Preferences And Fraudulent Transfers
Today is the third of a series of presentations that are in a longer format. For a while, I did short formats, just a few minutes per video, but there was a lot of overlapping, so I thought this might be a more useful way to present the information. The first two dealt with:
- Personal Chapter 11 cases.
- Two different types of business Chapter 11.
The third, which is today’s, will address Transfers because this issue arises frequently in bankruptcy law.
The big picture goal is to cover two different kinds of transfers, which are called Preferences and Fraudulent Transfers.
Preferences
- What Is A Preference?
- The First Big Goal: The Fresh Financial Start
In order to understand what a preference is, it’s helpful to have in mind the two big goals of bankruptcy law. The first big goal of bankruptcy law is to give the debtor a fresh start. So, if you’re the debtor listening to this, that’s our big goal for you. We want you to get a fresh financial start.
This idea has a laudable pedigree, believe it or not, it goes way back in history. Here are a few examples from ancient times:
- Bankruptcy In The Code Of Hammurabi
The first known statute or law that I’m aware of that dealt with some kind of bankruptcy was developed by a king in the first Babylonian Empire. His name was Hammurabi, and he developed his code sometime around 1850 BC. You can find translations of it on the internet and read them for free. It is about 75 to 80 pages as a PDF, and it was literally etched in stone.
Hammurabi’s code had some amazing things. For example, the code dealt with compensation for eye surgery. This is in 1850 BC! It specified how much you’d get paid if you were a doctor who performed eye surgery successfully; but it also had penalties if you were unsuccessful. I don’t know how many eye surgeries were actually performed, but its inclusion in the code suggests that there were some.
Another thing Hammurabi had in his code was a concept of bankruptcy that we would recognize today as sort of a hybrid of Chapter 7 and Chapter 13. Debts could be wiped out, or you could pay them over time.
- Bankruptcy In The Bible
The second big bankruptcy statute or big bankruptcy law that I’m aware of, is in the Bible, in the Mosaic Law. The Bible is made up of a lot of different books. The fifth book is called Deuteronomy. In the 15th Chapter, the first two verses have mandatory bankruptcy for the entire nation of Israel every seven years, just like clockwork. All debts had to be wiped out.
And if you go back a couple of books, in the Book of Leviticus, every 50 years, there was a super bankruptcy, where not only were all debts wiped out, but if you’d sold yourself into servitude, you were set free. And if you’d sold your land because you couldn’t pay your debts, it reverted back to you. That was called The Year of Jubilee. Bankruptcy must be a good thing because God said it’s a good thing. Who am I to argue with the King of the Universe?
- Bankruptcy In Ancient Rome
The Romans developed the next big bankruptcy law. The person who put it into place was Julius Caesar. He did it, I suspect, because he had a lot of debt. In fact, he had borrowed a lot of money from the various senators as he rose to power. This was how he got power. And then he developed the Roman bankruptcy law. I suspect that may have played a big role in his assassination on March 15, 44 BC, when all the senators, except for Mark Antony, stabbed him to death in the Roman Forum.
The play, Julius Caesar, is lots of fun. In it Shakespeare indicated that the reason for the assassination was Caesar’s tyranny. He doesn’t mention the bankruptcy law that probably played a significant role.
- Bankruptcy In The United States
Bankruptcy is also found in our U.S. Constitution.
The Constitution is divided into articles. After them come the amendments. The very first article, which is the article that deals with the legislative branch, has Congress’s enumerated powers. One of the enumerated powers is to develop uniform laws on the subject of bankruptcies throughout the United States. Our Bankruptcy Code is the statutory embodiment of that enumerated power.
In sum, bankruptcy has a great pedigree that provides the background for the first big goal of bankruptcy law: To give the debtor a fresh financial start.
The Second Big Goal: Fair And Equal Treatment Of Creditors
The other big goal of bankruptcy looks at the other side of the equation, that’s the creditors. The people who are owed money. And here the big goal is to make sure that the creditors, at least those who are similarly situated, i.e., have similar types of claims, are treated equally and fairly. This is also a laudable goal.
There are two ways in which debtors will sometimes violate this second big goal of treating all similarly situated creditors the same.
