What Not To Do Before, And Immediately After, Filing Bankruptcy?
- Fail to List All Creditors
One of the main goals of bankruptcy is to treat all creditors who are similarly situated equally and fairly. There are two ways debtors sometimes violate this big goal.
The first way debtors violate this goal is by not listing all their creditors. This is an imprisonable offense because the debtor (whether an individual or a business owner) swears under penalty of perjury that all the creditors have been listed. (The good news is that the sentence will be served in a federal penitentiary as opposed to a state penitentiary. Although I have never been in a penitentiary because I have never taken a criminal case, I have had bankruptcy clients who, prior to becoming my bankruptcy clients, spent years in penitentiaries; and they have assured that the food is better in federal penitentiaries.)
- Make Preferential Payments To Creditors
The second way debtors sometimes violate the big goal of treating all similarly situated creditors equally and fairly is by making preferential payments to a given creditor in anticipation of bankruptcy. Why do they do this? They may hope to curry favor with the creditor; or perhaps the creditor is a family member, close friend, or business associate.
Such a payment is called a preference, or preferential transfer. A preference is a payment to a creditor in anticipation of bankruptcy that prefers that creditor above other similarly situated creditors.
A trustee or a debtor in possession must avoid preferences that were done shortly before filing the petition. How shortly? If the creditor is an ordinary creditor, ninety days, measured from the date the bank honored the check. If the creditor is an insider — typically a family member or a close business associate — one year, measured from the date the bank honored the check.
The Bankruptcy Code has a carve-out for payments made in the ordinary course of the debtor’s business. For example, if you make your monthly mortgage payments just like clockwork, that is not a preference. But if you were to make double payments for a couple of months prior to filing the petition, the excess payments would be preferences.
- Preferences As Part Of Prebankruptcy Planning
Another type of preference is done as part of prebankruptcy planning. How does this work?
Subchapter V of Chapter 11 (Small Business Reorganization Act (SBRA)) has a debt ceiling that applies to small businesses and individuals whose debts are primarily business debts. Thus, if a debtor has too much debt to qualify for SBRA, the debtor might pay down some of the debt so that on the petition date, the total debt is below the debt ceiling.
Similarly, Chapter 13 has debt ceilings, one for secured debts and the other for unsecured debts. If either debt ceiling is violated, the debtor is ineligible for Chapter 13 relief. Therefore, the debtor might pay down some debt so that on the petition date the debts don’t exceed either ceiling.
While this strategy can work, the downside is the preference problem. Therefore, if you pay down some debt as a way to qualify for Subchapter V or Chapter 13 protection, you must wait until the preference period has expired before filing the petition.
- Injudiciously Convert Nonexempt Assets To Exempt Assets
While some prebankruptcy planning involving converting a nonexempt asset to an exempt asset is permitted, there are limits.
For example, a debtor might take nonexempt cash and put it into an exempt retirement account. Be careful. The IRS has limits on how much a person can contribute to a retirement plan within one calendar year. And if the retirement plan is a 401(k), funding is limited to income from the job. Alternatively, a debtor might take the cash and pay down the mortgage — i.e., convert the nonexempt cash into exempt equity in the home. However, that excess payment could constitute an avoidable preference, so postponing the filing is necessary.
Yet another land mine involves prebankruptcy planning in a divorce. The key case is In re Beverly. Beverly was an attorney facing a large malpractice lawsuit for $1 million. He and his wife had about $2.1 million in assets, half of which was in exempt retirement accounts, and the other half was nonexempt. The couple was in the process of a divorce. Beverly convinced his wife to divide the assets in the divorce by letting him keep the exempt funds, while she would get the nonexempt assets. He then filed a Chapter 7 bankruptcy. The Chapter 7 Trustee argued that the transfer of nonexempt assets to the ex-wife was a fraudulent transfer (I discuss fraudulent transfers in more detail below). The Bankruptcy Appellate Panel (BAP) agreed with the Trustee, and also held that Beverly was not entitled to a discharge because the fraudulent transfer was done during the one-year prepetition period. Finally, as a result of his behavior Beverly was suspended from practicing law.
At heart, Beverly was too greedy. The consequences he faced exemplify the old saying: “When a pig becomes a hog it is slaughtered.”
- Campaign For Plan Confirmation After Filing Bankruptcy
The Bankruptcy Code has limitations on soliciting acceptance of the Chapter 11 plan after the petition date. However, prior to filing the bankruptcy papers, the debtor can contact the creditors to discuss the possible terms of a Chapter 11 plan for which the creditors will vote. If there aren’t many creditors, the debtor can negotiate, creditor-by-creditor, to develop a prepackaged Chapter 11 bankruptcy plan. If the negotiations are successful and the creditors are on board, the debtor can file the Chapter 11 bankruptcy and move quickly to plan confirmation, thereby eliminating a great deal of complication.
- Incur New Debts
It is important to not incur new debts in anticipation of bankruptcy. As a matter of fact, the Bankruptcy Code has a provision that prohibits an attorney to counsel a potential bankruptcy debtor to incur debt in anticipation of bankruptcy, especially if it’s to pay the attorney’s fees. A challenge to this provision as a violation of the First Amendment’s free speech provision came before the U. S. Supreme Court, which determined that it is not an infringement of free speech, even though it prohibits an attorney to counsel the debtor to do something that is legal.
However, the opinion, which was authored by Justice Sotomayor, held that an attorney can have a frank discussion with a client about incurring debt for a non-bankruptcy purpose. The quintessential example is the incurrence of a car loan to replace a car that is ready to die. Thus, while incurring a new debt might make the otherwise ineligible debtor eligible for Chapter 7 protection, the legitimate non-bankruptcy purpose makes the debt incurrence legitimate. However, as a general rule, an individual debtor should not incur new debt in anticipation of bankruptcy.
