Subsection 5(b) of the Uniform Fraudulent Transfers Act: An Underused Creditors' Remedy?

Have you encountered this situation? You represent a judgment creditor and, in the course of collecting a judgment, you discover that all of the judgment debtor’s assets are subject to a security interest in favor of the judgment debtor’s principal. You also discover that while the judgment debtor was insolvent, significant payments have been made to the insider on account of the secured debt. Can these payments be recovered? The answer is “yes” if the judgment debtor is located in one of the approximately 38 states and the District of Columbia that have adopted Subsection 5(b) of the Uniform Fraudulent Transfers Act.[1] Subsection 5(b) states as follows:

(b) A transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the transfer was made to an insider for an antecedent debt, the debtor was insolvent at the time, and the insider had reasonable cause to believe that the debtor was insolvent.

UFTA,§5(b). Insiders are often quite legitimately advised to make loans to their businesses on a secured basis, or, having previously loaned money to the business, the insider is legitimately advised to further protect this debt investment with a security interest. However, if the business is insolvent at the time that debtor makes loan payments to the insider, the payments may be recoverable. Given the relative paucity of case law dealing with this nonbankruptcy “preference,” it appears that this potentially powerful creditors’ remedy has been underutilized.

Elements of a Subsection 5(b) Claim
In order to recover payments to insiders, the attacking creditor must show the following:

1. That there was a “transfer”. UFTA,§1(12).
2. That the debtor was insolvent at the time of the transfer. “Insolvency” is defined in §2 of the UFTA as follows:

1. 1. A debtor is insolvent if the sum of the debtor’s debts is greater than all of the debtor’s assets, at fair valuation.
   2. A debtor who is generally not paying his [or her] debts as they become due is presumed to be insolvent.
   3. A partnership is insolvent under subsection (a) if the sum of the partnership’s debts is greater than the aggregate of all of the partnership’s assets, at fair valuation, and the sum of the excess of the value of each general partner’s non-partnership’s assets over the partner’s non-partnership’s debts.

3. That the transfer was to an insider. UFTA, §1(7); and
4. The insider had reasonable cause to believe that the debtor was insolvent. UFTA §5(b).

“Transfer” is broadly defined as “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with an asset or an interest in an interest, and includes payment of money, release, lease, and creation of a lien or other encumbrance.” UFTA,§1(12). In the example cited above, both the granting of the security interest and the repayment of loans qualify as “transfers” under the Act. If the transfers were made on account of a pre-existing obligation, they were made on account of an “antecedent debt.” One useful definition of “antecedent debt” is “a legally enforceable obligation, which has been in existence prior to the time in question, to reimburse another with money or property.” West Encyclopedia of American Law (2d Ed. 2008). Another definition, taken from bankruptcy preference case law, is “debt that is incurred before the allegedly preferential transfer takes place.” See, e.g., In re Jones Truck Lines Inc., 130 F.3d 323 (8th Cir. 1997). Again referring to the fact pattern cited above, if the security interest was granted or payments made at the time when the insider had already advanced money or contributed property to the judgment debtor, the grant of the security interest or the repayment of loans was “on account of antecedent debt.”

Either the existence of other judgments or testimony from other unpaid creditors can establish that the debtor was “not generally paying its debts as they become due.” This is a subjective standard for insolvency that may be expensive and difficult to establish. More often, the debtor’s own internal financial statements will show that its liabilities exceed its assets, and that therefore the debtor is “balance sheet insolvent” within the meaning of UFTA§2(a).

The final element of proof, that the insider had “reasonable cause” to believe that the debtor was insolvent at the time of the transfers, is once again a subjective measure. However, by examining the insider’s relationship to the judgment debtor, it often becomes self-evident that the insider was familiar with the debtor’s financial condition. In one recent case in which the author was involved, for example, the insider was the corporate treasurer and majority shareholder. The insider testified that he prepared the judgment debtor’s internal financial statements and monitored the debtor’s bank deposits and payments. In a closely held corporation that is likely to be the subject of a §5(b) action, facts establishing the necessary “reasonable cause” should flow from the insider’s relationship to the judgment debtor.

Defenses to §5(b) Claims
Subsection 8(f) of the UFTA sets out the defenses available to a §5(b) claim:

(f)   A transfer is not voidable under §5(b):
(1) To the extent the insider gave new value to or to the benefit of the debtor after the transfer was made unless the new value was secured by a valid lien;
(2) If made in the ordinary course of business or financial affairs of the debtor and the insider; or
(3) If made pursuant to a good faith effort to rehabilitate the debtor and the transfer secured present value given for that purpose as well as an antecedent debt of the debtor. UFTA§8(f).

Case law developing the extent to which these defenses are available in the Subsection 5(b) context is rare.[2] However, by analogizing to the similar defenses afforded defendants in preference cases, 11 U.S.C. §§547(c)(4) for new value and 547(c)(2) for ordinary course of business, the existence and extent of these defenses can be ascertained and, if necessary, litigated.[3]

Conclusion
Subsection 5(b) of the UFTAcan provide a powerful tool to recover money on behalf of creditors where an insider has preferred him/herself by receiving money or property while the debtor is insolvent. This remedy is available in at least 38 states and the District of Columbia. However, the paucity of case law applying the statute seems to indicate that §5(b) is an underutilized tool in the creditors’ remedies’ toolbox.

Reference Material: Please click the following link below to view the accompanying Uniform Fraudulent Transfers Act chart arranged by state. Uniform Fraudulent Transfers Act Chart