First, they won’t list all their creditors. That’s a problem. Maybe it’s not such a big problem if you don’t mind living in a federal penitentiary. But if you don’t list them, you will have committed perjury and perjury is an imprisonable offense.
Having said that, you would end up in a federal penitentiary, and although I’ve never been in a penitentiary, I’ve never taken a criminal case; I have had some bankruptcy clients who prior to becoming my bankruptcy clients had, in some cases, spent years in penitentiaries, and they have assured me that the food is better in the federal penitentiaries. But my feeling is, let’s just take their word for it. You tell the truth, no problem. And part of telling the truth is you list all your creditors.
The second way in which debtors violate this second big goal of treating all similarly situated creditors the same is that they’ll make preferential payments to a given creditor in anticipation of bankruptcy. Maybe they’re hoping to curry favor with the creditor. “It’s my brother. I’m going to take care of my brother!” Yeah, what did you do? You treated your brother better than other similarly situated creditors. You preferred your brother; that’s a preference.
When you do that, and for example, you file under Chapter 7, the Trustee assigned to the case gets to undo that preference, grab the money from your brother or whatever other creditor you’ve made preferential payments to, but not return the money to you. Instead, the Trustee will distribute the money to all your creditors on a pro rata basis, according to certain priority rules found in the Bankruptcy Code. So, we don’t want you shoveling money at creditors in anticipation of bankruptcy.
You might think, “Wait a minute, does that mean I can’t make my mortgage payments? If I make my mortgage payments, will that be a preference, and I won’t get credit for the mortgage payments that I have made?” The Bankruptcy Code has a carve-out for things that you do in the ordinary course of your business, or your daily life. Your monthly mortgage payment is made in the ordinary course of your daily life, so it’s not a preference – with one caveat.
We make a little bit of an artificial distinction between what we call ongoing living expenses and payments on antecedent debts. Let’s go with the mortgage idea for a second. Suppose you missed three mortgage payments, but worked something out so you pay them back over the next few months. Your mortgage payment for the current month is an ongoing expense. However, paying the missed three months is paying an antecedent debt, which is a preference.
How far back can a Trustee go to avoid preferences? It depends on the kind of creditor. We make a distinction between what we call “ordinary creditors” and “insider creditors.” A creditor is someone to whom you owe money. You’re the debtor. They’re the creditor. An insider creditor is a creditor who is also either a family member, up to three degrees of consanguinity, or a close business associate. All other creditors are ordinary creditors.
If you make preferential payments to an ordinary creditor in the 90-day window prior to filing, that’s a preference, and the Trustee can avoid it. (This is a somewhat unusual usage of the word “avoid.” It means to render null and void.) However, if it’s a de minimis sort of thing, the Trustee is not going to waste time avoiding the preference. In fact, in the form that we use, the Statement of Financial Affairs, which is one of the documents that we include in a bankruptcy filing, you only have to list payments to a single creditor in the 90-day prepetition period that add up to more than $600.
This is important if you have recent debt. We need to age the debt before we file to avoid problems after we file. Part of the aging is to make de minimis payments to the creditor.
If the creditor is an insider creditor—remember, that means a creditor, who’s also either a family member or a close business associate—the Trustee can go back a year from the day you file the petition.
If you’ve been paying your brother or your mom or somebody like that, you need to stop, and then wait until it falls off the year radar. Sometimes that means waiting a while, unless the payments to mom have been de minimis payments, maybe 50 bucks a month. Be careful. Don’t start paying off creditors.
If you tell me you just paid off your car loan, you’ll need to wait to file because you just shoveled a bunch of money preferentially to that particular creditor. You may argue that the car loan is different from paying off a credit card debt because it is a secured debt. That is a debt that’s secured by a tangible asset, rather than an unsecured debt. But paying off the car loan is still a preference. So don’t start shoveling money at creditors. Unless, if you hire me, and I tell you to make de minimis payments in aging a debt.
In sum, I have just discussed the concept of preference – which is solely a creature of bankruptcy law.
I told you that there were two transfer concepts that we were going to talk about today. Let’s turn to the second one.
