Void Transactions in bankruptcy

Bankruptcy trustees investigate pre-bankruptcy transactions when they suspect the transaction improperly transferred assets away from the bankrupt that would otherwise be available to creditors.

What are the provisions designed to do?

Bankruptcy trustees investigate pre-bankruptcy transactions when they suspect the transaction improperly transferred assets away from the bankrupt that would otherwise be available to creditors. The Bankruptcy Act 1966 will in some cases allow voiding these transactions and require the other party to return an asset or make a payment to the bankruptcy trustee.

Who may recover money under these provisions?

Trustees of bankruptcies and personal insolvency agreement's (PIA) may use the provisions to void transactions. However, a PIA must give the bankruptcy trustee this right, as it may be excluded in some agreements.

What must the trustee do to be able to make a recovery?

To void a transaction, the bankruptcy trustee must do the following:

  1. Identify the transaction.
  2. Identify the other party to the transaction.
  3. Prove the transaction occurred within a specific period, or while the bankrupt was insolvent (i.e. as a debtor pre-bankruptcy).
  4. Prove the transaction was either undervalue or had the required intention.
  5. Show the transaction did not involve protected property.

Why do trustees void some transactions?

A bankruptcy trustee must ensure that all the bankrupt’s divisible assets are available to distribute to creditors. Part of this obligation is to find whether the bankrupt entered into a transaction that reduced the amount of assets available for distribution. The bankruptcy trustee seeks to recover these assets and void any transaction that provided an advantage to any creditor, so that they can make a more equitable distribution to all creditors.

Sometimes when debtors face bankruptcy, they try to protect some of their assets by hiding, moving or transferring assets to a third party to hold during the bankruptcy period. The

void transaction provisions attempt to deter debtors from moving assets at their creditors’ expense, and to allow rightful recovery.

What type of transactions may be voided?

The Bankruptcy Act enables the bankruptcy trustee to void:

  • undervalued transactions (under section 120 of the Bankruptcy Act)
  • transfers done with the intention to defeat creditors (under section 121 of the Bankruptcy Act)
  • transfers where the consideration was paid to a third party (under section 121A of the Bankruptcy Act).

Undervalued transactions – Section 120

What are undervalued transactions?

Asset transfers at less than market value are deemed ‘undervalue’. Sometimes a debtor will sell or transfer assets to third parties shortly before their bankruptcy and attempt to make the transaction look commercial. Undervalue transactions may take the form of the following:

  • A sale for less than the asset’s market value— moving a valuable asset to another party.
  • A purchase of something at a greater consideration than its value, thus

moving money to another party.

Examples of these transactions include a debtor:

  • selling their share of their home to their spouse for $1 or ‘natural love and affection’
  • granting a mortgage or security to a party in exchange for monies that were lent previously
  • purchasing an asset of limited worth but paying a price well over market value.

A bankruptcy trustee can void property transfers—including money—within five years before the bankruptcy commenced.

Are some transfers of assets protected?

Yes. The Bankruptcy Act protects some transfers from being voided when all three of these conditions are present:

  1. The transfer occurred over two years prior to the bankruptcy’s commencement.
  2. The transfer did not involve a party related to the debtor.
  3. The debtor was solvent at the time of the transfer and remained solvent after the transaction.

Transactions undertaken with non-related parties while the debtor was solvent should be protected, as this would not be prejudicing creditors by transferring these assets. The other party to the transaction has the onus of proving that the bankrupt was solvent at the transaction time and remained solvent immediately thereafter.

Is the timing different if the other party is related to the bankrupt?

Yes. The two-year period extends to four years (i.e. prior to bankruptcy) if the other party to the transaction is related to the bankrupt.

This means that any undervalue transactions that took place four years before the bankruptcy’s commencement are automatically void if they involve related parties, as defined as ‘related entities’ in the Bankruptcy Act.

Is insolvency important?

A person is solvent if they are able to pay all of their debts as and when they become due and payable. A person who is not solvent is therefore insolvent.

A transfer under section 120 of the Bankruptcy Act is not void against a bankruptcy trustee if it took place more than two years before the bankruptcy’s commencement date and the debtor was solvent. Therefore, a bankruptcy trustee must demonstrate the bankrupt was insolvent where the transfer took place between three and five years before the bankruptcy’s commencement.

For related-party transactions, this two-year period is extended to four years. A court will usually look to the bankruptcy trustee to provide some evidence to substantiate the insolvency at the time of the transfer. Consequently, the onus of defending these claims and therefore declaring solvency lies with the party seeking to rely on a defence. The Bankruptcy Act provides for a presumption of insolvency if the debtor did not keep proper financial records during that period, but this presumption is rebuttable (i.e. it can be disproved by positive evidence of solvency). This can be quite difficult if there are truly no records of the bankrupt’s financial affairs.

Are some transfers exempt?

Yes. Some transfers of property will not be void. The Bankruptcy Act protects tax payments, payments made under family law agreements, and payments under Part IX debt agreements (i.e. Part 9 of the Bankruptcy Act).

A transfer is exempt when it is:

  • a tax payment under Commonwealth, State or Territory law
  • a transfer to meet all, or part, of a liability under a maintenance agreement or order a transfer of property under

a Part IX debt agreement

  • a transfer of a kind described in the Bankruptcy Regulations
  • a transfer made under maintenance agreements or orders made in the Family Court of Australia.

The Family Court would have to overturn an original maintenance order before a bankruptcy trustee could make any recovery under

section 120 of the Bankruptcy Act. Getting the Family Court to overturn its decision to allow a bankruptcy trustee to recover assets from an ex-spouse can be difficult.

