How Changing the Character of your Assets to Protect Them Can Work Against You

An interesting situation came up recently in an online discussion between bankruptcy attorneys.  A client had received a workers’ compensation award of several thousand dollars within the past few months.  He used it to buy his girlfriend a car, and then filed a chapter 7 bankruptcy to wipe out his creditors.

If the money had remained in his bank account, he could have claimed it as exempt, meaning it would have been protected from claims by the bankruptcy trustee on behalf of his creditors.  Workers’ compensation benefits are sheltered from being seized by creditors under both Ohio and federal exemption laws.

However, the workers’ compensation award is not in the bank anymore.  He had to identify it, however, on his Statement of Financial Affairs where he was asked 1) what monies he’s received over the past 3 years other than from his employment,  2) what payments he’s made that benefited an “insider”, 3) what gifts of over $600 he has made to any person within the two years before he filed, and/or 4) what transfers of property he’s made.  If he fails to disclose that information, his bankruptcy filing will be fraudulent. Therefore, the Trustee is going to see the award he received, and will inquire as to what it was used for.  A gift to his girlfriend to purchase a car is not exempt from the reach of the Trustee.  Moreover, the attorneys believe, probably rightly, that the car was put into the girlfriend’s name purposefully to protect it from the man’s creditors.

So — the question is, if the source of the money is exempt, but that money is used to purchase something that is not exempt, can the trustee get the property back into the bankruptcy estate to divide among the debtor’s creditors?  Did the exempt asset lose its status when it was converted from a workers’ compensation award into a car, or will the bankruptcy court look at what the original source of the money was?  That is the question the bankruptcy attorneys are debating, and there are considerable opinions going both ways on the question.

Strangely, there is no clear-cut court decision or law that directs how this question should be answered under this set of facts.  However, looking at the judges’ decisions in other cases with somewhat similar facts does give us some guidance.  In one case, where the debtor received a workers’ compensation award and then paid the debts he owed to his parents and grandmother within 90 days of filing bankruptcy, those relatives argued that since the debtor could have claimed the money as exempt property under Indiana law, the exemptible nature of that money when transferred to them prevents the trustee from getting it back.  The bankruptcy judge disagreed, stating that:

Where a debtor makes a conscious choice to voluntarily transfer exemptible property to a creditor, the debtor has, at least impliedly, also made the choice not to claim that property as exempt.  The exemption is thus waived.[1]

Other courts have ruled just the opposite, and would have accepted the relatives’ argument.  They have followed the “no harm, no foul” approach, ruling that the trustee could not rescind the transfer because, if the transfer hadn’t occurred, the creditors could not have reached the property because it was exempt, and therefore the transfer did not harm them in any way.[2]  This approach seems to work best, however, when the property was not voluntarily transferred by the debtor, but instead was seized from him, and when the debtor made no attempt to conceal the property.

The courts realize that it is not uncommon for a person who is faced with mounting debts and being pressured by his creditors and is thinking that he needs to file a bankruptcy to attempt to protect his property by transferring it to others. This is likely to take place before that person talks to an experienced bankruptcy attorney.  However, the courts generally take the position that the very purpose of the bankruptcy laws is to make certain that those who seek the shelter of a bankruptcy filing do not play fast and loose with their assets or with the reality of their financial affairs.  Rather, the purpose is to provide “the honest but unfortunate debtor” who surrenders for distribution the non-exemptible property he owns at the time he files for bankruptcy, “a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debts.”[3]

This debtor might even be in jeopardy if the girlfriend were to sell the truck and put the money back into the debtor’s bank account, as that money would have lost its identity as a workers’ compensation award.  Nevertheless, in the event that the debtor did get his attorney’s advice, and rectified the situation as best he could before the bankruptcy filing, it is possible that he might be able to successfully claim the exemption to protect those funds.

If the debtor had received some bankruptcy counseling before he made the transfer, he would have known that exemption rights are fixed as of the date that the bankruptcy petition is filed.  And the assets that are exempt on the petition date retain their exempt status regardless of post-petition use or change in the character of those funds.[4]  Therefore, if this debtor had filed his bankruptcy before he gave his girlfriend the money to buy the car, he would have had no problems whatsoever!

The bottom line is, be very careful what actions you take in an effort to protect your property from the reach of a bankruptcy trustee.  You may be needlessly worrying about concealing an asset that is already exempt. Further, if the exempt money is deposited in an account with other money from other sources, you will want some way to identify, or trace, the exemptible portion. If you are thinking that a bankruptcy may be needed to get you on a fresh financial footing, your best course of action is to consult with a competent bankruptcy attorney.  Keep in mind that most of us either provide the initial consultation for free or for a small fee.  A little planning may save you from a lot of aggravation, as well as monetary loss!

[1] Warsco v. Ryan (In re: Richards), 92 B.R. 369, 372 (Bkrptcy.N.D.Ind. 1988)

[2] Kapila v. Fornabaio (in re Fornabaoi), 187 B.R. 780, 782-83 (Bkrtcy. S.C. Fla. 1995).

[3] Lassman v. Paulding (In re Paulding), 370 B.R. 11, 18-20 (Bkrtcy.D.Mass. 2007).

[4] In re Kim, 257 B.R. 680, 687 (9th Cir. BAP 2000).

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