This article was prepared by Kevin Checkett for his presentation at the U.S. Department of Justice National Advocacy Training Center in South Carolina. Mr. Checkett served on a panel explaining case administration issues to bankruptcy trustees from around the country. The topic of preference and fraudulent conveyances within this article is written in a straightforward manner and assumes the reader or listener has no substantial background on the topic.
Introduction
One of the underlying philosophies running throughout the Bankruptcy Code is that all creditors of the same class must be treated equally. To that end, when a debtor pays one creditor and not others or conveys any asset in such a way that is no longer available to lawful claimants, the trustee has the power to avoid and reverse those actions. In other words, given the right set of circumstances the trustee may file an adversary action against creditors who are preferred or persons receiving the debtor's assets for inadequate consideration, and make all such property equally available to claimants. These transfers are brought back to the bankruptcy estate and then distributed in the priority schedule set out in the Bankruptcy Code.
EXAMPLE: Trustee collects $10,000.00 from transferee of either a preference or fraudulent conveyance. The funds are placed in the trustee's account and distributed to all creditors pursuant to §§726 and 507. The transferee who repaid the funds is entitled to a claim for its entire balance due, including the preference or conveyance which has been set aside.
Strong Arm Provision
Section 544(a) grants to the bankruptcy trustee the status, however hypothetical, and the rights and power of a judicial lien creditor, a creditor with an unsatisfied execution, and a bona fide purchaser of real estate.
EXAMPLE: The debtor borrows $50,000.00 from First National Bank and pledges a bulldozer as collateral. The bank forgets to file its UCC-1 financing statement. The debtor then files bankruptcy. Because First National Bank did not perfect its security interest, the trustee's status as a hypothetical lien creditor takes priority over the unperfected interest. The result, the trustee and not the bank has first claim on the bulldozer. UCC-9301(1)(b)
PREFERENCES
It is not unusual that in business and consumer cases alike, that once in a cash crunch, a debtor may pay some creditors and not others.
EXAMPLE: Debtor operates a sporting goods store. It has more bills coming in than cash. In order to keep the store open the debtor pays current suppliers and utilities but ignores old vendors and other general creditors.
EXAMPLE: Consumer debtor realizes things are not going so well. A tax refund check of $5,000.00 comes in. Wanting to be sure she keeps in the good graces of the local bank, the funds are paid over on a signature note while other creditors are paid little or nothing.
For this reason, and again going to the philosophy that all creditors are created equal, the Bankruptcy Code allows the trustee to file adversary actions to recover preferential transfers to be returned to the bankruptcy estate.
Section 547(b) of the Bankruptcy Code provides that the trustee may avoid a transfer of the debtor's interest in any property,
EXAMPLE: debtor gives a check to a creditor;
EXAMPLE: debtor collateralizes an old loan by signing over a car title or a UCC-1 financing statement on equipment or inventory
which is made to the benefit of a creditor on an antecedent debt,
EXAMPLE: local bank gets $5,000.00 tax refund to apply on a signature note more than 30 days past due.
at a time when the debtor was insolvent (and the Code presumes insolvency within 90 days of the bankruptcy) and within 90 days prior to the filing of bankruptcy,
EXAMPLE: On May 1, 2004, debtor pays $5,000.00 to his grandfather and then files for Chapter 7 on October 1, 2004. Because the transfer was more than 90 days before the bankruptcy, the trustee must prove that on May 1 the debtor was insolvent. If the transfer had been within 90 days of October 1, insolvency is presumed.
or up to a year if the creditor is an insider such as a relative or a partner,
EXAMPLE: debtor wants her usual place at the Thanksgiving dinner table and to pay a perfectly valid debt signs over a car title to her uncle six months before her filing for Chapter 7
but only if the transfer allowed the creditor to receive a larger share than it would have within the bankruptcy case, not usually a difficult element to meet.
EXAMPLE: Because debtor gave $5,000.00 to the local orthodontist, she received 80% of her bill. The other creditors in the Chapter 7 case will only receive a 10% payment. The orthodontist has been preferred.
The Bankruptcy Code defines "transfers" broadly, including any voluntary and involuntary disposition or conveyance of an interest in property. Section 101(54).
