(b) action:
Under § 160/6(b), the elements of the cause of action are: (1) the creditor’s claim arose before the transfer; (2) the debtor made the transfer to an insider for an antecedent debt; (3) the debtor was insolvent at the time of the transfer; and (4) the insider had reasonable cause to believe that the debtor was insolvent
Courts in other UFTA jurisdictions have also addressed the “insider preference” type of claim.27 As discussed above, UFTA is a uniform act, and the decisions in other UFTA jurisdictions are entitled to precedential weight in Illinois.
VI. DEFENSES TO FRAUDULENT TRANSFER CLAIMS
The defendants in a fraudulent transfer suit may present various defenses. Some apply to all fraudulent transfer claims, while others depend on the type of fraud alleged.
1. Fraud in Fact
The lack of scienter is a valid defense to fraud-in-fact claims. In People ex rel. Hartigan v. Gaby’s Apparel, Ltd.29, the First District held that “a specific intent to defraud must be proved in fraud-in-fact cases.” However, the court need not hear the debtor’s admission of that intent; UFTA §5(b) lets the court infer that intent from the circumstances surrounding the transaction.
A recent line of Federal cases in the Seventh Circuit has created a question about the need to prove the transferee’s fraudulent intent, as well. For example, the following discussion appears in Fidelity Nat’l Title Ins. Co. of N.Y. v. Howard Sav. Bank, et. al.:
The Fidelity Nat’l Title Ins. Co. case cites Kennedy v. Four Boys Labor Service, Inc. as the basis for its focus on the transferee’s lack of fraudulent intent.
We respectfully submit that the Seventh Circuit cited Kennedy incorrectly and overstated its holding; we disagree that the elements of a fraudulent transfer claim require analysis of the transferee’s intent. The issue in Kennedy was whether transferees were bona fide purchasers of the debtor’s assets. While the transferees’ intentions were certainly relevant to the existence of a bona fide purchaser defense, it is not an element of the underlying UFTA claim.33 UFTA §5(a)(1) speaks in terms of the debtor’s intent to “hinder, delay, or defraud …” UFTA §5(a)(2)(B) discusses the debtor’s intent to incur debts beyond his ability to repay.34 Likewise, the §5(b) “badges of fraud” all focus on actions by the debtor from which the trial court may infer the debtor’s fraudulent intent.
We find this distinction important because a bona fide purchaser defense under UFTA §9(a) requires more than proof of good faith; the transferee must also prove he gave reasonably equivalent value for the transferred asset.
But to be a fraudulent transferee, you must know or suspect that you are not giving any return value to the owner.
2. Fraud in Law
Lack of scienter or fraudulent intent is immaterial to a fraud-in-law claim.
1. Fraud in Fact
UFTA §5 defines a “fraudulent transfer” as one that caused the debtor to become insolvent. Therefore, a defendant in a suit brought pursuant to §5 may deny that the transaction rendered the debtor insolvent.
UFTA §3 defines the term “insolvency.” Section 3(a) uses a balance-sheet test to determine insolvency, while §3(b) holds that a debtor who is generally not paying his debts as they become due is presumed to be insolvent. Sections 3(c)-(e) provide guidance about the insolvency of partnerships, and provide exclusions about what constitutes “assets” and “debts” for purposes of determining insolvency.
In Tower Investors, LLC v. 111 East Chestnut Consultants, Inc.,39 the First District cited to UFTA §3 to explain whether an entity is insolvent. In Baldi v. Samuel Son & Co., Ltd., Judge Posner summarized the concept of “balance-sheet” solvency/insolvency in the following quote:
To decide whether a firm is insolvent within the meaning of §548(a)(2)(B)(i) [of the Bankruptcy Code], a court should ask: What would a buyer be willing to pay for the debtor’s entire package of assets and liabilities? If the price is positive, the firm is solvent; if negative, insolvent.
Under §3(a), the court need not consider the nominal or “paper” value of assets when determining the solvency of a debtor. In Falcon v. Thomas, the Fourth District held:
It is of no moment that the property remaining in the grantor’s hands after the conveyance was in nominal value more than equal to the amount of his indebtedness if subsequent events show that the property retained was not sufficient to discharge all his liability.
2. Fraud in Law
Although UFTA §6(a) defines a “fraudulent transfer” as one that causes the debtor to become insolvent, we do not recommend a “solvency” defense to a claim for fraud-in-law unless the debtor can prove it with some degree of certainty. Case law focuses more on the effect of the debtor’s allegedly fraudulent transaction on the ability of the debtor’s creditors to collect. If the transaction tends to impair the creditors’ rights, the court will likely find it fraudulent.
