Asset protection the role of valuation in assessing fraudulent transfer exposure

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Asset Protection: The Role of Valuation in Assessing Fraudulent Transfer Exposure By: Gary A. Forster and Eric C. Boughman. An often overlooked, but essential component of asset-protection planning is making a careful assessment of a client’s financial status. Although timing is generally considered the most critical element of asset protection, due consideration must be given to both the value of assets exchanged and the effect of plan implementation on one’s balance sheet.

A fraudulent transfer claim is often the most effective weapon to disrupt an asset protection plan and reach assets transferred beyond a creditor’s grasp. Creditors can prove a fraudulent transfer by showing actual or constructive intent to hinder collection under the Uniform Fraudulent Transfer Act.1 Actual intent involves a debtor’s state of mind and a subjective analysis of whether the debtor intended to avoid a claim.2 In the context of a lawsuit, proving actual intent is unpredictable because it generally involves trying to prove a defendant’s thoughts and intentions. By contrast, “constructive” intent generally involves an objective, two-part test. First, a debtor must have transferred assets in exchange for less than “reasonably equivalent value.”3 Additionally, the asset transfer must generally have left the debtor “insolvent” or undercapitalized to carry on business.4 Constructive intent, thus, generally involves an objective analysis of financial values. This objective analysis is often the most expeditious method of attacking a transfer as fraudulent.

A professional analysis of “reasonably equivalent value” and “solvency,” in connection with a protective transfer, can bolster and clarify asset-protection planning. The same financial analysis is integral to proving a constructive fraudulent transfer.

Reasonably Equivalent Value Determining whether the debtor received reasonably equivalent value for assets transferred essentially involves a value comparison of “what went out” versus “what was received.”5 Reasonably equivalent value does not necessarily mean equal value.6 It is often dependent on the circumstances.7 Timing could be a consideration. Property that must be quickly sold is likely to fetch far less than if listed, advertised, and marketed under regular market conditions.

Another consideration is the perspective from which value is determined. Creditors will argue that assets received by a debtor must be excluded from the solvency calculation to the extent exempt from creditor claims. A debtor may, for example, argue that receipt of protected limited liability company (LLC) equity constitutes reasonably equivalent value received in exchange for the transfer of exposed cash or other personal assets into the LLC; or that receipt of an interest in a protected financial account (such as an IRA) is an equivalent exchange for cash divested to the account. Although the law is unsettled, courts have suggested that the determination of whether the debtor received reasonably equivalent value should be

made from the standpoint of the creditor.8 In a case arising in Florida, the 11th Circuit determined that transfers were not made for “reasonably equivalent value” when they drained assets that would otherwise have been available to creditors.9

Based on this interpretation, an ownership interest received by the debtor but not available to a creditor would not satisfy the act’s definition of equivalent value. Similarly, receipt of legally exempt or protected assets (in exchange for divested exposed assets) would not count “as reasonably equivalent value,” because the assets received would have no value from a creditor’s perspective. As an example, the conversion of cash from a personal checking account to a legally exempt IRA would not constitute an exchange for reasonably equivalent value in the fraudulent transfer context because the IRA is untouchable to the creditor. The contribution of cash into an LLC in exchange for an LLC membership interest is also not likely to be deemed reasonably equivalent value unless the interest is subject to foreclosure by a creditor.

Insolvency The second element of a constructive fraudulent transfer requires proof that a transfer rendered the debtor insolvent. A debtor is considered insolvent if the sum of his or her debts is greater than the fair value of his or her assets.10 This is generally referred to as “balance sheet” insolvency.11 The meaning of “fair value” in this context is not defined, but has been described as the sale of assets in a reasonable time at regular market value.12 Some parties may argue that assets should be valued according to generally accepted accounting principles (GAAP). Courts have ruled that GAAP may be potentially relevant, but is not controlling.13 The law requires that judges, not accountants, nor the board that promulgates GAAP, be the final arbiters of solvency.14 There are several legal considerations that veer from GAAP standards. For example, exempt assets are generally excluded from the calculation. Liabilities may be treated differently than in GAAP financial reporting. Valuations involving contingent assets and liabilities and disputed claims at the time of a transfer also warrant special consideration.

