Was Your Debtor's Bankruptcy Planned
Preventing Discharge and Getting Paid
on Your Unsecured Claim When the Debtor Least Expects It.
By Richard Ruszat

As you may be aware, the Bankruptcy Code presents a unique opportunity for debtors to avail themselves of a "fresh start." Through bankruptcy, debtors are able to discharge or manage burdensome debt and claim limited exemptions for personal and real property.i Although payment to creditors is also a goal of the Bankruptcy Code, the fresh start is more often at the expense of unsecured creditors that realize only pennies on the dollar, if a penny at all. In the best of worlds, debtors are candid with disclosures of their finances and assets. In realty, conscientious debtors are seeking ways to maximize their assets and stretch their exemptions with a practice known as "bankruptcy planning."

Maximizing Exemptions versus Defrauding Creditors

Although certain bankruptcy planning practices are acceptable, other practices may prevent the discharge of the debtor's liabilities.ii Debtors that possess significant assets risk having their assets collected and liquidated for distribution to creditors. Oftentimes, these debtors will practice bankruptcy planning to protect their assets. Although no clear line of demarcation exists, maximizing exemptions is permissible while a ploy to "hinder, delay or defraud creditors" will prevent discharge. Generally, acceptable bankruptcy planning practices include venue and choice of law decisions, transmutation of a non-exempt asset into an exempt asset, or use of present cash for payments on debt that will not be discharged (e.g., secured debt, taxes, and family support) instead of payment on unsecured lines of credit that are likely to be discharged in bankruptcy. On the other hand, illegal bankruptcy planning practices may include acquiring loans to purchase exempt property, incurring liabilities with an intent to file a bankruptcy petition, and executing transfers of personal or real property to insiders or for inadequate consideration. In any event, it is important to note that courts are variable on acceptable bankruptcy planning practices. Identification of these practices may result in the discovery that the debt is not dischargeable.

Getting a Handel on the Estate's Assets

If a debt is not discharged in bankruptcy, then the creditor's claim survives and the creditor may collect against the full value of the debt instead of receiving an insignificant distribution from the estate. In Re Handel is an illustrative case of a debtor's egregious effort to use bankruptcy planning practices to conceal a significant portion of assets from creditors.iii In In re Handel, the bankruptcy court of the Southern District of New York considered a series of challenges to the Debtor's discharge on the Creditor's motion for summary judgment.iv Through bankruptcy planning, the Debtor transferred his partnership payments, investment accounts, and retirement assets to his wife, a nondebtor. The Debtor asserted that his actions only constituted transformation of nonexempt assets into exempt assets and that there was no intent to defraud creditors. In addition, an issue arose concerning the value of certain antiques that were listed on an aged financial statement and the Debtor's bankruptcy schedules. Quite remarkably, the financial statement at issue was completed approximately ten years prior to the bankruptcy filing. In its opinion, the bankruptcy court considered the effect of the Debtor's bankruptcy planning on the Debtor's prospect for discharge.

Shuffling Exemptions for a Better Hand (el)

Prior to filing the bankruptcy petition, the Debtor transferred his partnership payments, investment accounts, and retirement accounts to his wife. The Debtor denied that these transfers constituted fraud on creditors; rather, the Debtor asserted that the transfers were a means of protecting exempt assets. The Creditor disagreed. Pursuant to § 727 (a)(2)(A), the Creditor moved the bankruptcy court for summary adjudication for a determination that the debt was nondischargeable.v This required the Creditor to show that: (1) the transfer occurred one year prior to the bankruptcy petition; (2) the transfer was done with actual intent to hinder, delay, or defraud a creditor or an officer of the estate; (3) the debtor or an agent of the debtor effectuated the transfer; and (4) the transfer concerned the debtor's property.vi

The only element at issue was whether the transfer occurred with an actual intent to hinder, delay or defraud a creditor. Since it is unlikely that a debtor will testify to perpetrating a fraud with "actual intent," courts conduct an analysis of the "badges of fraud" to determine whether intent exist.vii The badges of fraud include: (1) inadequacy of consideration; (2) transfer of property to family and friends; (3) retention of benefits derived from property; (4) financial condition of the transferring party; (5) transfer of property after incurring debt, financial difficulties, and suits by creditors; (6) omission and misrepresentations on the Debtor's schedules; (7) a debtor's reckless indifference to the truth; and (8) other facts and circumstances evidencing fraud.viii The bankruptcy court may deny discharge if any one of the badges exist. Although the Debtor wore several badges of fraud, the bankruptcy court cautiously concluded that a question of fact remained as to whether these particular transfers were done with the "requisite intent to hinder, delay, or defraud the creditor.ix

Discrepancy Appears in Handeling of the Antiques' Value

The Creditor also moved for summary adjudication to deny discharge on the basis that the Debtor made a false oath on financial statements dating approximately ten years prior to the bankruptcy filing. Pursuant to § 727(a)(4)(A), discharge may be denied if a debtor "knowingly and fraudulently ... made a false oath."x Under this section, an omission alone from a debtor's statement of affairs or schedules is grounds for denying discharge. At issue were the values assigned to the Debtor's antiques on an aged financial statement and his bankruptcy schedules. The financial statement attested that the value of the antiques was $200,000 whereas the bankruptcy schedules listed the value only at $5,000. To justify the discrepancy, the Debtor claimed that the financial statement was a combination of antiques owned by him and his wife, a majority of which were allegedly purchased by his wife through monetary gifts that constituted separate property. The bankruptcy court concluded that a question of fact remained as to whether the Debtor acted with fraudulent intent. The bankruptcy court also stated that if the Debtor "sincerely" believed that the financial statement requested information about assets belonging to himself and his wife, then the Debtor did not have the requisite fraudulent intent.

