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Four Types of Constructive Fraud Claims

by | Nov 18, 2018 | Judgments

Four Types of Constructive Fraud Claims

Several sections of New York’s Debtor and Creditor Law (“DCL”), which govern similar but distinct claims of constructive fraud, provide redress to creditors for various scenarios in which debtors conceal, move, or unlawfully distribute assets which could otherwise be used to satisfy a judgment.

DCL 273 prohibits debtors from transferring assets to third parties without clear consideration when the transfers render the debtor insolvent. Insolvency occurs when the liabilities of a company are greater than its assets, although accountants, financial advisors, and other finance professionals may dispute the value of a particular asset or generally whether a particular party’s assets exceed their liabilities, which can complicate matters.

To illustrate this claim, let’s assume that a corporate debtor owes $1 million to a creditor, but transfers $1 million to help one of the debtor’s affiliated entities. After the transfer, the debtor’s remaining assets are only worth $500,000. Even if the debtor transferred the assets for a legitimate reason, to help a struggling affiliate, the transfer was made without consideration and rendered the debtor insolvent, as the debtor’s liabilities now exceed its assets. As a result, the debtor would likely be held liable to the creditor for fraud under DCL 273.

DCL 273-A also makes it unlawful for debtors to dissipate their assets without reasonably equivalent value in consideration, but this section applies specifically to transfers made during the lawsuit, before a judgment has even been entered against the debtor, if the debtor ultimately fails to satisfy the judgment.

DCL 274 addresses a similar situation based on slightly different criteria. Rather than insolvency, DCL 274 applies when the transfer of assets leaves a debtor with unreasonably small capital, even if the debtor is not technically insolvent. Using the prior example, suppose the debtor transfers $1 million to its affiliate but still has $1.1 million in furniture, computers, and inventory after the transfer. While the debtor is not insolvent on paper, the remaining assets may not have a resale value large enough to cover its debts, which could constitute a fraud under DCL 274.

DCL 275 goes a step further than the previous sections by protecting both creditors and future creditors, meaning that persons or entities to whom the debtor is about to become indebted may have recourse for certain transfers of assets. Imagine our debtor from above is not yet a debtor, but intends to borrow $1 million from a future creditor. Two days before closing on the loan, the debtor sends $1 million to its affiliate, leaving the debtor insolvent at the time the loan is made two days later. Since the debtor knew that it was borrowing money from the future creditor when it transferred the $1 million to its affiliate, and was left insolvent as a result of the transfer, the debtor would be liable to the creditor for fraud under DCL 275 even though the debtor owed no money to the creditor at the time the debtor became insolvent.

Under these various sections, the DCL has established mechanisms intended to protect creditors from most situations where constructive fraud may arise. Where a debtor strips its assets to the point that the debtor becomes insolvent, or remains technically solvent but largely unable to pay its debts, the DCL provides recourse to both creditors and future creditors alike to help them satisfy judgments against fraudulent debtors.

In our next article, we will discuss actual fraud, as opposed to constructive fraud, as well as the challenges and potential benefits of bringing such a claim under the DCL.

Kenneth J Katz.jpgKenneth J. Katz
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