Fresh Start vs. Fraudulent Intent How Bankruptcy Courts Address Opposing Policy Objectives within the Bankruptcy Code

Fraudulent-transfer law is a crucial component of debtor/creditor relationships. In the bankruptcy context, fraudulent intent is an essential element for both a trustee’s clawback power through § 548‌(a)‌(1)‌(A) of the Bankruptcy Code[1] and for denial of a discharge through § 727‌(a)‌(2). The language of these statutes directly descends from the Statute of Elizabeth, which was written in 1571.[2]

Despite almost half a millennia of interpretation, the U.S. judicial system is often bewildered when applying the statute to facts. For bankruptcy courts, competing policy objectives within the Bankruptcy Code make this determination even more difficult. The Code protects an individual debtor’s property from liquidation through the application of exemptions but limits the extent that debtors may leverage this protection through fraudulent-transfer law.

These interests frequently create friction. Before seeking relief under the Bankruptcy Code, a debtor may shape his/her estate in order to benefit from the protections granted to him/her through § 522. The Code refers to these protections as “exemptions,” as they exempt property of the bankruptcy estate from chapter 7 liquidation. A debtor may utilize exemptions to protect his/her assets, but he/she may only do so to the extent that he/she has not transferred the property in an attempt to hinder, delay or defraud a creditor. If the debtor acted with fraudulent intent, the trustee may reshape the estate by reclaiming the transferred assets. Moreover, the debtor may be denied a discharge.

The exact location of the line dividing permissible estate planning and fraudulent transfers is unclear. The Code limits or prohibits many transfers of nonexempt property to an exemptible property type. Other transfers, such as transfers into retirement accounts, are not explicitly limited or prohibited. With this in mind, courts generally require the moving party to show more than the mere conversion of assets into protected property types. Rather, extrinsic evidence surrounding the conversion must indicate a purpose to hinder or delay creditors.[3] Fact-finders in bankruptcy courts are often asked to examine evidence for traditional circumstances or indications of fraud, commonly referred to as “badges of fraud.” Common badges of fraud include transfers made while the debtor was insolvent or on the eve of the bankruptcy filing, and transfers that allow the debtor to retain possession of the property.[4]

Cases implicating both of these policies ask the court to answer a difficult question: When a debtor, on the eve of bankruptcy, sells nonexempt assets and places the proceeds into an exempt retirement account, has the debtor transferred property with the intent to hinder, delay or defraud his/her creditors, or has the debtor merely taken advantage of the Code’s preference for retirement investments and engaged in permissible estate planning? If the debtor has disclosed the transfer and is not otherwise engaged in bad faith, nothing in the Code explicitly forbids the transfer. On the other hand, a fact-finder’s strict examination of the debtor’s intent in making the transfer — with an eye for the badges of fraud — provides evidence supporting fraudulent intent.

Exemptions and How the Code Encourages Pre-Petition Estate Planning

A discharge of the debtor’s debt provides him/her with what is often emphatically described (at least by debtor’s attorneys) as a “fresh start.” The expression symbolizes an essential objective of the Bankruptcy Code, as a discharge allows former debtors the opportunity to make contracts and incur debt without the burden of dischargeable debt obligations. The term “fresh start,” however, is somewhat of a misnomer. The debtor is not discharged from his/her obligation to pay all debts, nor is he/she stripped of all property interests after filing. Rather, the Code, through the exemptions expounded in § 522‌(d) or through the statute’s reference to state law exemptions, protects certain debtor assets from chapter 7 liquidation and allows the debtor to structure a post-bankruptcy life.

Consequently, exemptions protect the debtor’s future financial viability. The Bankruptcy Code seems to embrace this function, as many exemptions protect assets that provide income for the ongoing support of the debtor or the debtor’s dependents, such as annuity payments on account of illness or disability.[5] The Code limits the application of these exemptions, however, to the extent that is reasonably necessary for the support of the debtor and the debtor’s dependents.[6]

Through its protective treatment of certain types of assets, the Code incentivizes investment in those assets. For example, unlike the limits for annuity payments on account of illness or disability, the Code’s protection of retirement investments is unlimited. Section 522‌(b)‌(4) protects many retirement accounts in their entirety, regardless of whether applicable state law provides for the exemption. Further reiterating the Code’s preferential treatment of retirement accounts, § 541 places many retirement accounts outside of the debtor’s estate.