Things are a little different for a business debtor that has ongoing relationships with vendors who supply the business with consumer goods. Although the business will be incurring new debt every time it receives a new delivery, this new debt is acceptable because it is considered “in the ordinary course” of the business’s daily life.
- Make Fraudulent Transfers
- What Is A Fraudulent Transfer?
Making a fraudulent transfer is a very dangerous thing to do. The concept of fraudulent transfer goes back to ancient Rome. The ancient Romans not only had a well-developed bankruptcy system (that was created by the heavily indebted Julius Caesar), but they also had a well-developed fraudulent transfer law.
Although there are technical definitions of fraudulent transfer, the gist is this: A fraudulent transfer involves transferring an asset to someone, either with the intent to hinder, delay, or defraud creditors, or without getting a reasonably equivalent value in exchange for the transfer. For example, if a creditor is coming after a valuable asset and the debtor transfers that asset to a family member to shield it from the creditor, or transfers it for little or no consideration, the transfer is fraudulent.
Thus, in the Beverly case mentioned above, Beverly’s transfer of the nonexempt assets to his ex-wife was fraudulent because he was trying to shield them from his one big creditor.
- What Are The Consequences?
So what are the consequences?
- Transfer Avoidance
Outside of bankruptcy the creditor has the authority to undo — the legal term is avoid, meaning to render null and void — the transfer and seize the asset to the extent necessary to pay the antecedent debt.
Inside bankruptcy the trustee or DIP steps into the shoes of the creditor and has the authority to avoid the transfer. However, while the creditor can only avoid the transfer to the extent necessary to pay the antecedent debt, the trustee can avoid the entire transfer — even if it’s more than what is necessary to pay the particular antecedent debt. The reason for the difference is that the trustee is doing the avoidance on behalf of the entire bankruptcy estate for the benefit of all the creditors, and not just for the benefit of one creditor.
- Potential Ineligibility For A Chapter 7 Discharge
Yet another negative consequence: A debtor who has made a fraudulent transfer within one year of filing a Chapter 7 bankruptcy petition is ineligible to receive a Chapter 7 discharge.
- Inability To Exempt The Transferred Asset
In a Chapter 7 bankruptcy the debtor can exempt assets from seizure by the Chapter 7 trustee by using an appropriate exemption table. However, if the debtor transferred an asset before filing the petition, the debtor can’t exempt the asset because it now belongs to someone else.
- Transfer Avoidance
- The Differences Between A Preference And A Fraudulent Transfer
Is a fraudulent transfer the same thing as a preference? No, they are fundamentally different in several ways.
First, preference only exists in bankruptcy, whereas fraudulent transfer exists both inside and outside of the bankruptcy context.
Second, a preference is a payment to a creditor in anticipation of bankruptcy, whereas a fraudulent transfer is a transfer of an asset to anyone — not necessarily a creditor — to shield it from the legitimate depredations of creditors.
Third, a preference is a payment on an antecedent debt, whereas a fraudulent transfer can antedate the incurrence of the debt in question.
Fourth, the avoidance look-back periods are very different. The preference look-back period is 90 days from the petition date if the creditor is an ordinary creditor, and one year if the creditor is an insider.
The look-back period for fraudulent transfer avoidance is much longer, and depends on the statute to which the avoiding party appeals. If the trustee uses the Bankruptcy Code’s fraudulent transfer avoidance provision, the look-back period is two years from the petition date; unless the transfer was to a self-settled trust, in which case it’s ten years. However, the trustee can appeal to non-bankruptcy law. Under California law, the look-back period is four years from the date the transfer could have been discovered (typically the date the transfer was recorded with the appropriate governmental unit), with additional time up to seven years if the transfer couldn’t have been readily discovered. If the federal government is a creditor in the bankruptcy case, then the trustee can use the appropriate federal statute of limitations, which has a look-back period of six years, with up to an additional two years if the transfer couldn’t have been readily discovered. And if the IRS is a creditor in the case, the trustee can piggy-back on the IRS’s statute of limitations, which is ten years.
Therefore, if you owe the feds or the IRS, and you made a transfer that could be characterized as a fraudulent transfer sometime during the last eight or ten years, you may need some careful prebankruptcy planning.
- Prebankruptcy Planning
That planning might include:
- Paying any debt to the feds or the IRS, and waiting out the preference look-back period before filing, or
- Postponing filing until the relevant look-back period has expired, or
- Undoing the transfer and recovering the asset prior to filing for bankruptcy.
A Ninth Circuit case, In re Adeeb, provides the foundation for prepetition undoing of fraudulent transfers. Following abysmal counsel by a[n alleged] bankruptcy attorney, Adeeb made fraudulent transfers. Once Adeeb received better counsel, he realized the importance of immediately undoing those transfers. However, since those transfers had taken place within one year of filing the bankruptcy petition, the Office of the United States Trustee challenged his entitlement to receive a Chapter 7 discharge — despite the fact that the transfers had been undone prior to filing. The Ninth Circuit Court of Appeals, held that Adeeb was entitled to a discharge, in part, because since he had undone the transfers, it was as though he had never done them in the first place.
I have had more than one client who transferred the residence house to the children to avoid post-death tax consequences. In such a case, I instructed the client to undo the transfer and put the house back in the debtor’s name before filing the petition. This undid the fraudulent transfer, made it possible for the debtor to exempt the equity, and undid the problem that could have been grounds for denial of a discharge. Once the Court granted the debtor a discharge and closed the case, the debtor could transfer the house back to the children.
In sum, fraudulent transfers are absolutely terrible, and no debtor should consider making one, especially on the eve of bankruptcy.
- What Is A Fraudulent Transfer?
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