Dana Yankowitz, "i Could Have Exempted it Anyway": Can a Trustee Avoid a Debtor's Prepetition Transfer of Exemptible Property?

• Publication year: 2011

"I COULD HAVE EXEMPTED IT ANYWAY": CAN A TRUSTEE AVOID A DEBTOR'S PREPETITION TRANSFER OF EXEMPTIBLE PROPERTY?

INTRODUCTION

Imagine a soon-to-be debtor, overwhelmed by his financial obligations: he has lost his job, his bills are piling up, and his creditors keep calling. The anxious soon-to-be debtor might attempt to repay some debt, but ultimately he realizes that these attempts are futile. He learns of the possibility of bankruptcy from a friend, but understands that he could lose most if not all of his assets and property. He looks at his family, imagining the county marshal seizing his house to pay his creditors and his children forced to sleep on the street. Feeling that he has no alternative, the soon-to-be debtor transfers his house to his wife. They hastily draw up a deed, citing a ten dollar payment as consideration for the transfer. Feeling more secure about his family's future, the soon-to-be debtor hires an attorney and files for bankruptcy. The bankruptcy court appoints a trustee to act in the best interest of the estate, who files suit alleging that the debtor's transfer of the house was fraudulent. The debtor consults his attorney, who assures him that he could have exempted the house from the estate under state exemption laws so that it could not be used to pay creditors' claims. The debtor breathes a sigh of relief. After all, why would the court allow the trustee to avoid the transfer and recover the debtor's house if the house were exemptible anyway? Much to the debtor's chagrin, however, the court rules that the transfer was fraudulent and the trustee can avoid the transfer and recover the house for the benefit of the estate. The debtor is shocked and asks his attorney, "How can the transfer be fraudulent? I could have exempted it anyway!"

Federal bankruptcy law ("Bankruptcy Code"),¹founded in equity and subsequently codified, serves two purposes: to allow creditors to share equally in the assets of the debtor's estate and to provide the honest debtor a fresh start.²The equal distribution purpose is achieved when the debtor files for bankruptcy and the debtor's property becomes part of the estate for equal distribution to creditors.³Furthermore, the appointed trustee is permitted to avoid certain of the debtor's prepetition transfers and recover property so that creditors can share equally in the assets of the estate.⁴The fresh start purpose is achieved because the debtor can claim certain assets as exempt when he files the petition.⁵In addition, the debtor's debts are discharged at the conclusion of the bankruptcy proceedings, providing him a fresh start.⁶

A conflict between these two overarching purposes of bankruptcy law arises when a trustee tries to avoid a debtor's prepetition transfer of an asset that the debtor would have otherwise been able to exempt from the estate.⁷

Can the trustee avoid such a transfer and recover the asset to benefit the estate if the debtor could have exempted the asset anyway? Or would allowing the transfer reward the debtor for behavior that federal bankruptcy law discourages and thwart Congress's intent in enacting the transfer avoidance provisions?

Part I of this Comment outlines the transfer avoidance and exemption provisions in the Bankruptcy Code. Part II examines the history and development of the exemption provisions. Before Congress passed the Bankruptcy Reform Act of 1978 ("1978 Act"), courts held that a trustee could not avoid a debtor's prepetition transfer of exemptible property because exemptible property never actually passed to the estate so creditors would never have had any right to the property. Since Congress passed the 1978 Act, however, all of the debtor's property passes to the estate until the debtor claims an exemption. Part III analyzes the case law and the circuit split that has ensued since the passage of the 1978 Act. The minority of courts has continued to hold that a trustee cannot avoid a debtor's prepetition transfer of exemptible property, while the majority of courts has allowed a trustee to avoid such a transfer. Part IV reviews Tavenner v. Smoot,⁸a recent case in which the

Fourth Circuit upheld the majority view. This Comment concludes in Part V that Tavenner and the majority are correct: a trustee should be able to avoid a debtor's prepetition transfer of exemptible property. This conclusion is supported by three lines of reasoning: policy based on the overarching principles of bankruptcy law, the text of the Bankruptcy Code, and Congress's stated intent to allow a trustee to avoid such a transfer. Despite these three lines of reasoning, however, the minority of courts has continued to hold that a trustee cannot avoid a debtor's prepetition transfer of exemptible property. Therefore, Part VI suggests that Congress amend the Bankruptcy Code to clearly and explicitly direct courts to allow a trustee to avoid a debtor's prepetition transfer of exemptible property.

