Actions to Avoid Prior to Filing Bankruptcy
Part One: To the Extent Possible, Don't Use Credit Cards or Apply for New Loans!
Barring some medical emergency or the like, it is easy to avoid this one. Put simply: if you’re going to file bankruptcy, don’t use your credit cards! In fact, large purchases, excessive credit card use, high balance transfers, spending sprees, giving away money area all things you should avoid before filing bankruptcy. But in particular, use of credit cards or taking out new loans within 90 days before filing for bankruptcy protection raises a legal presumption that such purchases or transactions were "fraudulent." What does this mean? It means that although the debtor may, at the end of his or her bankruptcy, successfully get older debt discharged, this new debt may nevertheless survive the bankruptcy because it is deemed “non-dischargeable,” meaning the bankruptcy discharge will not apply to that debt, and it will survive the bankruptcy. One of the reasons that a particular debt may be declared "non-dischargeable" by the Bankruptcy Court is if that debt resulted from "fraud." Fraud in this context means that when the debtor used the credit card for a recent purchase (again, within 90 days before filing bankruptcy), then, according to the legal presumption of fraud, the debtor must not have had any intention to repay that charge. Our bankruptcy attorneys are always on the lookout for this problem area and advise our clients accordingly.
To understand how the presumption of fraud works, it is useful to consider an example. Let's say that John is a recently laid off NUMMI worker in Fremont, California who finds that he needs to file Chapter 7 bankruptcy because he no longer can afford to pay for basic living expenses let alone his credit cards. And let's say, John owes a certain credit card company $10,000 from normal consumer purchases that have accumulated over several years, when John could afford his monthly credit card payments. In fact, of that $10,000, perhaps only $6,000 represents actual purchases -- the rest has resulted from exorbitant interest (more than 10%), late fees, and other penalties. Now, let's suppose that during the 90 days immediately before filing bankruptcy, he or she purchases $4,000 worth of home electronics equipment from Costco.
When John now files bankruptcy, the credit card company, not the Court itself, is likely to challenge the $4,000 in new charges. By “challenge” we mean, they will file a special type of law suit (called an “adversary proceeding”) connected to John’s bankruptcy case to challenge the “dischargeability” of the $4,000 of new, presumptively “fraudulent” charges.
First of all, assuming John’s Oakland bankruptcy (filed in the Oakland Division because he lives in Fremont) qualifies for a bankruptcy discharge under Chapter 7, then John’s other dischargeable debt would be discharged in any event. In other words, the credit card company can only challenge the discharge of the $4,000 in question. If John has $30,000 in other unsecured debt, it would be discharged regardless of the credit card company’s adversary action over the $4,000. However, if the credit card company were to win in its “adversary” law suit over the $4,000 (that it was “fraudulent”) then John will still owe this $4,000 even after his bankruptcy case has closed, and he has won a discharge of his other debt.
In reality, this case would usually not go to trial. Even though the debtor’s attorneys’ fees can be awarded against the credit card company in an adversary case like this, most cases in this dollar range are neither worth it for the credit card company nor the debtor to see such a case through to trial. Our flat fee bankruptcy fees do not cover hourly litigation costs if an adversary action is brought by a creditor. Were an adversary proceeding concerning $4,000 ever to go to trial, then other mitigating factors would come into play for John. John might be able to overcome the presumption of fraud, for example, if he could prove that the $4,000 in charges, or some portion of them, were used for life necessities, like groceries, rent, or gasoline.
Adversary actions for fraud are relatively rare. Out of hundreds of cases per year, we see a handful of them per year. The simple way to avoid such an adversary action is not to use your credit cards during the three month period prior to filing bankruptcy. Additionally, you should also avoid taking any cash advances or making any balance transfers from one credit card to another during this period. Although it may seem counter-intuitive that a balance transfer should be treated as fraudulent, such transfers are still subject to the same presumption of fraud as new purchases if the transfer is made during the 90 days prior to filing bankruptcy. We believe this is a bad application the rule because, after all, the only reason why people transfer balances from one credit card to another is to take advantage of a lower interest rate on the balance, and the only reason one would care to get a lower interest rate is because that person intends to pay off the balance. Nevertheless, you should avoid such balance transfers if you think it is possible you may have to file for bankruptcy.
Part Two: Don’t Repay Debts to Family, Friends, or Business Associates
If you owe money to a family member, a friend, or a business partner, don’t repay them within one year prior to filing bankruptcy. Why not? Because there is a special rule in the Bankruptcy Code that allows the Bankruptcy Trustee to treat such a repayment as “preferential” and therefore prejudicial to other creditors. Such a preferential payment to an “insider” (defined as a family member, friend or business partner) can be “set aside” by the bankruptcy trustee, meaning that the bankruptcy trustee can sue the “insider” to recover the payment, bringing that money back into your Bankruptcy Estate to be redistributed among all the creditors – assuming that when such payment is lumped back into the Bankruptcy Estate, it would not be covered by an exemption.If you think about it, most anyone would use their last few dollars to repay a debt to a family member. Even though this may be your instinct, don’t do it! Because the Bankruptcy Code ostensibly tries to balance the interests of creditors and debtors, it aims to create a fair playing field among the creditors too. And since a preferential payment to a family member or friend is unfair to your other creditors, your Bankruptcy Trustee is charged with seeking the best possible distribution to all your creditors and does not respect your family relationship or friendship.
