Two recent cases out of the Western District of Wisconsin (by Judge Utschig, who is retiring at the end of the year) I’d like to share with you. Neither of these creates mandatory precedent in the Eastern District. However, it’s good to be aware that these cases are out there, because both decisions end with terrible results.
The first case is Osberg v. Halling (In re Halling), 449 B.R. 911, 913 (Bankr. W.D. Wis. 2011).
In this case, the debtor attempted to obtain a $45k loan from a bank, but was denied. In order to secure the loan, the debtor’s son agreed to guarantee the loan and put his real estate up as collateral. The debtor made payments to the bank – and in the 12 months prior to filing the bankruptcy case – paid in a total amount of $4,100.
Ordinarily, a trustee can recover “preferential payments” to a creditor if the amount exceeds $600 in the 90 days prior to filing the bankruptcy case. The public policy rationale is as follows:
A preferential transfer occurs when a debtor favors one creditor over another by paying that creditor to the detriment of other creditors. Preferences are treated with disfavor in bankruptcy because they contradict the fundamental bankruptcy policy of ensuring the equitable distribution of a debtor’s nonexempt assets among similarly situated creditors. In re Eckman, 447 B.R. 546, (Bankr. N.D. Ohio 2010)
However, when the beneficiary of payments is an insider (someone close to the debtor, such as corporate partners or relatives), the trustee can recover preferential payments going back 12 months prior to filing bankruptcy.
The reason that Congress created an extended period for insider transactions is simple. In a corporate setting, insiders are typically the first to recognize that a company is failing, and they may have an incentive to pay themselves, or to pay obligations which might otherwise result in their personal liability. The longer preference period was established to address the concern that a corporate insider (such as an officer or director who is a creditor of his or her own corporation) has an unfair advantage over outside creditors. […] Likewise, in a personal bankruptcy a debtor is likely to want to avoid harming family members and will pay (or “prefer”) debts which would impact them. The bankruptcy code strives to eliminate the incentive for doing so by providing that these payments (or transfers) can be brought back into the bankruptcy estate for the benefit of all unsecured creditors, not simply those closest to the debtor.
In this case, the court rules that because the debtor was making payments to the bank, that it caused a decrease in liability from the debtor’s son to the bank. That benefit created a preference to an insider, which was recoverable against the insider. Since the look-back period was longer for insiders than it was for ordinary creditors, the trustee could recover more by voiding the benefit bestowed upon the debtor’s son, rather than voiding the benefit bestowed upon the bank.
Payments to the “lender” in such a scenario are “for the benefit of” the guarantor because every reduction of the debt reduces the guarantor’s potential liability to the lender. Osberg v. Halling (In re Halling), 449 B.R. 911, 915 (Bankr. W.D. Wis. 2011)
The result: the debtor’s son was a creditor of the bankruptcy estate, received a benefit of decreased liability to the bank in the amount of $4,100 which was recoverable from the son as an insider preference.
The lesson: If you have a loan cosigned by a relative, consider having the relative make payments on the loan in the 12 months prior to filing bankruptcy, or consider filing Chapter 13.
Again, this is a Western District of Wisconsin case with no mandatory authority over any other federal district. To date, it has not been appealed, nor has it been cited as authority in any other case. But that could change, which is why I share the story.
The second case is Cirilli v. Bronk (In re Bronk), 444 B.R. 902 (Bankr. W.D. Wis. 2011).
In this case, the debtor had a considerable amount of non-exempt assets, owing partly to his residence which was owned free and clear of any mortgages. Prior to filing his case, he took a mortgage out on the home to reduce equity, and converted the cash he received from the mortgage into college savings plans (EdVest accounts) for his grandchildren, which he could exempt.
What is described above is one of the more extreme examples I’ve read of “exemption planning” which converts non-exempt assets into exempt assets. Does that seem wrong to you? It is. You can be denied discharge for these transfers if it can be shown that you intended to hinder, delay, or defraud creditors. Curiously enough, the court held in this particular case that there was insufficient evidence to prove fraud – presumably because either not all elements were proven or the trustee did not meet his burden of proof.
Nevertheless, this is a practice I hear about repeatedly from my clients who have non-exempt assets, and this is why I discourage the practice of intentionally converting non-exempt assets into exempt assets.
Though the debtor in this case retained his discharge, he wasn’t completely off the hook, and in that sense, there is some justice in this case. (Although the way in which the debtor was nailed doesn’t seem to make much sense, either.)
The court held that the debtor could not exempt the EdVest accounts because the exemption statute Wis. Stat. § 815.18 only covers the beneficiary’s interest in the account. In other words, if the grandchildren had filed for bankruptcy, they would be able to exempt the EdVest accounts, but the creator of the account (the debtor in this case) could not.
The reason this is odd is because the money in an EdVest account is completely in the control of the creator. The beneficiaries cannot touch the funds.
Lesson: Don’t convert assets from one form to another – you could be denied discharge for fraud. And if you are the creator of an EdVest account, you may encounter exemption issues.
This case has been followed by the Northern District of Illinois.