Fraudulent Transfers and Bankruptcy

When someone files for bankruptcy, he or she is required to disclose all assets to which that individual holds title. The reason for this disclosure is to allow creditors and the trustee to see what the debtor is holding, and whether some or all of those assets will become part of the bankruptcy estate, i.e., liquidated for the benefit of the debtor's creditors. While state and federal laws allow for exempting certain types of property and certain amounts of value, whatever cannot be exempted from the estate becomes fair game for creditors. In a chapter 7, the trustee has a duty to liquidate these assets, and distribute the proceeds to creditors who file timely proofs of claim.

For someone who has assets in excess of the exemptions available, a conceivable solution may be to transfer the asset to a third party and avoid having to disclose it as an asset in their bankruptcy schedules. While doing so may otherwise be valid on its face under state law, the trustee, along with any creditor, has powers to "avoid" or cancel a transfer under both state and federal laws. The legal reasoning is that the transfer was fraudulent to the extent that the transfer was made to protect an asset from creditors. Fraud can be actual, where the debtor deliberately transfers the asset to a third party to protect it, or constructive, where a transfer is made to a third party for little or no consideration; constructive fraud is presumed fraud. Constructive fraud also requires a showing that the debtor either made the transfer when he or she was insolvent or that the transfer in and of itself made the debtor insolvent. The practical effect of an avoidance action is that title reverts back to the debtor and the asset is seized by the trustee for the benefit of creditors.

Fraudulent transfers under federal law in bankruptcy are governed by 11 U.S.C. 548. The statute allows avoiding transfers that occurred up to two years prior to the date of filing of the bankruptcy. The statute further provides that fraud may be actual or constructive. 11 U.S.C. 544 further allows the use of any state avoidance law. Under California state law, fraudulent transfers are governed by Civil Code section 3439 et seq., and transfers made up to seven years prior to the filing may be avoided (up to four years for constructive fraud). Certainly, the party bringing the avoidance action has the burden of proving fraud, though in many cases establishing constructive fraud could be as simple as establishing that a transfer was a mere gift, i.e., nothing was paid by the grantee of the asset to the grantor-debtor.

But how would the debtor's creditors or the trustee find out about the transfer? For one, the Statement of Financial Affairs, a questionnaire that all debtors must complete and file, requires disclosure of all transfers, including cash transfers, that occurred within one year preceding the date of filing. Of course, the debtor could simply omit reference to any transfer, though doing so is illegal and can lead to federal criminal charges. On the other hand, the debtor could wait one year after a transfer is made to file bankruptcy to avoid having to disclose it, though most trustees can and will ask if any transfers have been made within up to ten years prior to filing at the 341 meeting of creditors. Debtors testify at these meetings under oath, and could face perjury and/or bankruptcy fraud charges, much less have their case dismissed with prejudice, for lying under oath and failing to disclose a transfer. Finally, creditors or the trustee can independently discover a transfer, either through a perusal of public records (e.g., to discover a transfer of real property), discover a transfer of money by looking at the debtor's financial statements, or simply have independent knowledge of any other transfer through the normal course of business.

Thus, it is urged that debtors provide a full and honest disclosure in their bankruptcy cases. If an individual contemplating filing for bankruptcy is concerned about losing some of his or her assets to the bankruptcy estate, he or she should speak with an experienced bankruptcy attorney and provide full disclosure of his or her situation. An experienced attorney can assess different options in filing and comment on their likely outcomes. Filing a bankruptcy without doing so may result in irreversible consequences. Finally, it is highly recommended that individuals contemplating filing for bankruptcy do not shift assets around prior thereto, as doing so may rouse suspicion of the trustee.