The Journal of The DuPage County Bar Association

Back Issues > Vol. 20 (2007-08)

Watch Out Third Floor: The Bankruptcy Trustees are Lurking1
by Kent A. Gaertner

The interplay of divorce law and bankruptcy law has given rise to lots of litigation in the past and will continue to do so in the future. An excellent example of that interplay—that will certainly affect practice on the third floor of the DuPage County Courthouse — is the case of In re Knippen3 decided by Judge Squires of the United States Bankruptcy Court for the Northern District of Illinois. This article will explore why Knippen makes it more difficult to avoid a Bankruptcy Trustee’s action to overturn an Marital Settlement Agreement (MSA) when one party gets more "hard assets" than the other based upon a waiver of maintenance.4

In re Knippen: The Facts. Debtor Kerry Knippen and his wife Jodi went through protracted divorce litigation from January 2002 until a judgment of dissolution was entered on September 30, 2004. Incorporated into the judgment of dissolution was a MSA entered into by the parties and approved by the Court. The MSA provided that Jodi was to receive the marital residence, which was valued at $208,000 by a recent appraisal. There were mortgages and liens against the house totaling approximately $160,000. In addition , Jodi retained ownership of her auto and her personal checking account.

The Debtor received an all-terrain vehicle, three other vehicles more than ten years old, two checking accounts, his tools and the 2003 income tax refund. He also retained 100% ownership of his small service business. No values were assigned to these assets in the MSA.

The liabilities were split with the Debtor and Jodi each being responsible for the credit cards in their individual names. Jodi was also responsible for unpaid promissory notes to her parents. Both Debtor and Jodi waived any right to maintenance against each other. Both testified at the prove up of the divorce that they believed the MSA fairly and equitably divided the marital estate.

Upon entry of the judgment of dissolution, the Debtor executed a quit claim deed to Jodi, which was recorded on October 28, 2004. Shortly thereafter, Jodi sold the house to her parents by warranty deed dated November 10, 2004. The purchase price was $200,000. The funds were escrowed and used to pay the monthly mortgage payments on the house, Jodi’s monthly rent, and other debts arising from the dissolution proceeding. Jodi and her children continued to live in the property and rent from her parents.

On April 28, 2005, the Debtor filed his Chapter 7 petition. The value of his personal property was listed on the petition, in the total amount of $8453.33. His 100% ownership interest in his business was listed as having a value of zero. He listed monthly income as approximately $1600 net per month and expenses of approximately $5580 per month. The debts listed on his petition totaled $69,046.52, all unsecured.

The Trustee brought a five count adversary proceeding against Jodi and her parents, alleging that the transfer of the marital residence was a fraudulent conveyance, under section 548 (a) and 550 (a) of the Bankruptcy Code5 and also under sections 5, 6, and 9 of the Illinois Uniform Fraudulent Transfer Act.6

The Law on Fraudulent Trans-fers. Section 548 of the Bankruptcy Code7 allows the Trustee to recover pre-petition fraudulent transfers of the Debtor’s property.

Subsection 548(a)(1)(A) allows the avoidance of a transfer where the creditor had an "actual intent to hinder, delay, or defraud" a creditor. Because "actual intent" is the operative factor for the cause of action under 548(a)(1)(A), it is referred to as an "actual fraud" count.8 Section 548(a)(1)(B), on the other hand, has no element of intent and is therefore referred to as "constructive fraud."

In an "actual fraud" count, the state of mind of the Debtor is at issue. Does he have actual intent? If so, malice or insolvency of Debtor is not required. Likewise, there need be no culpability on the part of the recipient on the transfer. The adequacy or equivalency of the consideration paid by the transferee is also not an issue in an actual fraud count.

Conversely, in the "constructive fraud" count, the Debtor’s intent is immaterial.9 The issue is solely the adequacy or equivalency of the consideration coupled to insolvency or the inability to pay debts as they mature.10 When the court lacks direct evidence of fraud, circum-stantial evidence may be used under section 548(a)(1)(A). The courts refer to this circumstantial evidence as "badges of fraud". These badges include: "(1) absconding with the proceeds of the transfer immediately after their receipt; (2) absence of consideration when the transferor and transferee knew that out-standing creditors would not be paid; (3) a huge disparity in value between the property transferred and the consideration received; (4) the fact that the transferee is or was an officer, agent, or creditor of an officer of the corporate transferor; (5) insolvency of the debtor; and (6) the existence of a special relationship between the debtor and the transferee."11 The court will then apply the "badges of fraud" analysis to the facts of the case to determine whether "actual intent" existed, thereby rendering the transfer fraudulent under section 548 (a)(1)(A).

