Hard cases make bad law, but Bankruptcy Judge Elizabeth E. Brown of Denver took a hard case to make good law. Although the debtor was not a sympathetic character, Judge Brown reached a result implied by conflicting precedent, even though she let the debtor off the hook for a preference.
Resolving issues of first impression in her district, Judge Brown ruled that the debtor’s discharge absolved him of liability for receipt of a preference because the claim was in personam. She also decided that an individual retirement account is not an entity separate from its owner.
The Preference
Before bankruptcy, the debtor had made a $750,000 loan from his individual retirement account to his closely held corporation. Within one year before the corporation’s bankruptcy, the company made two $75,000 interest payments to the IRA.
The corporation and the owner went into bankruptcy within days of one another. The owner received his chapter 7 discharge. Two days after the owner received his discharge, the corporation’s trustee sued the owner and the IRA’s custodian for $150,000 in preferences.
The IRA custodian contended that it was not an entity separate from the owner and thus should not be sued. The owner argued that his discharge barred the preference claim. Judge Brown ruled in favor of both the IRA custodian and the debtor in her March 25 opinion.
Separate Legal Identity of an IRA?
Judge Brown found “few reported decisions” saying whether an IRA is an entity separate from its owner. “Almost all of them,” she said, conclude that an IRA is not a separate legal entity, but the opinions do not provide “a great deal of analysis.”
Judge Brown began by observing that an IRA “is somewhat of a fictional creature, existing only to provide its owner with certain tax attributes.” She cited a decision arising from the Bernard Madoff Ponzi scheme as an example of a case holding that an IRA is not a separate legal entity.
In Madoff, the bankruptcy court in New York decided that an IRA was not the initial recipient of a fraudulent transfer because the custodian was a “mere conduit.” SIPC v. Bernard L. Madoff Investment Securities, LLC, 2019 WL 6245772 (Bankr. S.D.N.Y. Nov. 21, 2019). Judge Brown found only two cases holding that an IRA was a proper party defendant.
Instead of relying on one side of the split, the trustee argued that the IRA was a separate entity because it was a trust. On that issue, even the IRS Code “sends conflicting signals,” Judge Brown said.
Judge Brown cited “several courts” for holding that IRAs are not trusts, relying on a provision in the IRS Code that seems to say just that. Other courts have held that IRA custodians do not owe fiduciary duties to their owners because the IRAs are not trusts. Those cases, she said, view IRAs as nothing more than tax-deferral devices.
Judge Brown held that a “custodial IRA is not a separate legal entity. It is only a receptacle for a person’s assets . . . that enjoys certain tax attributes . . . .” That IRAs are not separate entities explains why debtors list IRAs among their assets and then claim exemptions, she said.
Judge Brown dismissed any claims against the custodian but ruled that the custodian nonetheless should be named as a nominal defendant.
The Discharge and Preference Claims
Countering the owner’s argument that his discharge cut off the preference claim, the corporation’s trustee contended that the suit was in rem and thus unaffected by discharge.
At one end of the spectrum demonstrating the difference between in rem and in personam claims, Judge Brown pointed to the treatment of secured claims in chapter 7. The discharge terminates a debtor’s personal liability on a mortgage, but the creditor is at liberty once the automatic stay ends to pursue an in rem action against the collateral.
When the line between in rem and in personam is blurred, Judge Brown said the “few” cases are “evenly split.”
At the circuit level, Judge Brown cited Parker v. Handy (In re Handy), 624 F.3d 19 (1st Cir. 2010). There, a husband fraudulently transferred funds to his wife, who used the money to purchase a home. The husband’s creditor sued the wife for receipt of a fraudulent transfer, but she received a discharge before the creditor could land a judgment.
According to Judge Brown, the First Circuit decided that the claim for money damages was in personam and therefore barred by discharge. The creditor’s claim for a constructive trust, the circuit said, was a remedial device that did not convert the in personam claim into an in rem remedy.
Judge Brown found Supreme Court sovereign immunity cases to be illuminating, because sovereign immunity only protects governments from in personam suits. She cited a footnote in Central Virginia Community College v. Katz, 546 U.S. 356, 372 n.10 (2006), where the Supreme Court observed that the difference between in personam and in rem may turn on whether a trustee seeks to recover the value of a preference or the “actual property transferred.”
The case at hand, Judge Brown said, presented a “close question” because the Supreme Court has not provided “clear guidance.” In the absence of binding precedent, she held that recovery of fraudulently transferred funds is an in personam claim.
Judge Brown dismissed the preference suit against the bankrupt owner of the corporation because permitting recovery “would be tantamount to entering a money judgment against him.”
Judge Brown dismissed the suit with prejudice. The time for appeal has run, so we won’t have appellate review.
Hard cases make bad law, but Bankruptcy Judge Elizabeth E. Brown of Denver took a hard case to make good law. Although the debtor was not a sympathetic character, Judge Brown reached a result implied by conflicting precedent, even though she let the debtor off the hook for a preference.
Resolving issues of first impression in her district, Judge Brown ruled that the debtor’s discharge absolved him of liability for receipt of a preference because the claim was in personam. She also decided that an individual retirement account is not an entity separate from its owner.
The Preference
Before bankruptcy, the debtor had made a $750,000 loan from his individual retirement account to his closely held corporation. Within one year before the corporation’s bankruptcy, the company made two $75,000 interest payments to the IRA.
The corporation and the owner went into bankruptcy within days of one another. The owner received his chapter 7 discharge. Two days after the owner received his discharge, the corporation’s trustee sued the owner and the IRA’s custodian for $150,000 in preferences.
The IRA custodian contended that it was not an entity separate from the owner and thus should not be sued. The owner argued that his discharge barred the preference claim. Judge Brown ruled in favor of both the IRA custodian and the debtor in her March 25 opinion.
Separate Legal Identity of an IRA?
Judge Brown found “few reported decisions” saying whether an IRA is an entity separate from its owner. “Almost all of them,” she said, conclude that an IRA is not a separate legal entity, but the opinions do not provide “a great deal of analysis.”
Judge Brown began by observing that an IRA “is somewhat of a fictional creature, existing only to provide its owner with certain tax attributes.” She cited a decision arising from the Bernard Madoff Ponzi scheme as an example of a case holding that an IRA is not a separate legal entity.
In Madoff, the bankruptcy court in New York decided that an IRA was not the initial recipient of a fraudulent transfer because the custodian was a “mere conduit.” SIPC v. Bernard L. Madoff Investment Securities, LLC, 2019 WL 6245772 (Bankr. S.D.N.Y. Nov. 21, 2019). Judge Brown found only two cases holding that an IRA was a proper party defendant.
Instead of relying on one side of the split, the trustee argued that the IRA was a separate entity because it was a trust. On that issue, even the IRS Code “sends conflicting signals,” Judge Brown said.