To understand how this works, let’s look at an example. A few years ago, long before he needed to file Chapter 7 Bankruptcy, our debtor Steve, who lives in San Jose, purchased a home with help from his mother in 2002. She lent Steve $20,000 toward his down payment with the understanding that when he eventually sold that house, he would repay her the $20,000. Two years later, in 2004, Steve did sell that house and made a profit of $60,000 over the original purchase price. True to his word, Steve repaid his mom the $20,000 she had lent him.
Unfortunately for Steve, three months after he sold the house, he lost his construction job, and the remaining $40,000 was already invested into a new house, which tragically, he soon will be unable to afford. Six months later, Steve still had not found a new job anywhere near San Jose, or the South Bay, and he needs to file bankruptcy due to mounting debt.
Steve files bankruptcy after burning through every bit of savings, and he qualifies for Chapter 7 bankruptcy protection. Steve properly and truthfully reports the $20,000 loan repayment to his mother nine months earlier in his bankruptcy “Statement of Financial Affairs” portion of his bankruptcy petition. The Bankruptcy Trustee assigned to Steve’s case questions Steve about this loan repayment to his mother at Steve’s 341 Meeting of Creditors. Steve explains the whole story: “Mom lent me the money to buy a home in 2002, when I sold the house, I repaid her that money.”
Sadly, the Bankruptcy Trustee responds to this revelation coldly. She requests the contact information for Steve’s mother. Within days, the Bankruptcy Trustee seeks permission from the Court to hire her own law firm to sue Steve’s mother in order to force her to give up the $20,000 that Steve had faithfully repaid to her when his financial situation seemed perfectly stable. Neither Steve nor his mother committed any bad act here. Neither had any intent to defraud any creditor or anyone at all. Nevertheless due to the rigid rules of the Bankruptcy Code and the dispassionate prosecution of those rules by the Bankruptcy Trustee, Steve’s mother will now suffer immensely.
Can she bear the loss of this money, the way a bank could? Of course not. She herself is likely struggling to maintain her standard of living. But in its infinite wisdom, the Bankruptcy Code’s attempt at fairness for creditors requires that the Bankruptcy Trustee claw back this “preferential payment” to an “insider.”
The moral of this story is simple. If you think you may need to file bankruptcy within the coming year DO NOT repay any debts to family, friends or business associates. You can always repay them voluntarily after your bankruptcy case is closed.
If you have a question about whether or not a debt can or should be repaid prior to filing bankruptcy, please contact one of the bankruptcy attorneys in our San Jose office for a free consultation.
Part Three: Do Not Give Away Money or Anything of Value to Anyone
Although we do not see many debtors giving valuable assets away frequently, the problems that arise when a gift has been made—sometimes years before filing bankruptcy—merit a special discussion here.Let’s look at an example. About eighteen months ago, Robert and Ellen of San Jose were not considering bankruptcy. Robert was earning good money from his construction job, and Ellen’s job at a title company seemed secure enough. Then Robert’s work dried up, and the title company Ellen worked for went out of business. They had little savings other than a bank certificate of deposit worth $10,000 which they can’t get to without a significant penalty, and after just three months of unemployment, they find they have fallen behind on all of their bills and have defaulted on their mortgage. There is no equity in their San Jose house. Unfortunately, Robert and Ellen already had substantial credit card debt before they lost their jobs, and now they can’t make the minimum payments.
Flash back to eighteen months ago, when Robert and Ellen’s situation seemed stable. Apart from their bank CD, Robert and Ellen had few assets, but they did have two cars, both paid for. Robert’s pickup truck, worth $15,000, and Ellen’s five year old Honda Civic, worth approximately $9,000. At the time, their 18 year old daughter, Jennifer, was just entering community college and working part time. She needed reliable transportation, so Robert and Ellen transferred title to their five year old Honda Civic to Jennifer as a high school graduation gift.
Now, Robert and Ellen are filing a Chapter 7 bankruptcy. Together with their bank CD and Robert’s truck, they have exhausted their available exemptions. If they still had the Honda Civic they gave to their daughter eighteen months earlier, it would not be exempt from being taken by the Chapter 7 Trustee.
As we have discussed in our article about the bankruptcy exemptions, when a Chapter 7 debtor files for bankruptcy, everything that the debtor owns becomes part of the bankruptcy estate apart from assets that can be covered by an exemption. The Trustee is given power to set aside or avoid certain transfers of the debtor’s assets out of the estate that unfairly place assets beyond a creditor’s reach. Such a transfer is generally known as a fraudulent conveyance.
