Fresh Start Head Start or Running Start Bankruptcy Exemption Planning

Journal Issue

Apr 2003

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Actions
on the eve of bankruptcy will many times determine the availability of the fresh
start: a new financial life free of debt with some exempt assets. Debtors push
the envelope on exemption planning because the legislative history of the
Bankruptcy Code emphasizes that the conversion of nonexempt assets to exempt
assets for the purpose of placing assets outside of creditors block is not,
without more, a fraudulent transfer.<a href="#1" name="1a">1</a> Lawrence Pondroff and F. Stephen
Knippenberg assert that "...courts and commentators have been
unprincipled and inconsistent in their attempts to describe when and why such
pre-bankruptcy conversions are permissible."<a href="#2" name="2a">2</a> Other commentators have
been more colorful: "Fraud in bankruptcy planning appears to enjoy the
same precise definition as pornography; the federal courts know it when they
see it."<a href="#3" name="3a">3</a> In three recent cases, courts have continued to address the
lack of a predictable outcome.

In
the case of In re Crater,<a href="#4" name="4a">4</a> the debtors
engaged in exemption planning once a creditor commenced legal action against
them. The debtor's attorney warned the creditor's attorney that
bankruptcy would result. The debtors sold non-exempt property and applied the
$40,000 proceeds to the second mortgage on their homestead. The bankruptcy
filing followed within 17 days. The creditor objected to discharge and moved
for summary judgment alleging circumstantial evidence supported "actual
intent to hinder, delay or defraud."

The Crater court focused on whether the
transfer effecting the exemption was made with actual intent, either to defraud
or to hinder or delay, as shown by a preponderance of the evidence. Relying on In
re Woodfield,<a href="#5" name="5a">5</a> the Crater court found that actual intent can be inferred from
circumstantial evidence. Because this was a summary judgment motion, the
creditor had the burden of establishing that a trier of the fact could not
conclude the debtor's intent was innocent.

The court began its
analysis of intent by dividing the badges of fraud into the following three
categories: (1) those indicating an act of fraud, (2) those indicating
motivation and (3) those indicating suspicious factors. The court then found
that the creditors had only raised suspicious timing factors. Neither the
timing of the transaction nor lack of an economic basis for the transaction
were elevated by the Crater court to a
rule that would prevent pre-exemption planning. The court cited legislative
history and In re Smiley<a href="#6" name="6a">6</a> in
deciding that the standard should not limit the debtor's right to
maximize exemptions "...unless the creditor shows a deception or
concealment, an insider transaction, a fraudulent conveyance, a secretly
retained possession or benefit, or debtor's explanations lack
credibility...," concluding that suspicious acts or timing will not
defeat a discharge.

Complaining
about the same lack of a coherent body of law on exemption planning, another
court came down on the other side of the question in the same time frame in In
re Boudrat.<a href="#7" name="7a">7</a> The debtors in Boudrat were subjected to entry of a $71,000 judgment.
Shortly after that, they liquidated $54,000 in nonexempt assets and applied the
proceeds to their homestead mortgage. After the bankruptcy filing, the judgment
creditor contested the discharge. At trial, the following facts were
established: (1) at the time of the transfer, the debtors knew of the judgment;
(2) the debtors knew the transfer would deplete all their available cash; and
(3) the debtors had no credible bankruptcy planning reason for the transfer
except to place assets beyond the creditor's reach.

Relying
on Tenth Circuit cases,<a href="#8" name="8a">8</a> the Boudrat
court found that the debtors had the requisite intent to hinder or delay
creditors, which was evidenced by their stated purpose to place the assets
beyond the reach of creditors even though it was done with advice of counsel.
The court emphasized that the "defendants made this transfer just shortly
after entry of the state court judgment against them without any credible
statement of an intent to engage in bona fide bankruptcy planning" and
that the "defendants appear to harbor animosity toward the
plaintiff."<a href="#9" name="9a">9</a> It is fair to conclude that this court knows fraud when it
sees it.

It
is apparent that the test for successful pre-bankruptcy planning is a gray one:
"If the debtor has a particular creditor or series of creditors in mind
and is trying to remove his assets from their reach, this would be grounds to
deny the discharge. If the debtor is merely looking to his future well-being,
the discharge will be granted."<a href="#10" name="10a">10</a>

That
test is made even more vague by a recent Wyoming decision, In re Baker.<a href="#11" name="11a">11</a> After noting that Wyoming is an
"opt-out" state, the court went on to find many badges of fraud
even though debtors liquidated non-exempt assets to create exemptions to
protect their financial future. The creditor's actions arose from the
debtor's guarantee of their children's debts. Even though the
debtors acted openly and with the advice of counsel, the court denied the
discharge, stating that there might be permissible exemption planning to
increase the value of a homestead exemption, but not when a debtor shields
almost all of their valuable assets and then files bankruptcy. This result is
consistent with In re Kulwin,<a href="#12" name="12a">12</a>
where the court denied the debtor a discharge and a "running start"
where a large amount of property was converted to exempt property, and only
certain creditors were paid. The court concluded that any other result would be
a "perversion" of bankruptcy law.

Perhaps
the commentators are right about the inconsistent case law surrounding the
transmutation of assets. Legislative history states that there is nothing
inherently wrong in adjusting assets to maximize exemptions. Creditors, whose
rights normally arise from contracts, do not bargain for exempt property.
Perhaps asset-conversion to preserve exemptions should be reconceptualized as a
property right in order to preserve a fresh start.<a href="#13" name="13a">13</a>

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> H.R. Rep. No. 595, 95th Cong., 2d Sess. 361 (1977); S. Rep. No. 989, 95th Cong., 2d Sess. 76 (1978). <a href="#1a">Return to article</a>

<a name="2">2</a> Pondroff, Lawrence and Knippenberg,
F. Stephen, "Debtors Who Convert Their Assets on the Eve of
Bankruptcy," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
N.Y.U. L. Rev. 235</a>, May 1995. <a href="#2a">Return to article</a>

<a name="3">3</a> Norwood, John M. and Jennings,
Marianne M., "Before Filing Bankruptcy, Move to Florida and Buy a
House," <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
SW. U.L. Rev. 439, 442 (1999)</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. 756 (Bankr. D. Ariz. 2002)</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
F.2d 516, 518 (C.A. 9 1992)</a>. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
F2d 562 (C.A. 7 1989)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. 582 (Bankr. W.D. Okla. 2002)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Carey, 938 F.2d. 1073 (10th Cir. 1991)</a>;

<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Serafini, 938 F2d. 1156 (10th Cir. 1991)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. 582, 587</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
re Oberst, 91 B.R. 97, 101 (Bankr. C.D. Cal.
1988)</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
B.R. 892 (Bankr. D. Wyo. 2002)</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
B.R. 341 (Bankr. D. Kan. 1995)</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> Pondroff and Knippenberg at 324-35. <a href="#13a">Return to article</a>

Journal Authors

Timothy D. Moratzka

Journal Date

Tuesday, April 1, 2003 - 12:00

Bankruptcy Rule

2003