EXAMPLES OF TRANSFERS:
- Signing a mortgage or deed of trust
- Endorsing a check
- Allowing for a UCC-1 financing statement to be filed
- Signing a quit claim deed
- Agreeing to a telephone transfer of funds from a checking account
- Garnishment by a creditor
- Entry of a judgment lien by a creditor
Exceptions to Preference Rules
- Substantially contemporaneous exchange for new value:
- Debtor borrows $30,000.00 to buy a new car and immediately signs over the certificate of title to create a lien for the lender. The estate was depleted not at all. No preference.
- Transfer in the ordinary course of business:
- Within 90 days of the bankruptcy the debtor pays $10,000.00 on a monthly account to a material supplier. The $10,000.00 payment was made within 30 days of receiving the material, just like always. Assuming the transfer was in the ordinary course of business both between the parties and within the industry, it is a defense to any claims of preferential payment.
- Subsequent advance of new value:
- After receiving payment from the debtor, particularly in a business setting, the creditor ships another $5,000.00 in inventory. In any adversary action for turnover of a preference, the creditor gets a $5,000.00 offset for the new value extended to the debtor to be applied against any preference claim.
FRAUDULENT CONVEYANCES
When we consider the term "fraudulent conveyance", many people tend to imply wrongdoing or bad intentions. However, the Bankruptcy Code at §548 defines fraudulent conveyances to mean not only transfers intended to delay or defraud creditors but ones made for inadequate consideration by an insolvent debtor.
The law authorizes the trustee to set aside transfers made with the actual intention to delay, hinder or defraud creditors,
EXAMPLE: realizing that creditors are closing in, the debtor signs over the family home to her son. The debtor continues to reside in the home while the son lives 1,000 miles away
as well as those made by an insolvent debtor who receives less than reasonably equivalent value in the exchange,
EXAMPLE: debtor sells convenience store worth $750,000 to a competitor for $450,000. The trustee can set aside the transfer as fraudulent but the buyer must be repaid the $450,000 purchase price.
or that leaves the debtor with inadequate capital to carry on its business, or renders the debtor unable to pay its debts as they become due.
EXAMPLE: this a classic case of the leverage buy out. For instance, the debtor pledges its assets for the benefit of a subsidiary corporation. The debtor receives no benefit for this advance and then has insufficient working capital to remain in operation.
The Bankruptcy Code limits the trustee to avoidance of fraudulent conveyances to those made within a year before bankruptcy.
EXAMPLE: debtor sells convenience store worth $750,000 to competitor for $450,000 and the deed is recorded on June 1, 2003. Debtor files a voluntary bankruptcy or is placed in an involuntary bankruptcy on May 20, 2004. Because it was transferred within one year of the petition date, the trustee may avoid the sale.
However, most states have fraudulent conveyance provisions, often the Uniform Fraudulent Conveyances Act, which allow a longer reach back, often four or five years.
EXAMPLE: Debtor sells $750,000 convenience store to her brother-in-law for $100.00 and other good and valuable consideration. The deed is filed on June 1, 2002. The bankruptcy is filed on July 1, 2004. Because the bankruptcy is more than one year after the transfer, the trustee must use state law and prove an actual intention to defraud.
The trustee may file an adversary action to recover the fraudulent conveyance and choose to proceed in court under the Bankruptcy Code or by using state law remedies.
Exemption of Preferences and Fraudulent Conveyances
As a general proposition, a debtor may not exempt assets recovered by the trustee as a result of a preference or fraudulent conveyance.
EXAMPLE: Trustee finds the lien on the debtor's car was for an antecedent debt and placed on the title within 90 days of the bankruptcy. The trustee is able to avoid the lien as a preference and now has the car. Debtor cannot claim the car as a vehicle exemption under either state or federal law. Instead, value created from the trustee's avoiding power, is not subject to exemption. Section 522(g)(1)(A)
Statute of Limitations
The Bankruptcy Code at §546 requires the trustee to file any adversary action to recover preferences or fraudulent conveyances within two years of the filing of the bankruptcy petition.
EXAMPLE: Debtor files voluntary Chapter 7 petition on June 1, 2002. Trustee's counsel files the adversary on August 7, 2004. The adversary must be dismissed as being barred by the statute of limitations. Section 546(a).
