Can the chapter 7 bankruptcy trustee recover property transferred from the debtor divorced wife to her parents on fraudulent transfer grounds where the property transferred would have been exempt under state law?

Can the chapter 7 bankruptcy trustee recover property transferred from the debtor divorced wife to her parents on fraudulent transfer grounds where the property transferred would have been exempt under state law?

In the case of Sullivan v. Welsch, 457 B.R. 748 (B.A.P. 8th Circuit, 2011), (In re: Mary Lumbar, Case No: 11-6018), the bankruptcy appellate panel for the Eighth Circuit Court of Appeals rejected the “no harm, no foul” rule and held that the debtor ex-wife might have fraudulently transferred property to her parents, even though the property would have been exempt under state law.

The wife’s parents entered into an installment sales contract or contract for deed for the purchase of certain real property, the title to which would remain with the parents until the contract payments were paid in full, at which time title would be conveyed to the married couple.  Under the contract, the husband and wife were to make installment payments and two balloon payments to the wife’s parents over the course of seven years, with the final balloon payment paying off the contract in full.  The contract for deed was recorded in land records after it was fully ratified.  The husband and wife failed to make the first balloon payment.  The parents continued to accept installment payments from the couple and subsequently transferred the contract to themselves as trustees of their living trust.  The husband and wife failed to make the second and final balloon payment.  Nevertheless, the wife’s parents continued to accept monthly payments from the couple.  Five years later, the husband filed for divorce from his wife.  The parents then declared a default in contract for deed.  As the property had appreciated in the interim from the contract sales price of approximately $150,000 to more than $560,000, with a balance due of only $188,000, the husband took legal action against his wife, her parents, and their family living trust to enforce the contract for deed and realize the appreciation in value.  The state court legal actions were settled with a cash payment from the wife’s parents to the husband in return for a release of his rights in the real property and his rights to other marital property.  In accordance with the comprehensive settlement, the husband and wife quit claimed their equitable interests in the real property to the wife’s parents.  The wife’s quit claim deed to her parents was not recorded.  A year later, the wife filed a chapter 7 bankruptcy case without listing any interest in the real property or claiming any exemption in it.

The chapter 7 trustee filed an adversary proceeding to set aside the transfer and recover the real property as an unperfected, voluntary and fraudulent transfer under Bankruptcy Code Sections 544(a), 548(a) and 550 and certain Minnesota state statutes.

The bankruptcy court first recognized that state law determines property rights in bankruptcy.  The bankruptcy court judge next recognized that Minnesota state law provided that one could not fraudulently transfer exempt homestead property, as creditors could not claim they were prejudiced by a transfer or claim that it was a fraud when there would be no recovery of value.  The bankruptcy court judge further held that that Minnesota protection extended to bankruptcy fraudulent transfers under 11 U.S.C. § 548 and denied the trustee’s avoidance actions.

On appeal, the bankruptcy appellate panel (“BAP”) held that the bankruptcy court judge erred by failing to analyze the alleged fraudulent transfer under Bankruptcy Code Section 548.  The BAP recognized two bases for the chapter 7 bankruptcy trustee’s avoidance powers:  (1) the avoidance powers of an unsecured creditor using state or federal law under Bankruptcy Code Section 544(b), and (2) the power to avoid a voluntary or involuntarily transfer within two years of filing found to be constructive fraud for lack of full, fair-market consideration while the Debtor was insolvent under Bankruptcy Code Section 548(a)(1)(B).  The BAP agreed with the chapter 7 trustee’s assertion that Minnesota law did not extend to avoidable fraudulent transfers in bankruptcy under 11 U.S.C. § 548.  The BAP recognized five elements to the trustee’s fraudulent conveyance avoidance powers under 11 U.S.C. § 548, and only the first one – the interest of the Debtor in property – depended upon an interpretation of state law.  The other four elements – (2) a voluntary or involuntary transfer, (3) within two years of filing bankruptcy, (4) for less than reasonably equivalent value, and (5) while the debtor was insolvent – all depended upon an interpretation of federal bankruptcy law.  The BAP ruled that the debtor, by entering into a settlement agreement and transferring the property, did have an interest in property under state law.  It also ruled that the transfer took place within two years of the wife filing her chapter 7 bankruptcy case.  As the other three elements were disputed, the BAP reversed and remanded the case for further findings by the bankruptcy court judge.

In reaching its decision, the BAP reasoned that the debtor could not claim the property as exempt because she voluntarily transferred the property before filing bankruptcy and her parents could not claim the exemption she might otherwise have.  By so doing, the BAP rejected the “no harm, no foul” rule that a minority of the courts have used to restrict the trustee’s avoidance power to those transfers involving nonexempt property.  The Fourth Circuit Court of Appeals, which includes the U.S. Bankruptcy Court for the Eastern District of Virginia, similarly rejected the “no harm, no foul” rule in a non-family law case in Tavenner v. Smoot, 257 F.3d 401 (4th Cir., 2001).

You should consult with your Virginia bankruptcy and divorce lawyer, or Richmond divorce lawyer James H. Wilson, Jr., to discuss how you or your spouse’s your divorce transactions might affect a Virginia bankruptcy case.

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