Several months ago, I stumbled upon an old opinion out of the U.S. Supreme Court suggesting that the right of a creditor to race to the courthouse to collect on its claim against a debtor—and to win (or lose) that race—is a basic right of contract that cannot be abridged by state law, absent fraud.
The U.S. Supreme Court opinion, from 1838, is Clark v. White. And it describes the race-to-the-courthouse right like this:
- “each creditor acts not only for himself, but in opposition to every other creditor, all equally relying upon their vigilance to gain a priority which, if obtained, each being entitled to have satisfaction, the payment cannot be questioned”;
- “debtor may prefer one creditor, pay him fully, and exhaust his whole property, leaving nothing for others equally meritorious”; and
- “why may not debts be partially paid in unequal amounts?”
- “If those who receive partial payments are willing to give releases, it is their own matter”; and
- “should a third person interfere, debtor and creditor could well say to him you are a stranger, and must stand aside.”[Fn. 2]
And such race-to-the-courthouse right is reflected in the U.S. Constitution’s Contracts Clause, which reads:
- “No State shall enter into any . . . Law impairing the Obligation of Contracts” (Article I, Section 10, Clause 1).
The Fraud Question
So . . . the question is this:
- What constitutes fraud that limits a creditor’s right of racing to the courthouse?
The Answers
–Bankruptcy Code
The Bankruptcy Code answers the question under federal law with its own preference and fraudulent transfer provisions and multiple other provisions that impair contract rights in a variety of ways.
,The authority of the federal government to impair basic contract rights, through its bankruptcy laws, also comes from the U.S. Constitution. The Constitution’s Bankruptcy Clause says:
- “The Congress shall have Power . . . To establish . . . uniform Laws on the subject of Bankruptcies throughout the United States” (Art. 1, Sec. 8, Cl. 4)
–State Law
Outside of bankruptcy, it is state laws on fraudulent transfers that answer the question.
The primary source of such state laws is the Uniform Voidable Transactions Act and its prior iterations.[Fn. 1] Here are some basic rules from that Act.
Value. Payment of an antecedent debt qualifies as “value.” Under Section 3(a) of the Act:
- “Value is given for a transfer or an obligation if, in exchange . . . an antecedent debt is secured or satisfied.”
In other words, the mere payment on an antecedent debt cannot be, in and of itself and without some additional indication of fraud, a voidable transfer under the Act—regardless of Debtor’s financial condition.
Here’s a hypothetical. Debtor has multiple creditors, Debtor pays one creditor $1,000 cash on a $10,000 loan and another creditor $1,000 cash on a $1,000 loan, and Debtor makes no other payment on any loan. Under the Act, both creditors received “value” and both creditors received a “reasonably equivalent value.” If these facts are the only evidence of what happened, the two payments are not voidable under the Act.
If, however, Debtor makes each of the two payments by delivering goods instead of paying cash, a question of “reasonably equivalent value” could remain.
Constructive Fraud. Constructive fraud, under sections 4(a)(2) and 5(a) of the Act, comes in the form of a combination of the debtor:
- receiving less than a “reasonably equivalent value” in exchange for what is transferred, and
- combined with debtor’s insolvency (i.e., debtor’s remaining assets are unreasonably small, or debtor will be unable to pay debtor’s debts as they became due).
Again, a cash payment on an antecedent debt cannot be, in and of itself, a voidable transfer for constructive fraud under the Act—regardless of Debtor’s financial condition—because a “reasonably equivalent value” is provided.
In the hypothetical above with the two $1,000 loan payments in cash, neither can be voidable for constructive fraud, even if Debtor is insolvent, because each of the payments qualifies as a “reasonably equivalent value” under the Act.
Actual Fraud.
Since parties who actually intend to hinder, delay or defraud creditors rarely admit to their nefarious intent, such intent must be found from circumstantial evidence.
The circumstances that have come, over time, to be recognized as “badges” of fraud are enumerated under section 4(b) of the Act and include:
- the transfer is to an insider;
- debtor retains control of the transferred property;
- debtor conceals the transfer;
- debtor had been sued or threatened with suit;
- debtor transfers substantially all debtor’s assets;
- debtor receives less than a reasonably equivalent value for the transfer; and
- debtor was insolvent at, or became insolvent by, the transfer.
In other words, the badges of fraud can provide, in appropriate circumstances, the indication of fraud needed to undo a creditor’s win in its race-to-the-courthouse.
But payments to non-insiders on antecedent debts are rarely avoided under the Act for actual fraud:
- that’s because a business in financial stress still has to pay its debts (at least some of them and even if payments are late) to continue operating; and
- throwing a creditor a bone (i.e., making a small payment on a defaulted debt) is standard procedure for debtors in financial stress.
And the badges of fraud are commonly applied to reflect such realities because, for starters, cash payments on antecedent debts qualify as reasonably equivalent value under the Act: it’s difficult (though not impossible) to characterize any transfer as “fraudulent” when a reasonably equivalent value is given in exchange.
- That’s one of the reasons that preference claims under the Bankruptcy Code become significant, once a debtor files bankruptcy.
Constructive Fraud & An Insider. The only time the Act transforms a transferee’s knowledge of debtor’s financial distress into voidability, without further proof of an actual intent to hinder, delay or defraud, is when a payment is made to an insider on an antecedent debt.
An insider is defined in Sec. 1(8) of the Act as a person in control of the debtor or closely affiliated with the debtor.
And Sec. 5(b) of the Act provides (emphasis added):
- “A transfer made by a debtor is voidable . . . if the transfer was made to an insider for an antecedent debt, the debtor was insolvent at that time, and the insider had reasonable cause to believe that the debtor was insolvent.”
It’s interesting to note that this insider preference provision of the Act has the same one year statute of limitations as the insider preference provisions of the Bankruptcy Code. Compare Sec. 9(c) of the Act with Sec. 547(b)(4)(B) of the Bankruptcy Code.
The reason for a special knowledge-of-insolvency rule for insiders is explained by the U.S. Supreme Court like this:
- “rules of fair play and good conscience” require that an insider cannot “avail himself of privileges normally permitted outsiders in a race of creditors” and “cannot utilize his inside information and his strategic position for his own preferment.”[Fn. 3]
In other words, mere knowledge of a debtor’s insolvency is not a sufficient indication, alone, to undo a creditor’s win (in the form of a cash payment on an antecedent debt) in its race-to-the-courthouse—unless the creditor is an insider.
Conclusion
A creditor’s right to race-to-the-courthouse to collect on a debt—and to win (or lose) that race—is a basic right of contract in these United States.
That right even has its foundation and protection in the U.S. Constitution’s Contracts Clause.
It is only when fraud intervenes that state law can undo a creditors win in that race. And outside bankruptcy, state law defines what qualifies—and what does not qualify—as such fraud. Typically, that definition is provided under state law by the Uniform Voidable Transactions Act or its predecessors (see footnote 1)).
———————–
Footnote 1. The Uniform Voidable Transactions Act is an updated version of the Uniform Fraudulent Transfer Act, which updated the prior Uniform Fraudulent Conveyances Act. On the basic rules under that Act described herein, the three versions are substantially the same.
Footnote 2. The opinion is Clark v. White, 13 U.S. 178, 200 (1838).
Footnote 3. The opinion is Pepper v. Litton, 308 U.S. 295, 311 (1939).
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MEDIATBANKRY 
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