Fraudulent Transfer
The second transfer concept is called Fraudulent Transfer. Because of the sensitivities of people who don’t like being told that what they did constituted fraud, California has renamed the Uniform Fraudulent Transfer Act. (We must have a department of euphemism in this state. However, renaming the concept doesn’t change the reality.) In any event, the new name is the Uniform Voidable Transfer Act.
1. What is a Fraudulent Transfer?
I’m going to use the classic term because I’m used to it, and it captures the reality. Part of Julius Caesar’s great contribution to bankruptcy law also included the concept of fraudulent transfer (although there is a case to be made that it might have antedated Julius Caesar).
The Romans had a Fraudulent Transfer Law, which means we’re dealing with well over 2000 years’ worth of developed law. Since people over the centuries have tried all kinds of machinations to try to get around the strictures of this law, it is very sophisticated.
We’ve heard the layup. What is fraudulent transfer? In the United States, we have two separate definitions of fraudulent transfer.
2. The First Definition
The first definition captures the ancient Roman concept: A transfer is fraudulent with respect to a creditor if it’s done with the intent to hinder, delay, or defraud the creditor. Let’s see this one in action.
Let’s go back to ancient Rome in our time machine to review the case of a homeowner named Horace. He’s got a nice home that overlooks the Appian Way. It’s worth 600,000 sesterces. Sesterce was the unit of currency in ancient Rome. He owes money to Crassus (the creditor), and he doesn’t have the money to pay Crassus. He knows Crassus is going to grab his house. To prevent the seizure, he’ll transfer the house to his brother, Brutus.
When Crassus comes and says, “Horace, give me my money.” Horace replies, “I’m sorry, Crassus, I can’t. I don’t have any money.” Crassus tells Horace, “Then I’m taking your house.” Horace answers, “What house? I don’t have a house. Hahaha!” Nuh-uh.
The Romans gave Crassus the authority to seize the house from Brutus. Horace’s story captures the essence of the first definition of a fraudulent: It’s a transfer done with the intent to hinder, delay or defraud the creditor; which is what Horace did. But there’s a problem with the word intent.
How do you know what another person intends? I mean, it’s not like we can read people’s minds. It turns out the Bankruptcy Court has a team of Vulcans from the planet Vulcan, and they will do mind melds and flash your thoughts on the TV screen. They charge $5 per hour for admission, and there’s a $2 premium for the dirty thoughts. If you believe that, I’ve got some real estate on the moon to sell you. What a beautiful view of the Earth! Air is a little thin, a bit of a fixer-upper, but you can’t beat the view. All right, let’s come back down to planet Earth and be a little sensible here.
Nonetheless, the problem with the first definition is in the word intent. We have a second definition that bypasses that problem altogether.
3. The Second Definition
The second definition bypasses intent altogether. A transfer is fraudulent with respect to a creditor if it’s done without getting a reasonably equivalent value in exchange for the transfer. Let’s go back to ancient Rome, and change Horace’s facts a bit. He still has a house worth 600,000 sesterces, and he still owes Crassus a debt he cannot pay. If he sells the house to Brutus for 10,000 sesterces, is that a legitimate sale? Yes, if he had no debts. But since he has a debt to Crassus it’s not a legitimate sale because he didn’t get a reasonably equivalent value in exchange for the house. Therefore, Crassus can still undo the transfer.
Unlike preference, which is solely a creature of bankruptcy law, the concept of fraudulent transfer exists both inside and outside of bankruptcy.
4. Fraudulent Transfer In Bankruptcy
The First Problem: Loss Of The Asset
When you file a bankruptcy petition (and let’s stick with Chapter 7, because it’s easiest as a concept), the Trustee assigned to the case by the Court steps into the shoes of the creditors and inherits the creditors’ right to avoid the transfer. The Trustee will avoid the transfer, grab the asset, liquidate it, and have money to pay your creditors. Well, that’s kind of nasty, isn’t it? Yeah, it is. That’s the first problem with a fraudulent transfer.
The Second Problem: Loss Of The Chapter 7 Discharge
The second problem is peculiar to Chapter 7. If you do a fraudulent transfer within the one year prior to filing your petition, you are ineligible to get a Chapter 7 discharge. That’s a particularly important reason why you really don’t want to do this.
