Since the enactment of the Fraudulent Conveyances Act of 1571, the law has prohibited transfers designed to hinder, delay, or defraud creditors.[1] Likewise, aiding-and-abetting and conspiracy are well-established bases for civil liability. Business lawyers live and breathe these concepts. Yet a survey of several cases shows that many lawyers are seemingly unaware of the real possibility that creditors could seek to hold them liable for assisting an insolvent or near-insolvent client to transfer assets, or do so despite knowing of the relevant ethical and legal issues. Attorneys — especially attorneys for closely held entities — should understand that such risks are real and ensure that they do not (even unintentionally) aid others in the fraudulent transfer of assets.
A Hypothetical
Imagine an attorney with a longstanding, profitable corporate client. While legally the attorney’s client is the corporation, in reality the attorney works with the client’s majority owner and president, who over the years has become the attorney’s friend and confidant. The attorney knows that recent general economic conditions have caused a contraction in the client’s sector, but he has not studied the client’s current financial condition. Yet because the attorney is confident in his friend’s leadership and believes that the president would tell him if business was bad, he has a general belief that the corporation’s business is fine.
One day, the president asks the attorney to transfer corporate assets to his son. The attorney asks why, and the president says (not implausibly) that he’s getting older and wants to provide for his children. The attorney papers the transaction. Among other things, the attorney writes a letter to the corporation’s secured lender stating that the corporation is financially sound and seeks to transfer the assets for legitimate reasons. Despite these statements, the attorney never asks the president whether he is trying to shelter assets in anticipation of a possible bankruptcy, whether the president is worried about the company’s future, or even how business is going.
As it turns out, business is rotten and the company seeks bankruptcy protection soon after the transfer. After the company enters bankruptcy, a chapter 7 trustee discovers emails showing that the president knew bankruptcy was inevitable and wanted to shelter assets from creditors. The trustee brings claims against the attorney for: (1) conspiracy to fraudulently transfer assets; (2) aiding and abetting a fraudulent transfer; (3) fraud; and (4) negligent misrepresentation.
Recent Developments
This scenario is not fanciful. While many states do not recognize claims against non-transferees for assisting a fraudulent transfer,[2] others do, and bankruptcy trustees and dissatisfied creditors do bring this kind of claim against attorneys for assisting clients in fraudulently transferring assets. In In re Restaurant Development Group Inc., [3] for example, the court held that Illinois law creates a cause of action against attorneys for civil conspiracy to commit actual fraud. In that case, a chapter 7 trustee alleged that attorneys conspired with corporate owners to transfer assets from the debtor to other companies, which would continue the debtor’s operations, in an effort to evade creditors. The trustee specifically alleged intentional deceitful conduct by the attorneys that was designed to further the conspiracy to commit actual fraud, including backdating documents to conceal the debtor’s financial liabilities. The court held that Illinois law creates an action for civil conspiracy, including conspiracy to commit a fraudulent transfer, and contains no exception for attorneys.[4] Provided that the trustee brings suit on behalf of the creditors as a class, the in pari delicto defense likely will not apply.[5]
Likewise, in Banco Popular North America v. Gandi, the New Jersey Supreme Court held that a third-party creditor could sue an attorney for torts committed in assisting a client to fraudulently transfer assets.[6] A bank loaned money to Gandi’s fast food franchises, personally guaranteed by Gandi. Gandi’s attorney, Freedman, represented to Banco Popular that Gandi met the loan documents’ representations and warranties. Later, when Gandi and a franchisor had a falling-out, Freedman advised Gandi to transfer assets into his wife’s name. When Gandi defaulted on the loan, the bank sued Freedman for (1) conspiracy to hide assets, (2) Freedman’s allegedly wrongful advice, and (3) misrepresentations in the letter to the bank. The New Jersey Supreme Court held that the bank could not sue Freedman for the legal advice he rendered to Gandi or for “creditor fraud[,]” but it allowed the bank to proceed on its claims for (1) civil conspiracy to fraudulently transfer assets and (2) negligent misrepresentation.[7]
Moreover, punitive damages may be available if the attorney’s behavior is later deemed willful and wanton, depending on the law of the jurisdiction.[8] This may be so even in states that, like Illinois, bar punitive damages in legal malpractice actions.[9]
Finally, in addition to civil liability, attorneys assisting clients in fraudulently transferring assets also face potential ethical sanctions pursuant to Model Rule of Professional Conduct 8.4[10] and its state equivalents, and even criminal liability, although those subjects are beyond the scope of this short article.
Liability in Our Hypothetical Scenario
In the hypothetical scenario described above, the chapter 7 trustee likely will survive a motion to dismiss and may prevail on his claims for conspiracy and aiding-and-abetting, because the attorney knew that the company likely was in dire financial straits. The trustee may even succeed on his claims for fraud and negligent misrepresentation, because the attorney vouched for his client’s financial wherewithal and intent without conducting an adequate investigation.
