One of the most common mistakes debtors will make prior to filing for bankruptcy is attempting to pay off certain debts. Even worse, we will often see debtors attempting to offload property so as to avoid the potential risks of owning property in bankruptcy. These types of transfers can be avoidable. This means the trustee, or in some cases the debtor, may “avoid” these transfers and claw back legal ownership of the property that was transferred from the debtor. This blog post will discuss preferential and fraudulent transfers, and what the process is for avoiding a transfer that happened too near the petition date.
Preferential Transfers
11U.S.C. Section 547 is the statute that governs preferential transfers to creditors. The main purpose of this statute is to prevent the debtor from giving favorable treatment to one creditor over other creditors that may not see any disbursement. Section 547 gives the trustee the power to avoid any interest that:
- Is for the benefit of a creditor;
- For or on account of an antecedent debt owed by the debtor before the transfer was made;
- Made while the debtor was insolvent;
- Made on or within 90 days before the date of the petition, or ninety days and one year before the date of the petition; and
- The payment enables the creditor to receive more than they would if the case were filed under chapter 7, the transfer had not been made, and the creditor received payment of the debt in accordance with the bankruptcy code.
While this may seem complicated, the key parts to keep in mind are that the payment needs to be to someone that is owed money on a debt owed by the person filing for bankruptcy. The payment must be made on or within 90 days of filing for bankruptcy. If the person being paid is an insider, this period is extended to one year and 90 days from before the filing date.
Fraudulent Transfers
Fraudulent transfers often get lumped together with preferential transfers. This is because they operate under very similar rules. A fraudulent transfer is when a debtor transfers property to another person or business in an attempt to defraud the creditors. 11 U.S.C. Section 548 covers the broad powers of a trustee to avoid any fraudulent transfer. To avoid a fraudulent transfer, a trustee must demonstrate first demonstrate that the debtor received less than a reasonably equivalent value in exchange for such transfer or obligation. If the trustee is able to prove that, he must then show:
- The Debtor was insolvent on the date of the transfer, or was made insolvent as a result of that transfer;
- The debtor was engaged in a business or transaction, or was about to engage in a business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;
- The debtor intended to incur, or believed they would incur, debts that would be beyond their ability to pay; or
- The debtor made the transfer to or for the benefit of an insider, or incurred the debt to or for the benefit of an insider, not in the ordinary course of business.
The key here is that the transfer must have specifically been made with the intent to defraud creditors. If the debtor was operating as normal, and incurring a normal amount of debt, the fraudulent transfer action should fail.
Key Definitions
For the purposes of the above, a debtor is considered “insolvent” when they do not have the money to pay their bills as they come due and owing. There is a presumption that a debtor is insolvent 90 days prior to filing for bankruptcy, but that can be overcome by demonstrating the debtor had the ability to make their payments as they became due in that time. The key take away is that a debtor is insolvent when they no longer have the ability to pay debts that are owed.
Another important definition is that of an “insider.” For the purposes of bankruptcy law, an insider can be various people, and sometimes even businesses. If the debtor is an individual, an insider is likely going to be a relative, or close friend of the debtor. A business owned by the debtor, or that the debtor is an officer of, could also be considered an insider. For business debtors, an insider is any of the officers or directors, person’s in control, or other managing agent of the debtor. This is important to keep in mind, as trustee’s will have the ability to pursue money paid to these parties, making that party a creditor.
Avoidance Actions
Once a trustee can demonstrate the above, they need to actually bring this to the bankruptcy court’s attention. Avoidance actions are typically commenced with a complaint, initiating an adversary proceeding. Once the adversary proceeding is initiated, the parties will engage in discovery to determine if the above elements are applicable and appropriate for the case at hand. If the court finds that the debtor made an avoidable transfer, that transfer will be clawed back, and likely distributed by the trustee. In a chapter 7 case, this will likely be done pro-rata. In a chapter 13 or chapter 11 case, this will be based on the plan filed with the court, and based on the priority of the claims that have been filed and allowed.
Conclusion
It is important for a debtor to be aware of potential pitfalls prior to filing for bankruptcy, including potential adversary proceedings that could cost the estate more resources. The attorneys at Scura, Wigfield, Heyer, Stevens & Cammarota LLP can help. Please call our offices to schedule a free consultation.
