Where is the Line Between Effective Bankruptcy Planning and Fraud? Recent Case Provides Guidance. (In re Klawitter)
The Northern District of Illinois Bankruptcy Court recently held that tens of thousands of dollars were not dischargeable in Chapter 7 for a Chicago-area family, who was alleged to have improperly shifted previously non-exempt bankruptcy assets. This case provides a helpful example to show when a discharge of debt under Chapter 7 can be denied.
Under the liquidation portion of the United States Bankruptcy Code, Chapter Seven (7), debtors are often able to dispose of virtually all of their debts. There are times however, that debtors are not entitled to have their debt discharged. A discharge for example, can be denied when the debtor has transferred or concealed property owned by the debtor within one year prior to the bankruptcy petition’s filing.
A recent case in the Northern District of Illinois involved a married couple who had an income of roughly $336,550, and whose business shuttered in 2018. Prior to filing their bankruptcy petition, the couple was alleged to have attempted to convert their non-exempt assets. Around January of 2019, the couple had more than $90,000 non-exempt property, by November of 2019, the petition was filed, the couple’s non-exempt property was just at $2,500.
The bankruptcy trustee alleged that the debtors spent their prior savings and 2019 earnings (of roughly $300,000 in that span) by paying a $35,000 non-refundable retainer to a law firm with no clear purpose; putting tens of thousands of dollars into several retirement accounts, including one that had just recently been opened; luxurious family vacations; tens of thousands to their children’s college education; and gifts to adult family members. While much of the court’s reasoning has to do with the spending habits, it also points out that the original bankruptcy petition either grossly misstated, or totally excluded, certain problematic transactions; for example, the retainer payment was totally excluded, and the college tuition payments was greatly undervalued.
In order for the debt to not be dischargeable, the court must find that the debtors did not intentionally hinder, delay, or defraud creditors as a result of the transfers in question. Both spouses claimed that they did not do so. The wife further argues that she relied on her husband’s actions to take part in these sorts of transfers. The court found though that they did make these wrongful transfers intentionally, and that they made false statements in connection with them.
The central expense which the court seems to take most issue with is the $35,000 retainer payment made to Piercey & Associates. The firm did not represent the couple, nor their business, at all in the bankruptcy proceedings. The fee agreement outlines that the payment was for legal advice regarding the “medical practices, estate planning, tax planning, business succession, and elder law.” The fee agreement also specifically noted that the purpose of entering into this sort of arraignment was because the debtors had said that they desired to secure the attorney’s “unlimited and immediate” availability, regardless of any future financial success or challenges.
In fact, the court writes that “the retainer payment is likely on its own to deny the Debtors a discharge, the Debtors’ other transfers further support a finding that they had a conscious scheme. . .” While the other actions may or may not have been able to be construed as just planning, it appears the retainer payment was the big issue.
The court was unconvinced by the couple’s reasoning that the purpose of this arraignment was, in part, to create estate planning documents for their children and family in the future, and second to potentially protect against a malpractice lawsuit which had been filed. By the time of the court proceeding, there had been no estate planning documents drafted, and the medical malpractice suit had already been dismissed prior to that time.
The court’s opinion includes a fairly extensive analysis of banking and investment accounts. While these are mentioned in the same context, it does appear that these appear to be less of the issue of interest for the court. The next issue though is regarding family vacations, rent, and a timeshare. The couple resides in McHenry County, Illinois, where the IRS Local Housing and Utilities standards puts rent at $1,000 a month for a family of five. The couple though rents a home for $2,850, a second apartment in Lake Geneva, Wisconsin for $1,359, and spent about $16,000 on maintenance fees for the timeshare in the roughly ten months leading up to the bankruptcy petition’s filing. Despite the timeshare’s spending, the family spent over $10,000 on a non-timeshare vacation to Florida in March of the year of the petition’s filing, Missouri in May, and Florida again in July.
In regards to the failure to disclose, the couple had already filed for their company’s protection under the bankruptcy code in the year prior. The court reasoned with that knowledge and familiarity, they knew what their sworn statements meant.
BANKRUPTCY PLANNING VERSUS FRAUD
A major issue for courts to consider when looking at shifting assets prior to a bankruptcy filing is to determine whether it is just bankruptcy planning, or if there is a greater intent to defraud creditors. Simply converting non-exempt to exempt assets does not necessarily equate to making debt non-dischargeable. “[B]ankruptcy planning [is not] necessarily . . . a fraud on creditors . . . [courts should] deny discharge only where the debtor has committed some act extrinsic to the conversion which hinders, delays or defrauds.” In re Smiley, 864 F.2d 562, 567 (1989) (Emphasis added).
The standard of “hinders, delays or defrauds” is laid out in Smiley. The four factors can include:
- that the debtor obtained credit in order to purchase exempt property;
- that the conversion occurred after the entry of a large judgment against the debtor;
- that the debtor had engaged in a pattern of sharp dealing prior to bankruptcy; and
- that the conversion rendered the debtor insolvent.
Smiley is not the only framework to determine whether there is an adequate scheme to hinder, delay or defraud. Other factors which have been used by courts across the country have included some such as the consideration received in exchange for property; whether control is retained of property; and the cumulative effect after the financial difficulties began to take place.
The court here found that the U.S. Trustee’s office had sufficiently demonstrated that the discharge should be denied. There are other fact-intensive lines of questioning which provide some insight as to the court’s reasoning and the case’s outcome. The court even specifies that the transfers to the Roth IRA, rather than a traditional IRA, as the Roth IRA allows for more flexibility to withdraw money at a later point in time without incurring a tax or other penalty. In regards to the tuition payments for their children, it appears the larger issue was the failure to properly disclose the payments, rather than the payments themselves.
The Complaint included two counts against the Debtors, the Judge agreed with the U.S. Trustee on both counts. The first being the denial of the discharge based on transfer or concealment of property pursuant to Section 727(a)(2), and the second being the false oath under Section 727(a)(4).
As in many cases of this nature, the fact-intensive inquiry can make it fairly difficult to say for certain where the lines in the sand are. While that line might be difficult to determine, it is fairly clear that the most important factors to the court’s decision-making process in this case was (1.) the $35,000 retainer with no clear benefit; (2.) the grossly underreported amounts of college tuition paid, as a false statement; and (3.) the lavish vacations right in the timeframe leading up to the filing despite having access to the timeshare. It should also be noted that the couples’ impressive background in medicine and elsewhere, as well as their experience in bankruptcy court with their business the year prior, may have had a substantial role to play as well. While bankruptcy planning is still an option, it is the extrinsic issues which can lead to debts becoming non-dischargeable.