When Do Bankruptcy Cases End Up In Litigation?

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In the previous article, I outlined the most common types of disputes that result in bankruptcy litigation. As a quick summary, they include:

• Challenges To Discharge: When the issue of whether or not a debt can be discharged is disputed. This is done to challenge either the discharge of a particular debt, or the entire discharge.
• Objection To A Claim: When a debtor is in a plan of financial reorganization, either in a Chapter 11 or a Chapter 13, for a limited time creditors can file proofs of claim. When a creditor files a proof of claim, it asserts that the debtor owes it a certain amount of money, to be repaid through the reorganization plan. If the claim is exaggerated, invalid, or otherwise objectionable, the debtor can challenge its legitimacy.
• Dispute Over Valuation Of Assets: Under the right circumstances, a debtor can remove a judgment lien against an asset — most typically a residence. And under the right circumstances, a debtor can remove a wholly unsecured junior mortgage. One of the key factors in lien stripping — whether to remove a judgment lien, or to strip off a junior mortgage lien — is the value of the property. If the property value is too high, the lien cannot be stripped. Thus, if there is a dispute over the stripping of the lien, it is typically over the value of the property.

Sometimes — most commonly in Chapter 7 bankruptcies — the Chapter 7 trustee will initiate litigation against recipients of what are called “preferences,” and what are called “fraudulent transfers.” This is done via an adversary proceeding, and can play a very big role in the bankruptcy case. Prebankruptcy planning is absolutely essential to avoid facing adversary proceedings to undo preferences and fraudulent transfers.

What is a Preference Lawsuit?

Before I discuss preference lawsuits, I must first explain what a preference is. It helps to know the two big goals of bankruptcy law.

A. The Two Big Goals Of Bankruptcy Law

The first major goal of bankruptcy law has a laudable pedigree. It was in the Code of Hammurabi — Hammurabi was a ruler of the first Babylonian empire — and is found in the Bible, ancient Roman law, and the U.S. constitution: To give the debtor a financial fresh start. The second big goal of bankruptcy law looks at the other side of the financial equation: To make sure that similarly situated creditors are treated equally and fairly.

B. Violating The Second Big Goal

There are a couple of ways that debtors sometimes violate the second big goal of treating all similarly situated creditors the same.

First, they won’t list all of their creditors in their bankruptcy petition. To say this is considered “a big no-no” is an understatement: It is actually an imprisonable offense. This is because it ultimately constitutes perjury, since debtors swear under penalty of perjury that they have listed all of their creditors on their bankruptcy petition. This is one reason why it is very important to list all of your creditors in your bankruptcy petition.

Second, in anticipation of bankruptcy, some debtors make preferential payments to a given creditor; perhaps to curry favor with the creditor, or to give preferential treatment to a friend, or family member, or a close business associate.

You might wonder what is wrong with repaying a family member instead of the bank. When you pay the family member you are treating that person better than other similarly situated creditors. In doing so, you are violating that second big goal of making sure that all similarly situated creditors are treated the same.

C. The Preference Avoidance Adversary Proceeding

By definition, a preference happens before a person files for bankruptcy. Once the bankruptcy is filed, the responsible party — usually a trustee — is empowered to initiate an adversary proceeding, to recover the preference.

How far back in time is the look-back period? If the recipient of the preference is an ordinary creditor, the look-back period is ninety days prior to the filing of the bankruptcy petition. If the creditor is an insider — family member, close business associate — the look-back period is one year. In each case, measured from the date the bank honors the payment.

An important consideration is the size of the preference. On the one hand, if the preference amount was only $500 that you paid your brother a few weeks before filing for bankruptcy, no one is going to take any action because just the cost of filing the adversary complaint will far exceed $500. On the other hand, if the preference amount was $50,000, your brother will face a preference avoidance action.

What is the cutoff? It depends on the facts, and who the trustee is. If you hit the trustee’s sweet spot, the preference recipient will face an adversary proceeding to undo the preference. If the trustee is successful, the money will not be returned to you. Instead, it will be used to pay all the creditors on a pro-rata basis according to certain priority rules that are listed in the Bankruptcy Code.

In sum, a preference lawsuit is a lawsuit to undo or avoid a preference.

What is an Adversary Proceeding in Bankruptcy?

The simple answer is that an adversary proceeding is a lawsuit that is specific to the bankruptcy system. “Adversary proceeding” is the term of art that is used to mean “lawsuit” in bankruptcy jurisprudence. If you sued someone in the California Superior Court you would say that you filed a lawsuit against that person. If you initiated a lawsuit against somebody in bankruptcy court, you would say that you initiated an adversary proceeding against that person.

For more information on Litigation Over Bankruptcy Disputes, an initial consultation is your best next step. Get the information and legal answers you are seeking by calling (562) 777-9159 today.