Contrastingly, the federal exemptions of § 522‌(d)‌(1) and (2) limit the exemptions applicable to the debtor’s equity in his/her residence or personal property. Even in “opt-out states” where state law fully exempts the debtor’s interest in his/her residence, § 522‌(p) limits the application of exemptions for recently acquired property interests. The Bankruptcy Code’s difference in treatment between these types of assets indicates a general preference for investments in retirement accounts over investments in real or personal property.

Congressional approval of estate planning and investments is not just implicit within the Code’s inter-workings. Legislative history reveals that Congress contemplated — and even encouraged — such planning. In explaining the revised Bankruptcy Code, the Commission on the Bankruptcy Law of the United States in 1975 stated that certain conversions of nonexempt property to exempt property are “not fraudulent as to creditors and [the Bankruptcy Code] permits the debtor to make full use of the exemptions to which he is entitled under the law.”[7]

Distinguishing Preparation from Fraud

Although the Code does not explicitly prohibit a debtor’s pre-petition conversion of assets into retirement accounts, the application of §§ 548 and 727 prevent a debtor from converting these assets with the intent to “defraud or delay” creditors. In an attempt to reconcile policy objectives within the statutes, bankruptcy courts seem to consider irrelevant evidence.

The Eighth Circuit Court of Appeals’ contrasting opinions in Hanson and Tveten are often cited as the strongest judicial criticism of the subjectivity involved in finding fraudulent intent in the bankruptcy context.[8] Judge Morris Arnold’s concurring opinion in Hanson expressed a concern that the court incorrectly based its decisions on evidence immaterial to fraudulent intent, such as the amount of the transfer and the debtors’ occupations.[9] His dissent stressed that the court’s evaluation of whether or not a transaction was fraudulent should be restricted to evidence that is relevant to the transaction and the circumstances surrounding the transaction.[10] Judge Arnold announced a fear that, by finding fraudulent intent based on immaterial evidence, judicial opinions will be inconsistent.[11] More recent cases indicate that bankruptcy courts continue to struggle with these competing policy interests and continue considering facts not relevant to the debtors’ intent. The Koehler and Asunmaa cases below provide examples of this conflicting case law.[12]

In Koehler, the court addressed whether the debtors’ sale of nonexempt furnishings within surrendered rental property and the conversion of those funds to an individual retirement account (IRA) account was fraudulent.[13] The debtors conducted the sale only a few days before filing their chapter 7 petition, netting $14,000 in profits. From the proceeds, they retained $12,000, placing it within a fully-exemptible IRA account controlled and operated solely for the benefit of the debtors.

Although many of the traditional badges of fraud were implicated, the court determined that the transfer was not fraudulent.[14] The court was persuaded by the fact that the debtors were in their mid-fifties and purchased the rental properties as an additional investment for their retirement.[15] The court further noted that the debtors, prior to filing, withdrew $80,000 from their retirement account in order to pay the operating costs of the rental properties. The court also stated that the money the debtors retained was “modest in light [of the lost investment].”[16]

In Asunmaa, the U.S. Bankruptcy Court for the Middle District of Florida contrarily resolved a factually similar case regarding the debtors’ conversion of a large nonexempt tax refund into an exempt retirement account.[17] The debtor husband was a former employee of Northwest Airlines, and during Northwest’s chapter 11 reorganization, he did not receive company contributions as required by his retirement benefits package.[18] Rather, the debtor received stock in the reorganized business as compensation for the lost contributions.

