Parents frequently transfer their ownership interests in a family-owned business to their children. This is usually done in connection with an owner’s estate planning or as part of an orderly succession of the business’ management. But what happens if an owner transfers his or her business interests in order to place the business assets or interests out of the reach of that owner’s creditors? In that case, the transfer may be avoided as a fraudulent transfer.
Many state fraudulent transfer statutes provide creditors a right to avoid the transfer of a person’s assets where that transfer was undertaken with an “actual intent to hinder, delay, or defraud any creditor of the debtor.” In order to determine whether there was an “actual intent” to defraud creditors, courts usually look for so-called “badges of fraud.” These badges typically include “whether the debtor retained possession or control of the property after the transfer, whether the transferee shared a familial or other close relationship with the debtor, whether the debtor received consideration for the transfer, whether the transfer was disclosed or concealed, whether the debtor made the transfer before or after being threatened with suit by creditors, whether the transfer involved substantially all of the debtor’s assets, whether the debtor absconded, and whether the debtor was or became insolvent at the time of the transfer.” If a creditor proves a transfer was fraudulent, the creditor will be able to recover the value of the property transferred from the initial transferee or, in certain cases, from a subsequent transferee. If the transferor files for bankruptcy, the United States Bankruptcy Code provides a bankruptcy trustee a similar right to avoid fraudulent transfers for the benefit of the debtor’s creditors.
In In re: Michael A. Wolf (Adv. No. 16 A 00066, November 19, 2018), a Bankruptcy Court in Illinois recently ruled that a father’s transfer of his interests in a business to one of his sons was a voidable fraudulent transfer and entered an award against the son for the full value of the business that was transferred. Michael Wolf was the 100% owner of Zig Zag Corp., which ran a furniture industry trade publication business called Monday Morning Quarterback (MMQB). His two sons, Scott and Peter, and his wife, Elizabeth worked for Zig Zag for many years. In addition to paying himself a “lavish” salary, Michael caused Zig Zag to pay his and his family’s personal expenses for many years.
By late 2011, Michael and Elizabeth’s marriage “began to fall apart.” In 2012, Michael transferred all of the MMQB assets to a separate company, ZZC, Inc. (ZZC), in which Michael initially held 100% of the shares. The MMQB assets were worth $2.1 million at the time of that transfer. According to the court, “[t]he purpose of the transfer was to remove [Michael’s] interest in the business from the reach of his creditors including, but not limited to, his wife, in anticipation of their impending divorce.” In around 2013, Michael transferred 51% of the shares in ZZC to Scott. In 2014, Scott transferred the MMQB assets to yet another company, MMQB, Inc., in which Scott owned 100% of the shares. None of these transfers were made in exchange for any payment or other consideration, however. All the while, the income from the MMQB business continued to go to Michael through loans and payments for his living expenses and legal fees.
Elizabeth filed for divorce in late 2013. Shortly thereafter, ZZC’s board, consisting of Michael and Scott, fired Elizabeth from her advertising job with the company. During the course of Michael’s divorce proceedings, he was ordered to sell his Aston Martin to pay for Elizabeth’s legal fees. Michael never turned over the proceeds of the sale and was held in contempt by the family court. He then filed for bankruptcy rather than face jail time for his contempt. As of the bankruptcy filing date, Michael owed the IRS, credit card companies and Elizabeth over $1 million.
The bankruptcy trustee sued Michael, Scott, ZZC and MMQB, Inc. to avoid the transfers of the MMQB business assets and to recover their value for the benefit of Michael’s bankruptcy estate and creditors. As an initial matter, the bankruptcy court agreed with the trustee that Zig Zag should be treated as Michael’s alter ego for purposes of owning the MMQB assets. Relying on Illinois law, the court determined that Michael Wolf was Zig Zag’s sole stockholder; that he commingled his own and Zig Zag’s funds by paying personal and family expenses; that he diverted Zig Zag’s business assets to related entities for no consideration; and that he was the “dominant personality” behind the MMQB business originally held by Zig Zag. Further, the court determined that Michael “used Zig Zag to promote fraud by draining its assets in an intentional attempt to prevent his creditors from reaching the value of the business, and thus the separate personality of Zig Zag should be disregarded.” Based on this determination, the court treated the transfer of Zig Zag’s assets as a transfer of Michael’s personal assets for purposes of his individual bankruptcy case.
The court then ruled that the trustee had shown that Michael made the transfer of the MMQB assets from Zig Zag to ZZC with actual intent to defraud his creditors, in particular his ex-wife, so that she could not recover anything from him in the divorce proceedings. Specifically, the court relied on the claims that the transfer was to an insider since Michael wholly owned and controlled ZZC at the time of the transfer; Michael retained possession or control of the property transferred to ZZC after the transfer; neither Michael nor Zig Zag received any consideration for the transferred MMQB assets; and Michael became insolvent after the transfer was made. Because the MMQB asset transfer was voidable as a fraudulent transfer, the Trustee was allowed to recover the value of the MMQB assets from ZZC. The court thus entered a money judgment of $2.1 million against ZZC.
The court also determined that Michael fraudulently transferred 51% of his stock in ZZC to Scott. Here, where Scott was Michael’s son, the transfer was to an insider. Michael also received no consideration for the stock. The court also found that Michael had concealed the transfer through his contradictory assertions in tax returns and in court filings. Michael also allegedly became insolvent as a result of the transfer. Finally, the court noted that Elizabeth’s imminent divorce filing tended to show a possible threat of suit by one of Michael’s creditors since he may have been subjected to an alimony award or a property division order as of the transfer date. Because the stock transfer to Scott was voidable as a fraudulent transfer, the Trustee was allowed to recover 51% of the value of the MMQB assets from ZZC. The court thus entered a money judgment of $1,071,000 against Scott in connection with his receipt of the stock.
The court also ruled that MMQB, Inc., as a subsequent transferee of the MMQB assets from ZZC, was liable for the $2.1 million value of the assets. Finally, the court determined that MMQB, Inc. was Scott’s alter ego. Scott was the sole shareholder, director, and officer of MMQB, Inc., and had himself entered into numerous “one-sided, non-arms length transactions with multiple related entities in order to siphon off value from the MMQB business being run through the MMQB, Inc. legal entity.” The court found alter ego liability was appropriate to avoid injustice since Scott used MMQB, Inc. to aid Michael in hiding assets from his creditors. The court thus entered an order that Scott was liable for the full value of the MMQB business to the same extent that MMQB, Inc. was.
Certainly, most transactions between family members to transfer family-owned business assets or stock are carried out in good faith and for legitimate business or estate planning purposes. However, the decision in the Wolf bankruptcy case serves as a stark reminder of the risks of personal liability to business owners and later transferees in situations where the transfers are alleged to be voidable under applicable fraudulent transfer laws.
Parties to business transfer agreements or arrangements should therefore carefully review applicable state fraudulent transfer statues to determine if the transaction is subject to avoidance by a creditor through a later lawsuit.
Even a bankruptcy filing by the transferor will not insulate the transaction, since a later-appointed bankruptcy trustee has the authority under the Bankruptcy Code to pursue fraudulent transfer claims for the benefit of the bankruptcy estate and the debtor’s creditors. Finally, as in the Wolf case, where parents are going through a divorce, their children may wish to tread carefully when entering into business transactions with one parent that arguably could injure the other parent in the division of marital property. Otherwise, they may be liable for the value of the transferred property as transferees of the fraudulently transferred assets.