I sometimes get a call from a man – it always seems to be a man – who reassures me that I don’t have to worry about the house because transferred it to his wife. Woo, aren’t you the clever one? I bet nobody’s ever thought to do that. It turns out, yes, people have thought to do that for many, many centuries. Not only that, when he transferred the house to his wife, the only thing he’s done is to prejudice his rights if he ever gets a divorce.
If you’ve done a fraudulent transfer during the one-year prepetition period, what can you do to maintain your eligibility for a Chapter 7 discharge? The answer is in a case from 1986, which, to me, wasn’t that long ago.
The debtor was named Adib. He went to an abysmal bankruptcy attorney, who gave him dreadful advice. The attorney told him to transfer all his assets in anticipation of bankruptcy.
Thankfully, before he filed the petition, he got alternate counsel who told him that he’d done a series of fraudulent transfers, and counseled him to undo them. He undid them and then he filed a Chapter 7 petition. The U.S. Trustee’s office sought to deny Adib a discharge based on his doing fraudulent transfers during the 12 prepetition month period.
Adib lost, so he appealed, and went all the way up to the Ninth Circuit Court of Appeals. The Ninth Circuit held that since he undid the fraudulent transfers before he filed, he was entitled to a Chapter 7 discharge.
The Look-Back Period
How far back in time can the Trustee go? This is where it gets a little bit complicated.
The Bankruptcy Code
If the Trustee appeals to the fraudulent transfer statute that’s in the Bankruptcy Code, then the Trustee can go back two years, measured from the day you file the petition and avoid any and all fraudulent transfers. But the Bankruptcy Code permits the Trustee to piggyback on nonbankruptcy Fraudulent Transfer Law.
California Law
In California, the Uniform Voidable Transfer Act (I’ll call it its new name) has a four-year look-back period. That means that the Trustee can go back four years, but not measured from the day you file the petition. Instead, it’s measured from the day the Trustee files the complaint to do the avoidance action. The Trustee has additional time up to seven years if the transfer couldn’t have been readily discovered.
Usually, these transfers are recorded with the county recorder’s office. If that’s the case, then it’s readily discoverable. The world is on notice. I realize this is a fiction; there aren’t people in India who suddenly know that you just transferred your house. The idea is that it’s discoverable if somebody were to do some sort of an investigation.
The Internal Revenue Code
If you owe the IRS on the day you file the bankruptcy petition, even $1, then the Trustee can piggyback on the IRS’s fraudulent transfer statute, and that goes back 10 years. Ouch!
I’ve had clients who owed the IRS. The fraudulent transfer was done five years ago, but that’s still within the 10-year period, so we had to wait, have the debtor pay the IRS back in full, wait so that the preference period is passed, and then file the petition. And then the transfer is no longer a problem.
Transfers To A Trust
A fraudulent transfer that is peculiar to the Bankruptcy Code: If you transfer an asset to a self-settled trust of which you are the beneficiary during the 10 years prior to filing, the Trustee can avoid that transfer. I suppose setting up these trusts is a good idea to protect assets if you’re going to face state court litigation in the California Superior Court, but it doesn’t work in bankruptcy. Those transfers can be undone in a heartbeat.
You might wonder, “What’s going on here? Why the difference?” The Bankruptcy Code was made pursuant to Article 1, Section 8, of the U.S. Constitution, so it’s all federal law. When somebody sues you in California Superior Court, that’s done under state law. Ok, so what? In Article 6 of the U.S. Constitution, there is a provision that says – I’m going to be colloquial here – if there is a tension between federal law and a state law, the federal law always wins. That’s why bankruptcy is so powerful. It comes in like a Sherman tank, and takes the field.
By the way, just a little side note. You might want to read the Constitution. It’s not very long. I think that if the entire population of the country read the Constitution at least once a year, we’d have a very different government. But that’s a little side note. Read the Constitution for yourself. Don’t take anybody’s word for it. If someone tells you that something is unconstitutional, ask where in the Constitution is the topic even mentioned. You might be surprised by what is, and what isn’t in the Constitution.
The Fourth Problem: Asset Exemption
There’s yet another problem with fraudulent transfer. It concerns exempting assets. (I’m only thinking in personal bankruptcy terms because the concept of exemption does not exist in a business bankruptcy.)
