Has Fraud Been Committed, Inadvertently? | Katz Melinger PLLC
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Has Fraud Been Committed, Inadvertently?

Has Fraud Been Committed Inadvertently

Companies or individual debtors can commit fraud inadvertently, all while doing business (or living life) as usual. This is known as "constructive fraud," a type of voidable transaction whereby a debtor's transfer of assets is considered fraudulent to a creditor even though the debtor did not intend to defraud the creditor.

When a debtor transfers assets while a lawsuit is pending against the debtor, the creditor may not only have a fairly easy claim for a voidable transaction, but may be able to extend the statute of limitations (how much time a creditor can go back to make a claim).

The statute of limitations for a claim of voidable transaction is four years. However, for transfers made during the pendency of a lawsuit, the statute of limitations does not start to run until a judgment in that lawsuit is entered (as opposed to running from the date of the fraudulent transfer). This means that, if the judgment is entered eight years after the lawsuit is filed, then the creditor not only has four years from the date of the judgment to bring a new lawsuit for voidable transaction for any unlawful transfers made during the lawsuit, but can seek damages for any such transfer that occurred during the original lawsuit, even if those transfers were made more than four years before the fraudulent conveyance claim was filed.

Under the debtor-creditor law, fraudulent conveyance claims require three main elements:

  1. Transfer without reasonably equivalent value in return: In a prior article, we discussed the two components of fair consideration: fair value & good faith. Almost any transactions involving "insiders" of a corporate debtor will be considered lacking "fair consideration." 

  2. Transfer during the pendency of a lawsuit: Any transfer that occurs after the debtor was sued would come under this purview. 

  3. Transfer while a judgment remains unsatisfied: The creditor only has to show that some sort of transfer occurred before the debtor satisfied the judgment.

Consider this example. A creditor brings a lawsuit against a corporation. Seven years later, a judgment is entered against the corporation for $500,000. During those last seven years, the corporation operated as it normally does: it distributed profits to shareholders; paid back loans to shareholders; loaned money to an affiliated company; and transferred property to a shareholder. Now that a judgment has been entered, all of these actions can be considered fraudulent conveyances and may expose the corporation and its shareholders and affiliated entities to liability. In this example, the creditor must only show that these transfers were made to "insiders", and that the transfers were executed during the lawsuit.

Creditors have very large windows of time to go back and assert claims on any transaction that occurred since the lawsuit was filed. This can be a powerful tool for creditors, and is difficult for corporations, or insiders, to defend against. Moreover, in New York, creditors are entitled to collect interest on any fraudulently conveyed assets at a rate of 9% per year, meaning that a $100,000 fraudulent conveyance claim grows to more than $170,000 after collecting eight years of statutory interest.

Even if the creditor believes that the corporate debtor is transferring assets to insiders during the pendency of the lawsuit, the creditor may need to wait until a judgment is entered before bringing claims against the debtor and any insiders. Once a judgment has been entered, a creditor has the power to subpoena the corporation's records, which may be the only way to discover all the fraudulent transfers that occurred during the lawsuit.

On the other hand, a debtor must be very careful once a lawsuit has been filed against it, as even otherwise routine decisions and transactions can expose shareholders to significant liability.

To learn more about how Katz Melinger can help you, contact us.

NOTE: This article has been updated to reflect changes in the Debtors and Creditors Law (DCL). The Uniform Voidable Transaction Act went into effect on Apr. 3, 2020.

Kenneth J Katz.jpgKenneth J. Katz
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