Value of Contingent Claims While the dollar value of contingent claims may be reasonably certain, the liability may never arise. Guarantees represent a classic example of contingent claims. Liability occurs only if the primary obligor fails to perform. In the solvency analysis (to determine if a transfer is constructively fraudulent), contingent claim values depend on the likelihood and timing of liability. The loan guarantee may be considered a greater liability if a default occurs (or is more likely to occur) tomorrow versus one year from tomorrow. Hindsight is generally not a factor in valuing contingent claims.

Under a “probability discount rule,” the “fair value” of a contingent liability “should be discounted according to the possibility of its ever becoming real.”15 In one case, a court gave the following example, where Company A, valued at $1.7 million, guaranteed a $28 million loan to Company B:

“Suppose that on the date the obligations were assumed there was a 1 percent chance that [Company A] would ever be called on to yield up its assets to creditors of [Company B]. Then the true measure of the liability created by these obligations on the date they were assumed would not be $28 million; it would be a paltry $17,000. For at worst [Company A] would have to yield up all of its assets (net of other liabilities), that is, $1.7 million, and the probability of this outcome is by assumption only 1 percent....�16

According to the court in Matter of Xonics Photochemical, Inc., 841 F.2d 198 (7th Cir. 1988), the proper value of the $28 million contingent claim was, arguably, not $28 million, but only $17,000. Alternatively, under the same assumptions, it might be reasonable to assign a $280,000 value to the contingent claim, based on a 1 percent chance of loan default. Either way, as this analysis suggests, valuation of a contingent claim is not an exact science.

Effect of Collateral Another issue affecting valuation of contingent claims is whether such claims are fully or partially secured (and the stability of the value of such security). The real estate crash of the mid-2000s made clear the issue of stability in the value of collateral. When mortgage loans went into default, many first-position lenders with an initial 70 to 80 percent loan to value (LTV) ratio, were left with partially unsecured loans after real estate values fell 50 percent or more. Many second- and third-position mortgagees were left with claims that were, for all practical purposes, entirely unsecured. In a strong market, real estate encumbered by first- and second-mortgage loans may have a neutral or positive effect on a balance sheet. The same loans may result in hefty liabilities, far in excess of the value of real estate to which they attach, in a depressed market.

This argument was raised successfully in BB&T v. Hamilton Greens, LLC, 2016 WL 3365270 (Bankr. S.D. Fla. 2016). Three months after a $3 million construction loan default, the bank sued the developer and the loan guarantors. Six months after the lawsuit was filed, one of the guarantors created an offshore trust into which he transferred most of his assets (nearly $1.7 million). After obtaining a $4.9 million judgment, the bank sought to invalidate the transfers to the trust as fraudulent transfers.

The defendant testified to several circumstances supporting his position that he had no reasonable expectation that he would owe any money to the bank arising from the development loan. The property securing the debt was (at the time of the loan) valued at $15 million, his co-guarantors had a combined net worth of over $100 million, and his co-guarantors had indemnified him from the claim and discharged his other contingent liabilities. Relying on these and other factors pertaining to the debtor’s intent, the court ruled (considering the minimal likelihood of liability at the time assets were transferred) that the transfers to the trust were not fraudulent transfers.17 The ruling supports the premise that a debt guaranty constitutes a personal liability (in the solvency calculation) only to the extent that the debt is unsecured at the time of the alleged fraudulent transfer.

Value of Disputed Claims Claims may be disputed as to liability, value, or both. Malpractice, personal injury, product liability, and environmental claims generally fall into this category. Disputed claims differ from contingent claims in that the latter are based on the occurrence of future events that may not occur.18

In In re Babcock & Wilcox Co., 274 B.R. 230, 262 (Bankr. E.D. La. 2002), a court was required to value future asbestos liabilities and noted that various methodologies would yield a wide range in results. Multiple variables, including exposure estimates, exposure intensity levels, causation, latency periods, product identification, etc., made the endeavor quite problematic. One of the more difficult tasks for the court was determining whether hindsight was appropriate since, after the fact, it was known that claims had apparently ripened at a much higher rate than predicted (and, thus, forced the debtor into bankruptcy). Ultimately, the court determined that hindsight was inappropriate and the court was left only to determine whether Babcock’s financial predictions were reasonable under the circumstances existing at the time they were made.19

Some courts have, however, considered subsequent events (such as claim rates, default rates, or the value at which an asset or liability is ultimately negotiated) in assessing whether a party’s valuation estimates were reasonable when made.20 Thus, in calculating insolvency, a court could consider future circumstances (unknown to the debtor at the time assets are transferred) as relevant for determining whether to accept a party’s own valuation estimates for disputed claims. One prudent approach (to diminish judicial hindsight) is to make clear the debtor’s reliance (as a condition to transfer) on a professional assessment of value.