What is an exemption? I will focus on Chapter 7 because it is the simplest chapter. In a Chapter 7 you will discharge debts without paying your creditors anything. But we don’t want you to end up living under a bridge in a cardboard box. You should go to a homeless shelter instead. That’s a bad joke, I’m sorry.
Instead, we want people to emerge with a fresh financial start. We don’t want people just tossed naked out on the streets, even if it sounds entertaining. The law therefore permits a Chapter 7 debtor to protect some assets by exempting them from the depredations of the Chapter 7 Trustee.
The Bankruptcy Code has an exemption table, but it permits the states, if they want to, to use their own state exemption table.
California is unique among the states in that we have two exemption tables:
- For homeowners with equity in their principal residence.
- For everybody else.
We don’t use the federal exemption table. Let’s say, for argument’s sake, you are a debtor who has your own home. What table are we going to use? Obviously, the homeowner’s table. In that table, there is a list of different categories of possessions. Some of those categories have dollar limits. Others have no dollar limits. One of them that has a dollar limit is the equity you have in your principal residence. The size of the homestead exemption depends on three different factors.
First, you have to have acquired the house more than 1,215 days (three years and four 30-day months) prior to the date you file your bankruptcy petition. This is an umbilical cord that takes us back to the Bankruptcy Code’s exemption table.
Second, you cannot have been convicted of certain types of felonies during the five years prior to filing the petition.
Third, depends on what county you live in.
If you acquired the house more than 1,215 days before filing, and you haven’t been convicted any of the specified felonies, then your exemption amount is the lesser of the median sale price for a home in your county and $722,502 (I made the video in November 2026. In January 2027, the exemption increased to $746,375).
However, if either you acquired the house less that 1,215 days prior to filing the petition, or you were convicted of one of the specified felonies during the five-year prepetition period, your homestead exemption drops to $214,000.
What are you exempting? The equity in the house. We calculate equity by subtracting the amount you still owe on any mortgages from the market value of the house.
Let’s say you transferred the house to your son a couple of years ago, and your son didn’t pay you a reasonably equivalent value in exchange for the transfer. Your attorney said that you’d better undo the transfer or you won’t be eligible for a Chapter 7 discharge, so you undo the transfer.
Suppose you undid the transfer a year ago. That means you only just reacquired the house a year ago, so you’ve run afoul of the 1,215-day window. You’ll have to wait until more than 1,215 days have passed since the transfer to file your petition – unless you have very little equity in the house. But if you transferred the house because you’re older and you’re trying to take care of your kids, you probably have a lot of equity. You’re going to need to wait quite a while.
In sum, doing a fraudulent transfer can create problems with exempting assets.
The long and short of it is, if you’re thinking about transferring assets, whether paying creditors or transferring assets because you’re trying to shield them from the legitimate depredations of creditors, and you’re thinking of doing a bankruptcy, don’t do it. Contact a bankruptcy attorney.
You may need to do some careful prebankruptcy planning. The Chapter 7 Trustees have a lean and hungry look because they get a cut out of the proceeds from selling nonexempt assets to have money to distribute the creditors.
In sum, we’ve got preferences. We’ve got fraudulent transfers. You should avoid them so that the Trustee doesn’t avoid them. Little pun on the two definitions of avoid.
5. Q&A with Michael
Michael: You mentioned at the beginning that bankruptcy has been written in coding, the Hammurabi code, the Romans, even in the Bible, and our Constitution. How do you think that things have evolved since then? Do you think, you know, with the purpose of giving the debtor a fresh start? Do you think modern law has it right, or do you think we still have areas to improve?
Nicholas Gebelt: Well, I think it’s righter than most of what we have in the past. I personally like the Deuteronomy 15 idea of bankruptcy, where it’s just a clean break. No question of whether you have assets. It’s just that every seven years, old debts get wiped out. But ancient Israel was a homogeneous population. The United States is extremely heterogeneous, so I’m not sure that that would work.
On one level, we have an improvement, certainly over the Romans. If you weren’t paying your debts – at least before Julius Caesar’s statute – you could be put to death. Pretty draconian. Even though Draco was a ruler in Greece, his acolytes were, I guess, in Rome. In fact, the Romans did send to Greece to get inspiration for what they call the 12 Tables, which was the foundation for Roman law. It was Greek law, mostly from the golden age of Pericles, which was the afflatus for the original Roman law.
