Daily Development for Tuesday, April 16, 2002

By: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
prandolph@cctr.umkc.edu

BANKRUPTCY; DENIAL OF DISCHARGE; TRANSFER WITH INTENT TO HINDER, DELAY OR DEFRAUD; TRANSFER OF EXEMPT ASSETS:  The debtor's transfer to a corporation controlled by his wife and children of $217,059.25 representing proceeds of a personal injury settlement was made with the intent to hinder, delay or defraud creditors, within the intendment of section 727(a)(2)(A), and therefor the debtor's right to a discharge in Chapter 7 bankruptcy was denied, even though the money was fully exempt from creditor claims under applicable state law.

Tavenner v. Smoot, 257 F.3d 401, 2001 U.S. App. LEXIS 15901 (4th Cir. 2001).

The debtor had several pending suits involving his employer.  The first involved compensation for on the job injuries.  In the second the employer was suing him for violation of wiretapping laws.  The injury claim "hit" first, and the court awarded debtor a net $210,000.  But it had already found that debtor would be liable for damages and attorney's fees under the wiretapping claim.

Knowing that another shoe was about to drop, with substantial damage claims, debtor transferred the personal injury proceeds to accounts owned by a corporation which his family controlled.  The wiretap claim then was resolved, imposing in excess of $350,000 in damages.  Thereafter, debtor spent about half of the money in the corporate account to buy various things for family members..

The court concluded that the debtor transferred the funds into the corporation's accounts with the express objective of shielding them from creditor's claims.  Ironically, however, the court also concluded that Virginia law would have exempted the personal injury recovery from reach by creditors.  Therefore, the transfer to the corporate accounts served the debtor nothing.  But because the bankruptcy law sanctions by denying discharge to debtors who, while insolvent and within a year prior to bankruptcy, engage in transfers with the purpose of defrauding creditors, the court here denied a bankruptcy discharge.  It concluded that the pending damages claim under the wiretap case was sufficiently threatening to render the debtor insolvent, although the exact amount of damages had not yet been fixed.

"Indisputably, had  [the debtor] left the proceeds from the settlement...in his account, he could have exempted those proceeds from his bankruptcy estate under Virginia law," the Court of Appeals acknowledged.   It commented that all property, including potentially exempt property, is property of the estate, and therefore the debtor's transfer of the proceeds to a family controlled business for no consideration was the kind of transfer that is sanctionable under section 727(a)(2)(A).  The character of the funds as exempt was no defense, "for if a debtor enters into a transaction with the express purpose of defrauding his creditors, his behavior should not be excused simply because, despite the debtor's best efforts, the transaction failed to harm any creditor."  It acknowledged that some courts have applied a "no harm, no foul" rule, but concluded that such approach represents the minority and, in any event, is "misguided."  The court instead elected to  follow Lasich v. Wickstrom (In re Wickstrom), 113 B.R. 339, 350 (Bankr. W.D.Mich 1990), which it described as the majority view.

The court went on to set aside the transfers in addition to denying the transfer.  It noted that the statute permits setting aside transfers made with the purpose of hindering or defrauding creditors, and, again, does not require that the purpose be well planned or successful.

Reporter's Comment:  The Court of Appeals analyzed the "novel  issue"  in the case as having two parts whether the pre-petition transfer of exempt assets can have a wicked enough character to cost the debtor its discharge, and whether the fraudulently transferred exempt assets can be recovered for the benefit of the estate -- i.e., for creditors and not for the debtor personally.   The wording of the Bankruptcy Code seems to require a "yes" to both halves if either is true.  For if the transfer was a voluntary made with the intent to hinder, delay or defraud creditors, so as to satisfy the requirements of 727(a)(2), then once the assets which were subject to the illicit transfer are recovered, the debtor has lost the right to claim any exemption over them, according to the rules embodied in section 522(g) and (h) of the Bankruptcy Code.

Editor's Comment 1: The sanction of denial of discharge is relatively easy to understand, whether one agrees or not.  But there remains that aspect of the order permitting the creditors access to the funds.  The statute says that the transfers made with the purpose of defrauding or hindering creditors can be set aside.  It does not, however, provide an independent basis for the creditors reaching these funds in the bankrupt's estate.  Why are they not still insulated under state law?  The court also indicated that the transfers could be set aside as fraudulent transfers to insiders without equivalent value (under this theory there is no  "intent to defraud" requirement.").  Again, it would appear that this analysis was correct, but only puts the assets back into the debtor's accounts.  Why would the state law protection of these assets not continue to apply?

UMKC Bankruptcy professor Ray Warner notes that Section 522(g) states specifically that exemptions are lost with regard to assets voluntarily transferred as was the case here.   The bankruptcy court says pretty much the same thing.  But here's the language of the statute:

"g) Notwithstanding sections 550 and 551 of this title, the debtor may exempt under subsection (b) of this section property that the trustee recovers under section 510(c)(2), 542, 543, 550, 551, or 553 of this title, to the extent that the debtor could have exempted such property under subsection (b) of this section if such property had not been transferred, if--

(g) (1) (A) } (1)(A) such transfer was not a voluntary transfer of such property by the debtor; and (g) (1) (B) } (B) the debtor did not conceal such property; or

(2) the debtor would have avoided such transfer under subsection (f)(2) of this section."

In other words, we have a negative reference.  Since the statute says that the debtor can preserve the exemption if the transfer that was set aside was involuntary, there is the inference that no such preservation right exists if the transfer in question (as here) was voluntary.  But the overall statute states exceptions to what appears to be the "ordinary" rule that state law exemptions would not apply.  Therefore, the only way the debtor rescues the exemption for recovered funds is under subsection (g), and that gives no relief here.

Comment 3:   Note that the same analysis might apply to a homestead exemption.

Comment 4:   Justified by the statute or not, to the editor, the "double whammy" here seems to be overkill.

Comment 5: Section 727 applies to Chapter 7's and some Chapter 11's, but not to Chapter 13's.

The Reporter for this case is Jim Stillman of the California Bar.

 

 

Readers are urged to respond, comment, and argue with the daily development or the editor's comments about it.

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