Value of Assets The value of assets in the fraudulent transfer context may be different than under accounting or regulatory definitions.21

Values determined by GAAP, SEC rules, and IRS revenue procedures may be unreliable because tax and accounting values on a balance sheet often have little to do with fair value in legal terms. Book value of retail inventory may be subject to an upward adjustment in anticipation of selling at retail value. Assets such as preferred distributions, debt-equity conversion rights, and voting control may have substantially different book values than fair values. Assets may also be valued individually or packaged in groups based on business considerations. Also, traditional GAAP rules for the treatment of debt as equity, and vice versa, may not be relevant in determining whether they are truly debt or equity in fraudulent transfer analysis.22

In EBC I, Inc. v. America Online, Inc. (In re EBC I, Inc.), 380 B.R. 348, 358 (Bankr. D. Del. 2008), both parties in a fraudulent conveyance action cited IRS Revenue Procedure 77-12 to support their arguments valuing the inventory of a retail business (for solvency purposes). One question was whether to use book value for inventory or to make an upward adjustment, because the inventory was to be sold at retail prices. The court was not persuaded to follow the revenue procedure, noting “[r]evenue [p]rocedures, like [GAAP], to be unhelpful because the tax and accounting implications of how assets are listed on a company’s balance sheet often have little to do with what a willing buyer and willing seller would agree is the fair market value of those assets.”23 The fair value of a debtor’s business assets may depend upon whether a company is a “going concern or on its deathbed.”24 The assets of a going concern are more likely to be sold in a prudent manner with reasonable time constraints and, thus, equate to a deliberate and calculated fair-market value.25 Liquidation value, however, may be more appropriate for valuing assets of a desperate debtor on its financial “deathbed.”26 Other Considerations Additional issues to consider are the impact and cost of insurance on liabilities, rights against third-party indemnities and guarantors, and potential claims against third parties. Ultimately, in deciding whether a debtor is solvent, a court should ask: What would a willing buyer pay for the debtor’s entire package of assets and liabilities (excluding creditor protected assets and exempt assets)? To this question, the court in In Re Tousa, Inc., 422 B.R. 783 (Bankr. S.D. Fla. 2009), answered that if the price is positive, the debtor may be solvent; if the price is negative, the debtor may be insolvent.27 Arriving at the result may involve as much art as science and will certainly require the expertise of a seasoned appraiser.

Conclusion Assessment of financial status is essential to avoid fraudulent transfer claims. Receipt of reasonable equivalent value and maintaining client solvency are as critical as the timing of transfers. Determination of those issues may be highly subjective. The rulings discussed above have set the stage for debtors to defend personal planning by relying on determinations of value and solvency. Careful consideration of these issues could mean the difference between preserving or destroying the efficacy of an asset protection plan.