In 2007, the debtors were forced to sell the stock for an estimated $70,000 to pay various debts and living expenses.[19] In 2009, the debtors received a $31,000 tax refund on their tax return. Suspiciously, the debtors failed to explain why they were entitled to the large refund and refused to provide a copy of the return. The debtors deposited $20,000 of the return into a Roth IRA 10 days before filing their bankruptcy petitions.[20] The court found that the transfer was fraudulent and permitted the chapter 7 trustee’s clawback of the funds for disbursement to creditors.[21]

The basic factual circumstances of these cases are similar. Each of the debtors converted nonexempt assets to exempt retirement accounts on the eve of bankruptcy. In both cases, the debtors made significant withdrawals from retirement accounts to pay debt obligations; however, they were ultimately forced to seek chapter 7 relief. When the chapter 7 trustees alleged that the conversions were fraudulent, the debtors contended that the transfers were not fraudulent, but were reinvestments in depleted retirement accounts.

Like the Hanson and Tveten cases, the Koehler and Asunmaa cases also have notable factual differences that ultimately led to the divergent holdings. The Asunmaa court appears to have been convinced that the transfers were fraudulent because of the circumstances in which the debtors acquired their interest in the funds. The court also noted that the debtors, in receiving the compensatory stock, had the ability to reinvest lost funds into their retirement account, but chose to sell the stock. Although these facts may raise concerns, the language of the fraudulent-transfer statutes requires a court to examine only a debtor’s intent in making the transfer.

Implications that the debtor acquired a tax refund through fraud and concerns regarding the debtors’ previous use of funds in a separate and unrelated transaction are immaterial to the question of whether the debtors converted the asset with the intention of defrauding their creditors. Furthermore, because these prior acts were separated by time and not related to the transfer in question, they are not evidence of the circumstances surrounding the transfer and do not implicate the badges of fraud.[22] If the debtors did in fact engage in tax fraud, the remedy should be adjudicated by the Internal Revenue Service and the fraudulently acquired funds should not be disbursed to creditors through chapter 7 liquidation. Moreover, the soundness of the debtors’ financial transactions prior to filing the petition, in the absence of other evidence indicating fraud, should not provide the basis for a fraudulent transfer claim.

The Need for Clarity

This article is not meant to suggest that bankruptcy judges are failing to understand relevance. Rather, case law indicates that judges are very aware of the policy interests espoused by the Bankruptcy Code and make decisions to further these interests. In their effort to equitably enforce these policies, bankruptcy courts create distinctions that are subjective and uneasy to predict. Where the facts demonstrate that the debtor has made the transfer in order to structure his/her post-bankruptcy finances, a court may consider the debtor’s transfer in relation to the debtor’s future reliance on the asset, as the court did in Koehler.

On the other hand, when the evidence indicates that the debtor has converted large assets, is engaged in a sophisticated profession or is engaged in prior bad faith, a court may consider that evidence as indicative of fraudulent intent. In so doing, the court considers evidence that is immaterial to establishing fraudulent intent and creates inconsistent judicial decisions.

Predicting the consequences of pre-petition estate planning requires a debtor’s attorney to make difficult subjective determinations of whether the court will find his/her client sympathetic. The Bankruptcy Code often requires debtors’ attorneys to serve as both the debtor’s advocate in bankruptcy proceedings and advise the debtor through financial transactions, such as requiring the attorney to approve reaffirmation agreements.[23] Furthermore, the Code requires debtors’ attorneys to refer to themselves as “debt-relief agencies,” indicating that a debtor’s attorney should provide financial consulting in addition to legal expertise. With these expectations, debtors’ attorneys may have some obligation to advise clients to engage in pre-petition estate planning. Because of the uncertainty in the law, however, debtors’ attorneys may be hesitant to encourage their clients to utilize exemptions and make sound financial transactions to plan for their post-bankruptcy life.

In some applications, the interests of the Bankruptcy Code diverge. In certain contexts, these interests cannot be consistently reconciled by subjective interpretations of fraudulent intent. Doing so requires a court to create distinctions that are unclear and have the potential to result in widely inconsistent holdings. Rather than relying on judicial interpretation, the Code can address this discrepancy by allowing debtors to make transfers into retirement accounts up to a defined limit, similar to the limits that are imposed on investments in real estate under § 522‌(p). Doing so provides a clear limit on the debtor’s ability to transfer nonexempt assets and allows the debtor to engage in solid financial planning.