U.S. Bankruptcy (Part Two)

Avoidance actions.

Debtors, or the trustees that represent them, gain the ability to reject, or avoid actions taken with respect to the debtor's property for a specified time prior to the filing of the bankruptcy. While the details of avoidance actions are nuanced, there are three general categories of avoidance actions:

Preferences: 11 U.S.C. § 547.

Federal fraudulent transfer: 11 U.S.C. § 548.

Non-bankruptcy law creditor: 11 U.S.C. § 544.

All avoidance actions attempt to limit the risk of the legal system accelerating the financial demise of a financially unstable debtor who has not yet declared bankruptcy. The bankruptcy system generally endeavors to reward creditors who continue to extend financing to debtors and discourage creditors from accelerating their debt collection efforts. Avoidance actions are some of the most obvious of the mechanisms to encourage this goal.

Despite the apparent simplicity of these rules, a number of exceptions exist in the context of each category of avoidance action.

Preferences.

Preference actions generally permit the trustee to avoid (that is, to void an otherwise legally binding transaction) certain transfers of the debtor's property that benefit creditors where the transfers occur on or within 90 days of the date of filing of the bankruptcy petition. For example, if a debtor has a debt to a friendly creditor and a debt to an unfriendly creditor, and pays the friendly creditor, and then declares bankruptcy one week later, the trustee may be able to recover the money paid to the friendly creditor under 11 U.S.C. § 547. While this "reach back" period typically extends 90 days backwards from the date of the bankruptcy, the amount of time is longer in the case of "insiders"—typically one year. Insiders include family and close business contacts of the debtor.

Fraudulent transfer.

Bankruptcy fraudulent transfer law is similar in practice to non-bankruptcy fraudulent transfer law. Some terms, however, are more generous in bankruptcy than they are otherwise. For instance, the statute of limitations within bankruptcy is two years as opposed to a shorter time frame in some non-bankruptcy contexts. Generally a fraudulent transfer action operates in much the same way as a preference avoidance. Fraudulent transfer actions, however, sometimes require a showing of intent to shelter the property from a creditor.

Fraudulent transfer may involve an actual or a "constructive" fraud. Actual fraud is based upon the intent of the transfer, whereas constructive fraud may be inferred based upon economic factors. Factors that may lead to an inference of fraud include whether the transfer was for reasonably equivalent value and whether the debtor was insolvent at the time of the transfer.

The conversion of nonexempt assets into exempt assets on the eve of bankruptcy is not an indicator of fraud per se. However, depending on the amount of the exemption and the circumstances surrounding the conversion, a court may find the conversion to be a fraudulent transfer. This is especially true when the conversion amounts to nothing more than a temporary arrangement. When finding the conversion of nonexempt into exempt assets to be a fraudulent transfer, courts tend to focus on the existence of an independent reason for the conversion. For example, if a debtor purchased a residence protected by a homestead exemption with the intent to reside in such residence that would be an allowable conversion into nonexempt property. But where the debtor purchased the residence with all of their available funds, leaving no money to live off, that presumed that the conversion was temporary, indicating a fraudulent transfer. Courts look at the timing of the transfer as the most important factor.