1 See Fla. Stat. Ch. 726. 2 See Fla. Stat. §726.105(1)(a); see also Uniform Fraudulent Transfer Act (UFTA) §4(a)(1).

3 See Fla. Stat. §726.105(1)(b); UFTA §4(a)(2).

4 See Fla. Stat. §726.105(1)(b)(1) and (2); UFTA §(4)(a)(i) and (ii); see also §726.106, which provides similar modes proving a fraudulent transfer (as to present, but not future, creditors). 5 In re Vilsack, 356 B.R. 546, 553 (Bankr. S.D. Fla. 2006). All states have adopted some form of the UFTA (or its successor, the Uniform Voidable Transactions Act) and courts routinely look to other states and to analogous provisions under the Federal Bankruptcy Code to interpret provisions of the act. See ASARCO LLC v. Americas Mining Corp., 396 B.R. 278, n.49, citing Creditor’s Comm. of Jumer’s Castle Lodge, Inc. v. Jumer, 472 F.3d 943, 947 (7th Cir. 2007); In re W.R. Grace & Co., 281 B.R. 852, 857 (Bankr. D. Del. 2002) (stating the court could seek guidance from cases interpreting similarly worded statutes, like the Bankruptcy Code); see also In re Tower Envtl., Inc., 260 B.R. 213, 222 (Bankr. M.D. Fla. 1998) (noting that Florida UFTA statutes are similar in form and substance to their bankruptcy analogs and stating that it is, thus, “appropriate to analyze the similar provisions of the state statutes and [the Bankruptcy Code] contemporaneously”). As such, we look to multiple states and bankruptcy courts in attempting to predict how a particular court might interpret provisions under the Florida act. 6 See In re Advanced Telecommunication Network, Inc., 490 F.3d 1325, 1336 (11th Cir. 2007) (“[R]easonably equivalent value does not demand a precise dollar-for-dollar exchange.”). 7 See In re 3dfx Interactive, Inc., 389 B.R. 842, 862 (Bankr. N.D. Cal. 2008), subsequently aff’d sub nom., In re 3DFX Interactive, Inc., 585 F. App’x 626 (9th Cir. 2014); see also In re Vilsack, 356 B.R. at 553 (internal quotations omitted) (stating factors courts consider, including “good faith of the parties, the disparity between the fair value of the property and what the debtor actually received, and whether the transaction was at arm’s length”). 8 See, e.g., In re 3DFX Interactive, Inc., 389 B.R. at 863; First Fed. Sav. & Loan Ass’n of Galion, Ohio v. Napoleon, 428 Mass. 371, 378, 701 N.E.2d 350, 354 (1998); In re Rodriguez, 895 F.2d 725, 727-729 (11th Cir. 1990). 9 See In re Rodriguez, 895 F.2d at 727-729 (“The purpose of voiding transfers unsupported by reasonably equivalent value is to protect creditors against the depletion of a bankrupt’s estate.”) (internal quotations omitted). 10 See Fla. Stat. §726.103(1). 11 Paragon Health Services, Inc. v. Cent. Palm Beach Cmty. Mental Health Ctr., Inc., 859 So. 2d 1233, 1237 (Fla. 4th DCA 2003). 12 See In re TOUSA, Inc., 422 B.R. 783, 858 (Bankr. S.D. Fla. 2009) (citing several courts), quashed in part, 444 B.R. 613 (S.D. Fla. 2011), aff’d in part, rev’d in part, 680 F.3d 1298 (11th Cir. 2012). 13 In re Sierra Steel, Inc., 96 B.R. 275, 278 (B.A.P. 9th Cir. 1989). 14 Id. 15 In re Advanced Telecommunication Network, Inc., 490 F.3d at 1335. 16 See Matter of Xonics Photochemical, Inc., 841 F.2d 198, 200 (7th Cir. 1988).

17 Hamilton Greens, 2016 WL 3365270 at 9.

18 See In re Dill, 30 B.R. 546, 548 (Bankr. 9th Cir. 1983). 19 In re Babcock & Wilcox Co., 274 B.R. at 262. 20 See SEC v. Antar, 120 F. Supp. 2d 431 (D.N.J. 2000); W.R. Grace & Co. v. Sealed Air Corp., 281 B.R. 852. 21 See, e.g., In re 3DFX Interactive, Inc., 389 B.R. at 867 (“The [c]ourt’s determination of what constitutes an asset will be guided by the applicable UFTA definition, not the accounting definition.”); In re EBC I, Inc., 380 B.R. 348, 358 (Bankr. D. Del. 2008), aff’d, 400 B.R. 13 (D. Del. 2009), aff’d, 382 F. App’x 135 (3d Cir. 2010). 22 As discussed in In re EBC I, Inc., 380 B.R. at 358-359. 23 EBC I, Inc., 380 B.R. at 357, n. 3. 24 See In re David Jones Builder, Inc., 129 B.R. 682, 689 (Bankr. S.D. Fla. 1991) (citations omitted); see also In re Imagine Fulfillment Services, LLC, 489 B.R. 136, 145 (Bankr. C.D. Cal. 2013), citing In re DAK Indus., Inc., 170 F.3d 1197, 1199 (9th Cir. 1999). 25 See In re Imagine Fulfillment Services, LLC, 489 B.R. at 145. 26 Id. 27 In re TOUSA, Inc., 422 B.R. at 860.

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