C. Defenses to the Fraudulent Transfer Claim
UFTA §9 identifies several defenses, including a bona fide purchaser (“BFP”) defense.43 We recommend that any attorney considering a UFTA claim first review this section carefully. Note that §9(a) does not define the term “in good faith” as it applies to the BFP defense. However, we suggest that the term should be interpreted as the transferee’s lack of knowledge about the voidability of the transaction. We recommend a look at For Your Ease Only, Inc. v. Calgon Carbon Corp.44, where the Seventh Circuit discussed that issue at length.
UFTA §9(a) provides a BFP defense to claims under §5(a)(1); the law does not let the creditor-plaintiff set aside a fraudulent transfer against an innocent third party who acquires an asset from the debtor in good faith and for fair value. Under §9(a) a bona fide transfer precludes the creditor-plaintiff from setting aside transfers to subsequent transferees. However, a court may set aside a transfer when the transferee either knows or should have known about the debtor’s fraudulent intent.45 However, §9(a) does not afford any remedies against fraud-in-law claims.
UFTA §9(d) also provides a limited defense. Notwithstanding the voidability of a transfer, §9(d) entitles a good-faith transferee to relief to the extent he/she/it paid value for the transferred asset.
UFTA §9(e) provides two defenses to fraud-in-law claims. The plaintiff-creditor cannot set aside a transfer that would terminate certain leases or the enforcement of security interests under Article 9 of the Uniform Commercial Code.46 Likewise, §9(f) affords two defenses to claims of fraudulent-in-law transfers involving insiders.
D. Transfers for Value
Under UFTA §§5(a)(2) and 6, a transfer is voidable as fraudulent if the debtor made it without receiving a reasonably equivalent value in exchange for the transfer, and the debtor was either insolvent at that time or became insolvent as a result of the transfer.47 Therefore, receipt of reasonably equivalent value is a defense to a fraud-in-law claim.
1. What Constitutes “Value”?
The UFTA concept of “reasonably equivalent value” is not well defined and may become the subject of dispute. We recommend a careful review of UFTA §4, which offers a statutory definition.48 Other than for foreclosure sales, UFTA does not define “reasonably equivalent value.” However, consideration and reasonably equivalent value are not necessarily synonymous.
UFTA §4(a) defines “value” for a transfer only as (a) a transfer of property, or (b) the satisfaction or security of an antecedent debt; therefore, the alert creditor’s attorney will challenge other types of purported consideration given by the transferee as “value,” especially if it provides no benefit to the creditor.
We could find no Illinois decisions defining “value” or “reasonably equivalent value” under §4(a). Therefore, a review of the corresponding section of the Model Act is instructive (UFTA §4(a) is identical to §3(a) of the Model Act). The drafters of the Model Act include a Comment to §3(a), which contains the following:
Value” is to be determined in light of the purpose of the Act to protect a debtor’s estate from being depleted to the prejudice of the debtor’s unsecured creditors. Consideration having no utility from a creditor’s viewpoint does not satisfy the statutory definition.
However, we found two 2005 bankruptcy court decisions that looked to the Bankruptcy Code to help define “reasonably equivalent value” under UFTA.
UFTA §4(c) requires that the exchange of value must be a present exchange. Reasonably equivalent value is measured at the time of the transfer.52 Accordingly, promises to pay another’s expenses in the future are not equivalent value.53 Courts are “particularly insistent upon proof of commensurability when they are dealing with intrafamilial transfers attacked as fraudulent conveyances.”
A question of value may arise when the transferee gives an indirect benefit to the debtor in exchange for the debtor’s transfer of property. A creditor should view such indirect benefits with suspicion and challenge the adequacy of “value” unless the transferee can show some real benefit to the debtor.
A few bankruptcy cases construing UFTA address this issue; these cases generally acknowledge that a debtor does not receive reasonably equivalent value if it made a transfer in exchange for a benefit to a third party. However, the cases also recognize an increasing willingness by courts to consider the benefits more holistically and look at the overall effect on the entity making the transfer. In doing so, these bankruptcy courts give consideration to whether the debtor received an indirect benefit, as long as that indirect benefit was “fairly concrete.”55 In Creditor’s Committee of Jumer’s Castle Lodge, Inc. v. Jumer,56 the Seventh Circuit discussed the question of “reasonably equivalent value,” and placed the burden of proof upon a plaintiff alleging transfers between a corporation and its shareholders.57 In For Your Ease Only, Inc.,58 the Seventh Circuit held that “UFTA does not limit reasonably equivalent value to money nor to value transferred pursuant to a valid contract.”