In any event, I think our bankruptcy system is much improved over that, and we are trying to balance the rights of creditors with the rights of debtors.
In fact, generally, that’s what happens in law: We seek to resolve competing interests. I suppose a case can be made that it’s not so much the goal in criminal law, but criminal law is a tiny sliver of the law. Most people watch TV and the movies, and think, “This is what the law is all about!” I’ve never taken a criminal case. I know a lot of attorneys; I don’t think any of them have either. It’s really not much of what’s going on in law. Most of what goes on in law is civil law, although there are some attorneys who are less than civil.
In any event, the idea here is a balancing. In resolving competing interests, we want to produce a result that is maybe the least bad, not necessarily the best. More generally, in life, especially in the economic realm, there isn’t an ideal. Instead, there are tradeoffs. It’s sort of a balancing act.
But I think our bankruptcy system is good. Is it perfect? No, there are some problems. Certainly, in the realm of nondischargeability, there are some things that I think need to be corrected. For example, the student loan issue is a social time bomb that is about ready to explode. Student loan debt is massive. Part of the reason is the perverse incentives infused into the system. Perhaps a little historical background will help to put this in perspective.
At the end of World War II, there were guys coming back. They’d fought for their country. They’d faced really nasty enemies: the German National Socialists, the Italian Fascists, the Japanese Imperialists. They’d seen their buddies blown up. They fought, and put their lives on hold for years.
The country, if I can sort of anthropomorphize the country as one big blob, decided these guys needed some help getting started, so they set up the GI Bill. That meant that the GIs could get money to go to school, to get training, to get a good job, to get ahead. Great idea.
Not long after the enactment of the GI Bill, other people asked, “What if I didn’t fight World War II? Can I get some money too?” This led to the inception of the student loan program. In order to give banks an incentive to fund student loans, the federal government backed them. Thus, if you defaulted, the bank didn’t have a downside; they’d still get paid back.
Then what happened? Large numbers of people went to schools and paid for their schooling using student loans. The schools were collecting tuition without any downside because the feds would cover any defaults. The result: Tuition started to go up and up. The inflation rate on college tuition is absolutely breathtaking.
The message went out: If you want to get a good job, you’ve got to get a college degree. You’re going to be spending a lot of money, but it’s okay. You can borrow money, and it’ll all be taken care of. Now, we have a massive population that has huge amounts of student debt, and a lot of these folks are never going to be able to get a job that’s going to pay enough for them to service the debt.
At one time in American history, under the bankruptcy statute, you could discharge student loan debt in bankruptcy. Then there were some concerns that maybe banks would be skittish about making loans if you could just ditch the debt, especially if it’s a private student loan. (There are federally backed student loans, but you can also get private student loans.)
Then Congress bumped it up. You had to have been making payments for at least five years, and then it was bumped up to seven years. But there were still real concerns that maybe future generations wouldn’t have money available because we don’t want people just getting rid of them. Then the Bankruptcy Code was amended to say you can’t get rid of student loans unless … Unless what? Unless having to pay your student loan would be an undue hardship on you and your dependents.
That’s pretty vague. What do you mean by an undue hardship? Courts wrestled with this until a case out of New York a couple of decades ago, called In re Brunner. I’ve heard it pronounced Broo-ner, Bruh-ner … You choose your own pronunciation. I never met the person. I always think a person should be called what that person wants to be called, not vulgarities or anything like that. I don’t know what the correct pronunciation is.
In any event, the Brunner court handed down a decision that courts around the country accepted. It presented three factors that were used to determine whether the undue hardship was satisfied.
- You must be unable to have a minimal standard of living if you have to pay anything. If you just graduated from college, and have no job, this factor is easy to satisfy.
- That status must persist over the life of the loan repayment. If you get a great job after graduation, that status is no longer persisting, so the second factor is harder to satisfy.
- You must have already made a good-faith effort to pay the loan.