Best Practices
What should an attorney do when a client asks for help in transferring assets and the attorney has reason to suspect that the client is insolvent or nearly so? We recognize that we live in the real world. Attorneys are not auditors, and are entitled to trust their clients’ representations. That said, the liability risks are real.
If the attorney is at all aware that the client’s business, or even its sector, is experiencing difficulty, the attorney should conduct at least some investigation into the client’s solvency. At a minimum, the attorney should obtain the client’s balance sheets and any financial disclosures. Explain to your client that you are doing this for both their benefit and your own. The attorney should document any concerns, and the reasons why he is proceeding with the representation in writing — perhaps by letter or a memo to the file. Finally, the attorney should refrain from making any representations to third parties about the client’s financial health or intentions, and if such a statement is required (say, by a lender), the attorney must make his own independent investigation, or rely on information from an accountant or auditor.
While it is always difficult to question a client about the reasons for a proposed transaction, simple precautions can save the attorney from allegations that, even if unfounded, could lead to lawsuits or disciplinary proceedings, or at a minimum tarnish the attorney’s reputation.
[1] 13 Eliz 1, ch. 5 (1571).
[2] See GATX Corp. v. Addington, 879 F. Supp. 2d 633, 643-645, 648-50, (E.D. Ky. 2012); In re Parker, 399 B.R. 577, 580-81 (Bankr. E.D.N.Y. 2009); Freeman v. First Union Nat’l Bank, 865 So. 2d 1272, 1277 (Fla. 2004); see also Nastro v. D’Onofrio, 263 F. Supp. 2d 446, 458-59 (D. Conn. 2003) (holding Connecticut law does not allow action against attorney for aiding and abetting fraudulent transfer); 6 Del. Code § 1307(c) (requiring creditor to show bad faith to bring claim against attorney related to transfer).
[3] See, e.g., In re Rest. Dev. Grp. Inc., 397 B.R. 891, 897-98, (Bankr. N.D. Ill. 2008); see also In re Harwell, 628 F.3d 1312 (11th Cir. 2010) (holding that fact issue as to attorney’s good faith precluded summary judgment for attorney on equitable mere-conduit defense where trustee sought recovery for fraudulent transfers); Essex Crane Rental Corp. v. Carter, 371 S.W.3d 366 (Tex. Ct. App. 2012), reh’g overruled (June 7, 2012), review denied (Aug. 31, 2012), review denied (Nov. 30, 2012) (reversing summary judgment where material fact issue existed as to whether judgment debtors’ attorneys knowingly drafted documents to hinder creditor); D. Lee Khachaturian, Protecting Against Attorney Liability or Fraudulent Transfers, available at http://summerconvention.utahbar.org/2013/materials/A1_Fraudulent%20Transfers.PDF (last visited Nov. 1, 2014) (discussing, inter alia, Harwell and Essex Crane Rental Corp.).
[4] 397 B.R. at 897-98.
[5] See, e.g., In re Equip. Acquisition Res. Inc., No. 09-BK-39937, 2012 WL 4620624, **4-5 (Bankr. N.D. Ill. Oct. 1, 2012); In re Auto. Professionals Inc., 398 B.R. 256, 262-63 (Bankr. N.D. Ill. 2008).
[6] 184 N.J. 161 (2005).
[7] Id. at 175-86.
[8] Compare Aristocrat Lakewood Nursing Home v. Mayne, 729 N.E.2d 768, 782, (1999) (punitive damages available under Ohio UFTA); Volk Const. Co. v. Wilmescherr Drusch Roofing Co., 58 S.W.3d 897, 900 (Mo. Ct. App. 2001) (same under Missouri UFTA), with In re Fill, 82 B.R. 200, 227 (Bankr. S.D.N.Y. 1987) (punitive damages generally not available under New York law); C & A Investments v. Kelly, 792 N.W.2d 644, 647 (Ct. App. Wis. 2010) (reversing award of punitive damages under Wisconsin UFTA where plaintiff was not awarded compensatory damages); Litchfield Asset Mgmt. Corp. v. Howell, 799 A.2d 298, 309 (2002) (same under Connecticut UFTA); but see Robinson v. Coughlin, 266 Conn. 1, 6-9, 830 A.2d 1114, 1117-19, 2003 WL 22171908 (2003) (criticizing statement in Litchfield that Connecticut UFTA is wholesale codification of common law).
[9] Cripe v. Leiter, 683 N.E.2d 516 (Ill. App. Ct. 3d Dist. 1997) (allowing punitive damages in fraud claim against attorney, despite state statute barring punitive damages in all actions for legal malpractice).
[10] See MRPC Rule 8.4(c) (“It is professional misconduct for a lawyer to ... engage in conduct involving dishonesty, fraud, deceit or misrepresentation[.]”).