I. THE BANKRUPTCY CODE: ITS PURPOSES AND PROVISIONS

The Bankruptcy Code serves two purposes: to allow creditors to share equally in the assets of the estate and to afford the debtor a fresh start.⁹

Transfer avoidance provisions, specifically fraudulent transfer provisions and preferential transfer provisions, allow creditors to share equally in the distribution of the debtor's assets.¹⁰Exemption provisions, along with the debtor's right to a discharge of his debts at the conclusion of the bankruptcy proceedings, allow the debtor to make a fresh start.¹¹

A. A Trustee's Power to Avoid the Debtor's Prepetition Transfers

To protect creditors and ensure their equal treatment in bankruptcy, a trustee can avoid a debtor's prepetition transfer under certain circumstances.¹²

The trustee avoids such transfers to benefit all creditors who are paid out of the estate.¹³The trustee can recover the property transferred or the value of the property from the initial transferee or any immediate or mediate transferee of the initial transferee.¹⁴Two types of transfers that a trustee can avoid are fraudulent transfers and preferential transfers.

1. Fraudulent Transfers

A soon-to-be debtor facing debt and impending bankruptcy may be tempted to save as much property and as many assets as possible for himself and his family. For example, the debtor in the Introduction transferred his house to his nondebtor wife for consideration of ten dollars. The debtor intended to keep the property out of the estate, hide it from his creditors, and have his nondebtor wife transfer the property back to him after the court discharged his debts. The Bankruptcy Code allows a trustee to avoid such a prepetition transfer as fraudulent. Under Sec. 548(a)(1),

The trustee may avoid any transfer . . . of an interest of the debtor in property . . . that was made . . . within 2 years before the date of the filing of the petition, if the debtor voluntarily or involuntarily-

(A) made such transfer . . . with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, . . . indebted; or

(B)(i) received less than a reasonably equivalent value in exchange for such transfer . . . and

(ii)(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;

(II) was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital;

(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor's ability to pay as such debts matured; or

(IV) made such transfer to or for the benefit of an insider, or incurred such obligation to or for the benefit of an insider, under an employment contract and not in the ordinary course of business.¹⁵

A transfer is fraudulent and avoidable if the debtor exhibited actual intent to hinder, delay, or defraud under Sec. 548(a)(1)(A) or what is known as constructive intent under Sec. 548(a)(1)(B). Alternatively, the trustee has the power under Sec. 544(b) to avoid a transfer that any unsecured creditor could avoid under state fraudulent transfer law.¹⁶Most states have adopted the

Uniform Fraudulent Transfer Act ("UFTA"), which sets similar requisites as

Sec. 548(a)(1) of the Bankruptcy Code to determine whether a transfer is fraudulent.¹⁷

2. Preferential Transfers

A trustee can also avoid a debtor's prepetition transfer as preferential under the Bankruptcy Code. A preference is a transfer that gives a creditor "payment of a greater percentage of his claim against the debtor than he would have received if the transfer had not been made and he had participated in the distribution of the assets of the bankrupt estate."¹⁸Under Sec. 547(b) of the

Bankruptcy Code, the trustee may avoid any transfer of an interest of the debtor in property-

(1) to or for the benefit of a creditor;

(2) for or on account of an antecedent debt owed by the debtor before such transfer was made;

(3) made while the debtor was insolvent; (4) made-

(A) on or within 90 days before the date of the filing of the petition; or

(B) between ninety days and one year before the date of the filing of the petition, if such creditor at the time of such transfer was an insider; and

(5) that enables such creditor to receive more than such creditor would receive if-

(A) the case were a case under chapter 7 of this title; (B) the transfer had not been made; and

(C) such creditor received payment of such debt to the extent provided by the provisions of this title.¹⁹

Unlike the fraudulent transfer provisions in the Bankruptcy Code, which focus on the debtor's actual or constructive intent, the debtor's intent is irrelevant in determining whether a transfer is preferential.²⁰

The purpose of the trustee's ability to avoid preferential transfers is twofold.²¹First, preference avoidance discourages creditors, knowing that the debtor is...