If you can satisfy all three factors, then you can get rid of the student loan. Great! This came up primarily in Chapter 7. Chapter 7 debtors had a bunch of student loan debt they wanted to get rid of. How does a debtor get rid of them? This isn’t self-executing. It’s not like you file the bankruptcy and poof, the student loans go away. Quite the contrary, they don’t go away. Instead, it’s incumbent upon the debtor to ask the bankruptcy judge to declare that these debts are dischargeable. How is this done?
The debtor has to file a lawsuit in the bankruptcy court. We call lawsuits in bankruptcy adversary proceedings. The debtor has to win it as well. If you file it and you don’t win it, “Sorry, pal, the debt’s still not discharged.” Because the adversary proceedings were initiated mostly by Chapter 7 debtors who did not have the financial resources to hire an attorney to prosecute the adversary, the rulings were uniformly bad. At that point, the only people who were ever going to get rid of student loan debt were people who got into a dreadful car accident, were paralyzed, and were never going to work again.
Then, a few years ago, the Department of Education put forward a program. This program is only for federal student loans. It will not work for private student loans. Under this program, if you filed the adversary you would have to serve a copy on the Department of Education. The DOE did its analysis of the adversary using a declaration that they would provide for you to complete. If, based on the declaration the DOE concluded that you really did satisfy the three Brunner factors, it would not oppose the adversary. Then you’d get a default judgment of discharge of the student debt.
The program helped some folks, and it’s still going on. But the last I heard is that it’s going to sunset in July of 2026, meaning you have to have filed your adversary complaint before July of 2026, in an active bankruptcy case.
The problem is you still have to do the adversary, so there are additional fees. I don’t know how much of that plays into whether or not people are filing these things in the first place, but at least it’s a lot more streamlined.
If the DOE says, “Nah, we don’t agree, we’re going to fight this one,” then you’ve got a real battle on your hands. That can make an attorney skittish about doing it for a fairly low fee because there is the potential for a big adversary.
If you’re representing a debtor who’s a good candidate to get a student loan discharged, they’re probably not flush with cash to fund the entire adversary. However, this can work out if, for example, a family member, mom, or dad, are willing to fund the adversary. That’s what is happening with the student loans. The long-winded answer to your question is that there is a sore spot in our bankruptcy system. Since there weren’t student loans under the Hammurabi Code, there weren’t student loans under the Law of Moses, there weren’t student loans in ancient Rome … this problem is peculiar to our setting here in the U.S.
Michael: You did talk about, you know, kind of like fraudulent transfer, but in terms of treating all creditors the same, what if somebody genuinely forgets a creditor? How does the court tell the difference between an innocent mistake and being intentionally deceptive?
Nicholas Gebelt: That’s a good question, and it’s going to be very fact specific. If on the one hand you owe $100,000 to ABC Bank and you just happen to forget it, that’s going to look awfully suspicious. If, on the other hand, you owe 50 bucks to Wells Fargo and it doesn’t show up on the credit reports (I always order the credit reports), so you don’t list it, that’s really not going to be a problem. In fact, the court probably wouldn’t even know about it. Thus, it’s very, very fact specific.
This can come up if you have a big-ticket creditor with whom you’ve been dealing, and there is a paper trail showing that you tried to negotiate with the creditor. If you don’t list them you have committed perjury.
I have to send bank statements to the Trustee after I file the petition in both a Chapter 7 and a Chapter 13. We also have to tender bank statements even in Chapter 11, but for a different reason. If the Trustee goes over the bank statements and sees a bunch of payments to ABC bank, and there is still a balance the Trustee will want to know why you didn’t list ABC Bank as a creditor. If you’ve had a good relationship with the bank, and didn’t want to jeopardize it by listing it, you’re in trouble. You’ve committed perjury in your bankruptcy petition. Ultimately, the analysis is fact specific. There isn’t a nice bright line rule that you can just impose on the general question.
Michael: In the case of fraudulent transfer, how does that work in a situation where there’s partial ownership? Because I know you did the house kind of metaphor, but in terms of, let’s say, you know, you’re in a business with a good friend or a brother, and you incur debt trying to get that business off the ground, and you’re, what if you know your partner wants to give you a break and let you kind of sell at lower than it’s worth to get out of debt, is that still fraudulent transfer?