Under the Bankruptcy Code, there are two types of fraudulent conveyances: actual fraud, and constructive fraud. Actual fraud entails (1) making a transfer within one year before the date of the filing of a bankruptcy petition and (2) is made with the intent to hinder or defraud a creditor.
Constructive fraud involves a transfer where the debtor transfers assets for what the court determines as “grossly inadequate consideration.” This is defined by the debtor getting less than reasonably equivalent value for the exchange AND was insolvent on the date the transfer was made (or became insolvent as a result of the transfer).
Section 727 of the Bankruptcy Code states that a Chapter 7 Debtor cannot receive a discharge if he or she has transferred property with the intent to hinder, delay, or defraud a creditor in the one year before filing. In addition, Section 548 of the Bankruptcy Code allows the trustee to recover transfers made for less than fair consideration in the two years before filing bankruptcy.
Now, Robert and Ellen did not have any intention to “hinder or defraud” their creditors when they made the gift of the car to their daughter. However, because it was a gift, and they did not receive fair value for it from her, and because they made this gift within two years of filing bankruptcy, the Chapter 7 bankruptcy Trustee can sue Jennifer to recover the car and bring it back into the bankruptcy estate.
Moreover, certain states have a fraudulent conveyance statute that looks back for longer than two years, and California is one of them. California Civil Code Section 3439.04 lays out a very similar statute to Section 548 of the Bankruptcy Code. Civil Code Section 3439.09 lays out the statute of limitations for a fraudulent conveyance action in CA, which is four years; which may, however, be extended to seven years under Civil Code Section 3439.09(c) after the transfer was made or the obligation was incurred.
Thus, it is possible that in California a Bankruptcy Trustee may seek to set aside a transfer of a valuable asset in bankruptcy based upon an alleged fraudulent conveyance pursuant to state law, which in certain cases may have occurred long before the time frame set out in the Bankruptcy Code.
The moral of this story is that if you believe there is any chance you might need to file bankruptcy in the future, you should not give valuable items away or sell them for less than they are worth or else if you do find you need to file bankruptcy, the Trustee in your case may be able to sue the person to whom you gave the asset to force them to give it up to the Trustee.
Part Four: Do Not Cash Out Your Retirement Savings
It’s an all too common story with a tragic ending: A client comes to us after months of attempting to obtain a loan modification from their home mortgage lender only to be denied. The house is nearing an inevitable foreclosure, and for the last year the client has been robbing from their 401(k) or IRA to make payments on a house they already have lost or will inevitably lose in the near future.It took years of hard work and diligent contributions to the client’s 401(k) or IRA to accumulate what retirement savings they had, and in the futile effort to save a property in which the client had no equity, and on which the bank was unwilling to modify the loan. Now the retirement savings is gone or significantly depleted.
Our message is simple, do not, I repeat, do not, rob yourself of your 401(k) or IRA retirement savings to pay debts, not even a mortgage if the likelihood is that you will ultimately lose the home, and especially not unsecured debts such as credit cards. Ever.
As we have discussed in our article on Chapter 7 bankruptcy exemptions, and elsewhere in our article about the Chapter 13 liquidation test, different kinds of assets are treated differently in bankruptcy. Exemptions differ for such items as cars, tools, jewelry, home equity, and, most importantly here, retirement savings.
In a Chapter 7 bankruptcy 401(k) savings are completely untouchable by creditors and by the Chapter 7 bankruptcy trustee. They are totally protected by virtue of the spend thrift clause contained in the federal legislation that created them. That means the Chapter 7 debtor could have an unlimited amount saved in such an account, and it will not be taken away in Chapter 7. Likewise, 401(k) savings (as well as certain other federally created employee pension accounts) are not calculated into the Chapter 13 liquidation test at all.
Similarly, Individual Retirement Account (IRA) savings accounts, although not unlimited, have an exemption of up to $1 Million. That’s right, the Chapter 7 debtor could have $1 Million in his or her IRA at the time of filing bankruptcy, and the Trustee cannot touch this money.
Retirement savings are the most protected asset a bankruptcy debtor can have. But if the debtor has taken money out of such retirement accounts prior to filing bankruptcy, and wasted it on a futile effort to pay bills, a home mortgage on a negative equity property, or worst of all, on paying down credit card debt, that retirement money is gone forever. In the most tragic of situations, the debtor has used his or her retirement savings to pay credit card debt, debt that may be completely dischargeable in bankruptcy.
The bottom line is this: if there is even a small chance you may need to file for bankruptcy protection, whether Chapter 7 or Chapter 13, in the future, do yourself a favor and leave your retirement savings alone.
To further discuss actions you should avoid prior to bankruptcy and to schedule a free consultation with one of our experienced bankruptcy attorneys at the Law Offices of Jon Brooks in San Jose, CA, please call us at 408.286.2766. Prior to our appointment, we ask that you download our Personal Bankruptcy Questionnaire, fill it out to the best of your ability, and bring this information with you to our meeting.
We are proud to be a Debt Relief Agency as defined by federal law. We help people get out of debt by filing for relief under the Bankruptcy Code.