The Bankruptcy Court Handels It to the Benefit of the Creditor

In its final request for summary adjudication to deny discharge, the Creditor asserted that the Debtor failed to adequately explain the differences in the values assigned to the antique furniture.xi Pursuant to § 727(a)(5), discharge may be denied if a debtor fails to explain "satisfactorily ... any loss of assets or deficiency of assets to meet the debtor's liabilities."xii Unlike the other sections, § 727(a)(5) does not require an intent analysis and is construed broadly. If a creditor establishes that a loss occurred, the burden shifts to the debtor to explain that any conduct was the product of good faith and business-like conduct. Furthermore, vague and indefinite explanations of losses are deemed unsatisfactory if based on estimates and uncorroborated by documentation. The bankruptcy court concluded that the Debtor's "self-serving" statements regarding ownership and value of the antiques were unavailing and not corroborated with any documentation. Accordingly, the bankruptcy court entered summary judgment for the Creditor and denied the Debtor's discharge.

Conclusions

In re Handel is an illustrative case of the effect of bankruptcy planning on a debtor's discharge. It also presents a valid avenue for creditors to challenge discharge if the creditor can research the debtor's prior financial dealings. Although the courts may consider certain practices as legitimate (e.g., transformation of nonexempt assets to exempt assets), other practices are clearly suspect and may be grounds to deny discharge (e.g., value discrepancies and transfers to insiders). The bankruptcy court is clear that the intent requirement under certain provisions of § 727 is the central focus of the inquiry. If intent can be inferred from the facts and circumstances of a particular case, then a creditor may be able to successfully challenge a debtor's discharge. The creditor need not establish actual intent. Moreover, § 727(a) (5) does not require any showing of intent if there is a discrepancy in the value of assets listed on financial documents, or any other document, and the debtor's bankruptcy schedules. If a discrepancy is found, a debtor is required to satisfactorily explain the disappearance of assets prior to the bankruptcy filing. If the debtor fails to satisfactorily explain the demise in assets, then discharge may be denied and the creditor may seek recovery from the debtor for the full amount of its claim.

i. The Bankruptcy Code gives each state an option with regard to exempt property that is protected from creditors. Pursuant to the Bankruptcy Code §§ 522 and 541, a state may allow debtors to: (1) exempt from their bankruptcy estates property included in the federal "laundry list" of exemptions, or (2) rely on state law and federal law other than the laundry list for allowable exemptions. See 11 U.S.C. §§ 522 and 541. Additionally, a state may also entirely "opt out" of the federal exemption scheme. See 11 U.S. C. § 522(b)(1).

The option scheme has provided for varied results among the states. For example, pursuant to federal law, the exemption value for a homestead is $15,750.00. However, the State of Florida, subject to very limited exceptions, provides an exemption for the full value of the homestead. See Fla. Const. art. X § 4 (West 2002); See also Fla. Stat. § 222.01 (West 2002). Additionally, states may add exemptions for personal property that are not listed under the Bankruptcy Code. A unique exemption is found under Texas law, which permits an exemption for two (2) firearms (certainly, this adds to smooth relations among aggressive creditors). See Tex. Prop. Code. Ann. § 42.002(a)(7)(West 2002). As one Texas bankruptcy court noted, "the typical hunter serious about his or her sport will have a shotgun for birds and a rifle for other game." See In re Schwarzbach, 1989 WL 360742, *4 (W.D. Tex.1989).

ii. A majority of consumer debtors willpossess assets that meet the exemption requirement under state and federal law, and therefore, these assets are out of the reach of creditors.

iii. See In re Handel, 266 B.R. 585 (Bankr. S.D.N.Y.2001).

iv. The Debtor also filed a cross-motion for summary adjudication, which the bankruptcy court denied on all claims. The bankruptcy court did not discuss the reasoning for its denial of the cross-motion for summary judgment.

v. See 11 U.S.C. § 727(a)(2)(A).
vi. See Id.
vii. See Najar v. Kablauoui (In re Kablaouli), 196 B.R. 705, 709 (Bankr.S.D.N. Y.1996).
viii. See Salomon v. Kaiser (In re Kaiser), 722 F.2d 1574, 1582-83 (2nd Cir. 1983).

ix. The Creditor also moved for summary adjudication pursuant to § 727(a)(2)(B) for transferring unnamed assets from his estate to his wife's account. Section 727(a)(2)(B) permits the bankruptcy court to deny discharge if the debtor, with an intent to "hinder, delay, or defraud a creditor.. .transfers property from the estate, after the date of filing the petition." See 11 U.S.C. § 727(a)(2)(B). The bankruptcy court concluded that the same analysis under § 727 (a)(2)(A) applied and denied summary judgment to determine whether the transfers were to protect exempt assets or to defraud creditors. See In re Handel, 266 B.R. at 589.

x. See 11 U.S.C. § 727(a)(4).

xi. The Creditor also moved for summary adjudication on the basis that the Debtor failed to adequately explain the reasons that his capital account at his law firm had a positive value of $400,000 in 1989, whereas it had a negative value at the time the bankruptcy petition was filed. See In re Handel, 266 B.R. at 590. The Debtor attributed the negative balance to a change in accounting methods and the loss of a valuable asset at the firm. See Id at 591. Although the bankruptcy court denied summary judgment on this issue, it did not state its reasoning. The logical inference is that the bankruptcy court believed that this explanation was satisfactory. xii. See 11 U.S.C. § 727(a)(5).

Blakeley & Blakeley LLP Reprinted by permission from Trade Vendor Quarterly