Nicholas Gebelt: That’s a somewhat murky area because exactly how do you value the business? You’re saying it’s a reduced price, but is this a business that you could just sell on the open market and get a higher price? If it’s just you and your business partner, and it’s a relatively small business, this is probably not a business that you could just put an ad saying, “Hey, you want to buy this business?” and somebody’s going to come knocking, “Yeah, I’ll buy the business!” So that gets to be a little bit tricky.
You do want to have a reasonably equivalent value in exchange for the transfer. By the way, there is the issue of whether you get money from your business partner when you make that sale. The money is an asset and you’re going to have to exempt it; otherwise, a Trustee is going to grab the money.
But producing a valuation of a business is tricky. We can certainly say at least one factor is the value of the hard assets. “We’ve got this machinery. We’ve got these accounts receivable. We’ve got this money in the bank.” That’s part of it.
The other, and this is where it gets really tricky, is business goodwill. If you have had a business for 40 years and you have a roster of repeat customers that are coming in, you’ve got business goodwill. How do you produce a value for that? That’s a little bit tricky, and sometimes you need to hire a marketing expert to produce a value and opine on the value of the business goodwill.
This comes up in Chapter 11, when you’re having to determine how much you’re going to repay the creditors over the life of a Chapter 11 plan. One of the requirements is what I call the Chapter 7 liquidation requirement for Chapter 11, that is, how much would the creditors have gotten if you did a Chapter 7 liquidation? To answer this question, you must value the business.
I’m not sure if that was entirely what you were getting at because your fact pattern wasn’t clear if you were selling the business to your partner and you’re getting an extra chunk of money, or you were getting a lower price. If it’s a lower price, then technically it is a fraudulent transfer, but how do you determine that it was too low a price?
Michael: The last one I had, and again, this might be a very small percent of people, but I was just curious. You mentioned there’s kind of, like a two-factor exemption table, or there are two exemption tables in California. So, what happens if there’s a drastic change in someone’s equity during the process? You know, if they had a house and then it burned down? Or, like, if it’s happening during the process, is it ever a case where somebody might need to swap to the other table, or are you kind of locked in once you get on that table?
Nicholas Gebelt: It depends on where in the process you are. If, on the one hand, it’s prepetition – before filing the bankruptcy – then if you have a catastrophic event, you can switch tables, because you haven’t filed it yet. If, on the other hand, after you file the petition, you want to switch tables, well, the federal rules of bankruptcy procedure do allow you to amend your schedules at any time during the process.
But if the Trustee has incurred a bunch of costs doing an investigation and suddenly you pull the rug out from the Trustee and say, “Oh, we’re switching tables. Just kidding!” you will get some pushback from the Trustee, who may say “You owe me for the time I spent,” and may file a motion to compel you to pay for the Trustees’ time in doing the investigation.
But generally, yes, you can switch tables certainly before you file a petition, because nothing is etched in stone, and even afterwards, maybe there was a mistake. Occasionally, I’ll be at a hearing where it is clear that whoever prepared the schedules (not my client, of course) was doing a mixing and matching, grabbing some from the homeowner’s table, grabbing some from the renters’ table. You’re not allowed to do that. So, if you’re going to amend the schedules, you’re going to have to be uniformly either in the homeowner’s exemption table or the renter’s exemption table.
If the house burns down, well, you still have the land. This has been an issue up in Pacific Palisades, which isn’t far from here, where whole swaths of homes were just incinerated, and not just in Pacific Palisades. In fact, I have a client, we haven’t filed for her yet, but her house burned down. Now, she’s having to rent a place, and now the question is, will she ever get this house rebuilt? Because the bureaucratic torpor is just breathtaking. I think maybe two or three houses have been rebuilt after all these houses were turned to piles of ashes.
So, it’s unclear exactly how that’s going to work out for her, but we’d certainly argue that she still owns the land and that has value, and we’d exempt it using the exemption table. But if she doesn’t own the land, then okay, well, we wouldn’t use the homeowner’s exemption table, because she doesn’t own her principal residence. It gets to be a little murky, especially in the context of these fires, because my goodness, they were absolutely catastrophic. I don’t recommend it unless you want to be depressed. You can drive up to Pacific Palisades and Altadena and see complete devastation.
