Fraudulent Conveyance Risk a Recession Reality
It is unfortunate that credit unions often must deal with insolvent debtors and guarantors. Insolvency of a credit party can leave a creditor in an unanticipated position; namely, with no lien or with an unenforceable guaranty. Section 548 of the U.S. Bankruptcy Code establishes the law of “fraudulent conveyances” and empowers a bankruptcy trustee or a debtor in possession to void or cancel certain security interests or guarantys that:
(i) were made or incurred when the grantor of the lien or guarantor was insolvent, or
(ii) that rendered the grantor of the lien or guarantor insolvent, or
(iii) left the grantor of the lien or guarantor with unreasonably small capital, or
(iv) left the grantor of the lien or guarantor unable to pay its obligations as they matured, and
(v) were made or incurred for less than reasonably equivalent value.
A credit union must assess whether a credit party under the loan is insolvent or will be rendered insolvent by reason of the loan; or will be left with unreasonably small capital; or will be unable to pay its obligations as they mature.
In addition to evaluating a credit party’s credit worthiness, a credit union must also determine whether the credit party received something meaningful in exchange for its guaranty or pledge of assets. If not, the guaranty or pledge could be deemed void or voidable. The risk of fraudulent conveyances can become particularly acute in loans to a consolidated group of companies, particularly where parties pledging assets or guaranteeing the loan are not receiving loan proceeds.
When evaluating and monitoring credit extended to a parent company and its subsidiaries, many lenders often focus solely on the consolidated financial statement of the credit parties. They fail to evaluate and monitor the credit worthiness of each individual credit party.
Because of the concern of fraudulent conveyances, this approach is inherently flawed. Credit unions should evaluate all the facts when making these types of loans in order to mitigate the fraudulent conveyance risks.
One approach to monitoring solvency is to require updated and audited financial statements for each of the credit parties. This would allow the credit union to monitor the solvency of each party, reserving the right to refuse to lend additional amounts if any critical repayment source is not sufficiently solvent.
In short, there is no substitute for careful monitoring of the financial status of each credit party on a stand-alone basis. Simply relying on the financial strength of the consolidated group of credit parties can lead to problems down the road.
As long as credit unions enter into loan transactions with their eyes open and with an understanding of the fraudulent conveyance risks, loans can be analyzed and structured to at least mitigate the chance that guaranties or collateral pledges could be avoided in the event of the insolvency of an obligor.