How to minimize the risk of fraudulent transfer claims when a vendor goes bankrupt Featured

9:01pm EDT May 31, 2012
How to minimize the risk of fraudulent transfer claims when a vendor goes bankrupt

Your parts distributor has always been reliable, offering you prices that its competitors couldn’t beat. It was a great deal for you — until the distributor went bankrupt.

You find another supplier and move on. But months — or years — later, you are called on by a bankruptcy trustee that has been appointed to oversee the bankruptcy case. The trustee says that the commodity you were purchasing was priced much lower than market rate. And because the trustee’s job is to collect funds in this case, he’s delivering you with a lawsuit to charge you with paying the difference between your below-market prices and the market rate for those years you purchased the commodity.

“Increasingly, customers of bankrupt businesses are being caught by surprise with fraudulent transfer claims asserted by bankruptcy trustees, who claim that they received a deal that was too favorable,” says Alan Koschik, co-chair of the Commercial & Bankruptcy Practice Group at Brouse McDowell. “These claims seek to renegotiate sale transactions long after they took place and create a new layer of uncertainty for certain business transactions.”

Smart Business spoke with Koschik about how businesses can help protect themselves against fraudulent transfer claims.

What are fraudulent transfers and when do they most commonly occur?

Technically, a fraudulent transfer claim is a transfer of property that is made with the intent to hinder or delay a creditor, or put property beyond their reach. In typical cases, a debtor might transfer his home or savings accounts to another person, an insider such as family or a spouse.

Fraudulent transfer claims most often arise in these familiar situations: transfers to insiders, as described; so-called upstream guaranties of a corporate parent’s debt by a business that ultimately cannot pay its creditors; and leveraged buyout transactions that cause an insolvent debtor to take on too much debt while permitting former equity holders to cash out of the business.

What is surprising about the new class of fraudulent transfer claims?

The new class of claims is distinctly different from these typical cases. They do not involve insider transactions, or extraordinary transactions. The claims are being charged against customers that have engaged in day-to-day business transactions, such as simply buying a commodity a company sells.

The customer isn’t trying to defraud or hinder anyone; it simply wants to buy the product and the seller (debtor) is offering an attractive price. However, bankruptcy trustees are seeking to change the price term of regular sales transactions long after they were completed by arguing that the value paid was less than ‘reasonably equivalent.’ Litigation ensues and usually involves an expensive debate about the sufficiency of the price.

What typical business transactions could lead to fraudulent transfer claims?

Sales of commodities are the most typical sales that can trigger a fraudulent transfer claim because a bankruptcy trustee has access to pricing information. Commodities are traded in a variety of exchanges, so trustees can look up idealized prices and make comparisons to prices actually paid to the debtor, the business that went bankrupt. Then, the trustee can calculate the difference and come up with a figure that he contends the customer should have paid.

The trustee justifies this based on commodities prices, charging that the debtor would have collected X more dollars if it had charged the reported market price. Commodities are more likely to be subject to a pricing comparison and lead to a fraudulent transfer claim than, say, accounting or legal services that are typically considered unique and less likely to have a non-negotiable ‘market price.’

In case of a lawsuit, what defenses can a business raise?

These new fraudulent transfer claims can be challenged with the argument that non-insider customers that negotiate at arm’s length set their own market price and should not bear the burden of guarantying the debtor-seller’s debts to its creditors. The customer shouldn’t have to help pay the vendor’s debt just because it was offered a lower price on a commodity during a regular business transaction.

A non-insider customer’s negotiated price should be considered to be ‘reasonably equivalent value’ by definition and the trustee’s claim should fail. However, the problem is that litigation is a lengthy, costly process, and customers frequently end up paying more in a settlement.

How can businesses protect themselves against fraudulent transfer claims?

If your business purchases commodities, dig deeper when vendors offer a surprisingly low price. Why is the price so low? How long has the company been in business? Are you aware of the financial state of the vendor’s business? Is it in trouble? How much lower than market rate is this vendor charging?

While it’s prudent in business to seek out vendors with competitive prices, if a deal seems too good to be true, it just might be. That said, if you move forward with a vendor offering a price you can’t resist, engage in a futures contract or swap agreement. These transactions are common in the commodity trade, and there are safe harbor defenses built into the bankruptcy code regarding futures trading.

It’s a good idea to consult with your attorney if you engage in commodities purchases to discuss pricing and the potential risks associated with fraudulent transfer claims. Then protect your business by making decisions not based solely on cost.

Alan Koschik is co-chair of the Commercial & Bankruptcy Practice Group at Brouse McDowell. Reach him at akoschik@brouse.com.

Insights Legal Affairs is brought to you by Brouse McDowell