Litigation on point

The L aw Offices of Solomon J. Jaskiel, esq.Litigation on Point December 2011 A Powerful Weapon PREFERENTIAL TRANSFERS AS FRAUDULENT CONVEYANCES The Problem Creditors suspect that the debtor has paid other creditors close to him– instead of paying the creditor. Such payment are called preferential transfers. Preferential transfers are typically recoverable only in bankruptcy. Under a relatively unknown line of cases, a creditor may be able to recover payments made to an insider. The law of fraudulent conveyances is a powerful tool for collecting debts from unscrupulous debtors. In the classic case, the debtor has put his or her assets out of a creditor’s reach by giving them to someone else. The law allows a creditor to retrieve those assets. The hallmark of a fraudulent conveyance is the transfer of the asset without adequate consideration in return. If a debtor prefers one creditor over another, the transfer would not seem to be fraudulent. “[A]n insolvent debtor has the right to sell and transfer the whole or any portion of his property to one or more of his creditors in payment of or to secure his debts, when that is his hon- q Preferential est purpose, although the effect of the sale or trans- transfers fer is to place his property beyond the reach of his are not only other creditors and render their debts uncollectible” recoverable Micalden Invs. S.A. v Guerrand-Hermes, 30 A.D.3d in bankruptcy 341, 342-3, 819 N.Y.S.2d 228 (1st Dep’t 2006). cases. Since he is paying a debt, the debtor received fair consideration. The consideration is the satisfaction q of the loan. Only if the debtor subsequently files for or is forced into bankruptcy, can the trustee recover the payment for the benefit of all creditors, using the federal law of preferential transfers. Debtors are often forced into bankruptcy for the sole purpose of recovering preferential transfers. Under the relatively unknown line of cases, a creditor can,One in a series of articles using the state fraudulent conveyance law, recover preferential trans-designed to highlight fers made to certain persons, even if the debtor is not in bankruptcy. useful litigation tactics 3025 Quentin Road, Brooklyn, NY 11234 tel: 347.462.2295 fax: 212.202.4009 email: soljas@gmail.com

Unlike bankruptcy, the creditor can recover the trans- gives that person an unconscionable advantage over thefers for his own benefit, and does not need to share it other creditors. Either the individual is violating his orwith all creditors. her duty to act as a trustee of the assets of the corporation for the benefit of creditors or he or she is using the The seminal case in New York is Southern access to inside information and his or her control ofIndustries, Inc. v. Jeremias, 66 A.D.2d 1978 (2d Dep’t the corporation to benefit himself over other creditors. 1978). Jeremias was an officer, director and major Either way, a payment to an insider is not made in goodstockholder of Mazel Knitting Mills, Inc. (the “cor- faith and can be recovered by the creditor. Also seeporation”). Over the years, Jeremias had legitimately Farm Stores, Inc. v School Feeding Corp., 102 A.D.2dloaned the corporation over $200,000. At the same 249 (2d Dep’t 1984), aff’d, 64 N.Y.2d 1065 (1985). time, Southern Industries, a trade creditor of the corpo- American Panel Tec v Hyrise, Inc., 31 AD3d 586, 588ration, was owed over $30,000. (2d Dep’t 2006)(citing cases). Soon after, the corporation ceased doing The filing of a judgment of confession consti-business, the board of directors decided to transfer its tutes a transfer of a debtor’s property. The judgmentremaining assets, worth approximately $60,000, to creditor obtains a lien on theJeremias in partial payment of the debt owed to him. debtor’s property. Under theSouthern Industries, around that time, obtained a judg- q doctrine of Southern Industries,ment against the corporation. It then began an action Payment made even if the judgment creditor isseeking to recover the payment made to Jeremias, argu- legitimately owed the money, to insidersing that the transfer was a fraudulent conveyance. the confession of judgment may are not made Article 10 of the New York Debtor and Credi- be avoided if the judgment credi- in good faith.tor Law (“DC&L”) defines to two types of fraudulent tor is an insider of the judgmentconveyances: (a) those made with an actual intent to debtor. Posner v. Posner 1976 qhinder, delay or defraud creditors (DC&L § 276) and (b) Irrevocable Family Trust, 12those that are constructively fraudulent (DC&L §§ 273 A.D. 3d 177, 784 N.Y.S.2d 509 (1st Dept. 2004) (Courtet seq.). The Court held that the transfer, by the corpora- avoided confession of judgment given to trust con-tion to Jeremias, was constructively fraudulent. trolled by debtor). A transfer will be deemed constructively It remains to be seen how far courts will go infraudulent if it is made at a time when a debtor is unable extending Southern Industries’ doctrine.to pay his or her debts or is insolvent and is not made in In most small corporate businesses, the prin-exchange for “fair consideration.” One of the elements cipal shareholders have contributed their own funds toof “fair consideration” is that the transfer must be made either start up the business or to help it grow or survive. “in good faith.” DC&L § 272(a). If the funds are deemed capital contributions, creditors The Court defined “good faith” broadly: the must be paid before the funds may be returned to thetransfer must be made (a) with a true belief in the pro- shareholders. If the funds were contributed as a loan,priety of the transfer, (b) without the intent to take im- the shareholder may think that he can “pay himselfmoral advantage of others, and (c) without the intent back” before other creditors. The doctrine of Southernto hinder, delay or defraud others. Essentially, “good Industries mandates that creditors recover these fundsfaith” means that the parties to the transfer must be from the principal.dealing honestly, fairly and openly. The first step in applying this doctrine is to ob- The Court maintained that a transfer by a tain information. Creditors should act quickly after ob-corporation to a person who is an officer, director and taining a judgment to subpoena bank records, the mostmajor shareholder (otherwise known as an “insider”) expedient way of ascertaining the movement of assets. n S ol o m on J . J a sk i el , e s q . Commercial and Estate Litigation n Creditors’ Rights

Litigation on point

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