Property development companies regularly create single-purpose entities (SPE) to acquire new real estate for development, construction or renovations. SPEs are often comprised of only a few members, and no assets beyond the property itself, and are considered “closely-held” companies.
There has been a growing trend in New York construction defect lawsuits in which boards of managers of newly-constructed condominiums that have sued the sponsor-developer-SPEs also name the SPE’s individual members as defendants. The plaintiffs rely on New York’s Debtor & Creditor statute Article 10, referred to as the “Uniform Fraudulent Conveyances Act” (UFCA). The UFCA authorizes “claw-backs” of money and other asset transfers as a remedy for some creditors.
Effective April 2020 in New York, after 95 years, the Uniform Voidable Transactions Act (UVTA) will replace the UFCA. The new statute will contain modified definitions and clearer criteria for which transactions may be unraveled. The question is whether this will reshape the courts’ understanding of sponsor-developer-SPEs’ equity financing arrangements, which by their nature have created a conflict with the UFCA.
Under the UFCA, a transfer can be voided, i.e., undone – even when the transferor, now a defendant-debtor, lacked any nefarious intent – when the transferor dispensed with assets without “fair consideration,” rendering it insolvent; was about to engage in a business or transaction and the transfer left it with “unreasonably small capital;” or when the transfer would result in unmanageable debts. A transfer made to “insiders,” e.g., corporate officers or directors, or LLC members, is a “badge of fraud” under the case law. Courts have sustained many such claims past the initial “pleading” stage because they are fact-intensive and cannot be decided summarily.
SPEs have been particularly vulnerable to the UFCA. The raison d’etre of an SPE, of course, is to limit any income and liabilities to one business “purpose,” customarily one asset held by the company. This shields an SPE’s members from exposure to liability for debts that exceed the profitability of the asset. Public policy encourages formation of SPEs so that people will take on the risks inherent in development and construction.
While transfers of profits to “insiders” instinctively raise suspicions, the problem for a closely-held company (often family-held) is that all of the members are “insiders.” Add to that the financial structure of a sponsor-developer-SPE: after completion of the project, it is to create a net profit after subtracting the equity and financing used to purchase property and pay construction costs, leaving “unreasonably small capital.” Often the debts are paid with funding and monthly accrued interest over an extended time period that can be fraught with delays, with anxious equity contributors waiting for their ROI. There is little incentive for a sponsor-developer-SPE to hold onto profit longer than necessary.
New condominium boards of managers have prevailed in using the UFCA by urging that the sponsor-developer-SPE allegedly transferred all of the income from the SPE to its members before all of the debts were accounted for. In doing so, they would point to an existing “claim” prior to the SPE’s last equity distribution, such as a resident complaint of water leakage. They would urge that their claim need not have even “matured” under the statute’s definition of a “creditor.” And they would characterize any equity distribution that exceeded the initial equity contribution as a transfer without “fair consideration.” An SPE’s operating agreement with unambiguous mandates to make equity distributions within strict time frames would not insulate the transfers from scrutiny.
The UVTA is supposed to replace an outdated statutory framework and provide clarity. Its name alone addresses the previous confusion where a transfer did not have to contain qualities of fraud, or even be a conveyance, in order to be voidable. Although the burden of proof for evaluating “intentional fraudulent” transfers has been lowered from “clear and convincing” to “preponderance of the evidence,” in some aspects the UVTA makes it more difficult for alleged creditors to “claw back” transactions. The statute of limitations has been decreased from six years to four years, and one year for an otherwise-appropriate “insider” transaction, along with a more stringent standard for the creditor to meet.
As for terminology, in addition to recognizing that a transaction need not be a conveyance, and can even be an “obligation” and be voidable in the DCL, the UVTA replaces “fair consideration” with “reasonably equivalent value.” This aligns with the Bankruptcy Code and is helpful in combatting collusion in foreclosure sales, for instance.
Creative condominium counsel will always seek loopholes to find leverage against sponsor-developers, and defendants’ litigation counsel will continue to navigate judges past the smoke and mirrors. Any hope that the new UVTA alone will revolutionize case law involving sponsor-developer-SPEs, however, may be optimistic – but at least there is a clean slate for a new battleground.