The trustee must refund the consideration received

Section 120 of the Bankruptcy Act voids the entire transaction, not just the recovery of an asset or money. This means that to get the transferred asset back, the bankruptcy trustee must refund any consideration the bankrupt received as

part of that transaction. Consequently, each party is back to the position they held before the transaction was undertaken. Otherwise the estate would have both the consideration and the asset that was transferred.

What is not consideration?

Some things are not deemed consideration and cannot be refunded. These include:

  • the transferee being related to the transferor
  • the transferee being a spouse or de facto spouse of the transferor
  • the transferee’s promise to marry or to become the de facto spouse of the transferor
  • love or affection
  • the transferee granting a spouse a right to live at the transferred property.

How long does the trustee have to take the recovery action?

A bankruptcy trustee must commence recovery action within six years of

a person becoming bankrupt.

Transfers to defeat creditors – Section 121

What are transfers to defeat creditors?

Sometimes debtors transfer property primarily to protect it from their creditors. The Bankruptcy Act allows such transfers to be voided where the bankrupt’s intention was to stop divisible assets becoming available to creditors, or to defeat or delay the proper distribution of assets to creditors.

What makes a transfer fall into this category?

To be a transaction to defeat creditors, it must involve the following:

  • Property that in all likelihood would have become part of the estate—or been available to creditors—and is made unavailable to the bankruptcy trustee because of the transfer.
  • The intention of making that property unavailable to creditors, permanently or temporarily.

What types of transactions are caught?

There must be a transfer of property. Something must pass from the bankrupt that would

have become a divisible asset in the estate. However, a transfer can also be property created by the debtor that results in someone becoming the owner of something that did not previously exist. For example, the creation of a mortgage, securities, or other interests over property owned by the bankrupt, where the security would stop the property becoming available to the bankruptcy trustee.

How do you determine the bankrupt’s intention?

One of the transaction’s main purposes must be to protect the asset from creditors. This is subjective and usually inferred from the transaction’s circumstances, the bankrupt’s financial position at that time, and the result of the transaction.

However, intention can also be deemed by the debtor’s actual or impending insolvency (i.e. if it can be shown the bankrupt was—or was about to become—bankrupt at the time of the transaction). If the debtor was solvent at the time and remained solvent thereafter, it may be difficult to connect the transaction to the knowledge of insolvency.

Is insolvency important?

A person is solvent if they can pay all of their debts as and when they become due and payable. A person who is not solvent is insolvent. A court will usually look to the bankruptcy trustee to provide some evidence of insolvency at the time of the transfer if the bankruptcy trustee is using the deeming provisions.

Transfers are not void if done in good faith

The Bankruptcy Act protects transfers where the transferee acted in good faith. To be able to rely on the good faith defence, the other party to the transfer must show all three of these conditions:

  1. Provided consideration at least to market value, calculated at the time of the transfer.
  2. Had no knowledge of—or could not have reasonably inferred— the bankrupt’s intention.
  3. Could not have inferred at the time that the transferor was insolvent, or about to become insolvent.

To be able to use this defence, the other party must have been completely unaware of the debtor’s financial position and intention. As many of these transactions are done with relatives

or other related parties, this lack of knowledge may be difficult to prove. Transactions examined under section 121 of the Bankruptcy Act are rarely undertaken with complete strangers.

How long does the trustee have to take the action?

Actions under section 121 of the Bankruptcy Act can start at any time after the bankruptcy trustee discovers the transaction. Unlike other recovery provisions under the Bankruptcy Act, a section 121 transaction involves fraud and can be pursued vigorously.

Transactions where consideration given to a third party – Section 121a

Who else may be involved in these actions?

Third parties that are not directly involved in a transaction between the bankrupt and another party can be subject to a bankruptcy trustee’s recovery actions. Section 121A of the Bankruptcy Act allows a bankruptcy trustee to collect money from a third party where that party received money that should have been paid to the bankrupt.

In these third-party scenarios, it is not essential that the original transaction was undervalued or intended to defeat or delay creditors, as it is the payment of consideration to the third party that is examined. For example, did the third party give valuable consideration to the bankrupt for the money, or was the bankrupt’s intention to direct the payment to the third party done to defeat creditors?

What can be done?

The Bankruptcy Act deems that when a third party receives consideration, it should be viewed as a transfer of property by the bankrupt.

That consideration therefore constitutes that the property transferred and the transfer may be reviewed under sections 120 and 121 of the Bankruptcy Act. If that payment of consideration is deemed void for the reasons set out in the sections above, the consideration will be recoverable from the third party.

A bankruptcy trustee can take action against the original party to the transaction and separately against the third party that received the consideration.

Protection of certain transfers

What protection does the Bankruptcy Act provide?

The Bankruptcy Act provides some protection to people transacting with a debtor before bankruptcy. A transaction is not automatically void because the debtor becomes bankrupt.

Essentially, people who had no knowledge of the impending bankruptcy and acted in normal business circumstances can be protected.

Who gets this protection?

Section 124 of the Bankruptcy Act protects an innocent, unknowing party who entered in a commercial transaction in ordinary dealings with the bankrupt, if the following conditions are met:

  • The transaction happened before the bankruptcy—as the bankrupt does not have the right to deal with their assets after bankruptcy.
  • The other party was unaware of the impending bankruptcy.
  • The transaction was done in good faith and in the ordinary course of business.

The conditions of ‘good faith’ and ‘ordinary course of business’ may be difficult to prove. The other party must not have acted in any manner that would give the impression

that they were not acting in good faith. The ordinary course of business must be held in the ordinary course of the relevant industry, not the ordinary course of the particular creditor.

The burden of proof rests with the party attempting to gain this protection.