When a debtor files for bankruptcy, all of the debtor's assets and liabilities are automatically transferred into a bankruptcy estate. These assets are then used either to help a debtor reorganize or to repay all of the debtor’s creditors in liquidation. Under the United States Bankruptcy Code (the “Bankruptcy Code”), to preserve the estate assets a bankruptcy trustee can avoid certain transfers made by debtors as fraudulent transfers. Without this power to avoid transactions that occur prior to a debtor filing for bankruptcy, debtors could engage in transactions that drain the company of any of its valuable assets and leave little to no value for creditors.
There are two types of fraudulent transfers recognized under the Bankruptcy Code – actual fraudulent transfers, and constructive fraudulent transfers. A bankruptcy trustee can avoid actual fraudulent transfers if the transfers were made with an actual intent to delay, hinder, or defraud creditors. A bankruptcy trustee can avoid constructive fraudulent transfers if the debtor: (1) received less than equivalent value in exchange for the transfer; and (2) the debtor was insolvent at the time that the transfer was made or became insolvent as a result of the transfer, the transfer left the debtor with unreasonably small capital, or the debtor intended to incur debts beyond its ability to pay.
This memorandum focuses on constructive fraudulent transfers by reviewing the tests that bankruptcy courts apply to determine whether a debtor was insolvent. Part A discusses the balance sheet test, Part B examines the capital adequacy test and Part C addresses the cash flow test.