To prove "constructive fraud" under section 548(a)(1)(B), the trustee must establish the following elements by a preponderance of the evidence: (1) a transfer of the Debtor’s property or interest therein; (2) made within one year of the filing of the bankruptcy petition; (3) for which the Debtor received less than a reasonably equivalent value in exchange for the transfer; and (4) either (a) the Debtor was insolvent when the transfer was made or he was rendered insolvent thereby; or (b) the Debtor was engaged or about to become engaged in business or a transaction for which his remaining property represented an un-reasonably small capital; or (c) the Debtor intended to incur debts beyond his ability to repay them as they matured.12

The receipt by the Debtor of less than a reasonable equivalent value is critical to the finding of constructive fraud. The test to determine "reasonably equivalent value" requires the Court to determine the value of what was transferred against the value of what was received.13 The factors used in determining reasonably equivalent value include: (1) whether the value of what was transferred is equal to the value of what was received; (2) the fair market value of what was trans-ferred and received; (3) whether the transaction took place at arm’s length; and (4) the good faith of the transferee.14

If it is established that the transfer was for less than the reasonably equivalent value and the Debtor was insolvent at the time (or the transfer rendered him insolvent) or he intended to incur, or believed he would incur, debts beyond his ability to pay as they mature, the Court can find "constructive fraud" and avoid the transfer without reference to the intent of the Debtor.

The Trustee is also, under section 544(b)(1)15, allowed to avoid a fraudulent transfer under applicable state law. In Illinois, that law is the Illinois Uniform Fraudulent Transfer Act (UFTA).16 Sections five and six of that Act are similar to section 548 of the Bankruptcy Code. The main difference is that under section 548 the transfer to be avoided must have occurred within one year of the filing of the Petition. Under the Illinois UFTA, the time frame extends to four years.

Lastly, after the transfer is avoided under either section 548 (a)(1)(A) or 548(a)(1)(B) or the Illinois UFTA, the Trustee can then use section 550(a) of the code to recover the value of the transfer from the initial transferee or the immediate or mediate transferee of the initial transferee.

In re Knippen: The Result. The Court reviewed the facts of the case in light of both "actual fraud" elements and "constructive fraud" elements. The Court found the following three of six badges of fraud existed for the actual fraud count: (1) a special relationship between the Debtor and the transferee; (2) the Debtor was insolvent at the time of the transfer and; (3) a large disparity of value existed between what the transferee received (i.e. the house) and what the Debtor received .

The Court determined that the Debtor’s property listed in his schedules totaled only $8,453 while his scheduled debt was approximately $69,000. His income was approximately $1600 per month net while his expenses were approximately $5500 per month. Hence, the Court concluded the Debtor was insolvent at the time of the transfer or was rendered insolvent due to the transfer.

The Court also found, based upon the evidence and the testimony, that the Debtor’s one-half interest in the property was $28,500. The property he received in exchange for his transfer of his one-half interest was approximately $8500 based on the value of the assets listed in his schedules. The difference of $20,000 represented a significant disparity in the value of the property transferred.

Despite finding that three of the six badges of fraud existed, the Court declined to avoid the transfer based upon the actual fraud count under section 548(a)(1)(A). However, the Court did find that the Trustee proved all four elements of the constructive fraud count by showing the Debtor: (1) transferred the property, (2) within one year of the filing of the petition, (3) for less than reasonably equivalent value (i.e. the Debtor received $8500 in assets in exchange for Jodi receiving $28,500 in assets), and (4) the Debtor was insolvent at the time of the transfer or was rendered insolvent by the transfer. Note that under the Illinois UFTA, element two could have been extended out to four years with the same result.17

Since the transfer was voided under Section 548(a)(1)(B) as constructive fraud, the Court ordered, under Section 550(a)(2), the return of $20,000 from the parents. The parents defended stating that under section 550(b), they paid fair value for the property, in good faith, and without know-ledge of the avoidability of the transfer.18 The Court agreed that they took for fair value and in good faith, but found that they were deemed to have knowledge of the avoidability of the transfer. The Court found that their knowledge of the financial circumstances of the Debtor and their daughter Jodi constituted sufficient knowledge to constitute an awareness of the avoidability of the transfer.

Jodi Knippen and her parents appealed the decision. U.S. District Court Judge Suzanne B. Conlon affirmed the Bankruptcy Court’s decision in all respects.19 One issue Judge Conlon noted is of particular importance. Counsel for Jodi Knippen argued on appeal that Jodi’s waiver of maintenance should have been included in the calculation as to whether she had given equivalent value to her husband in exchange for the house. Judge Conlon rejected the argument stating that not only was there no evidence of the value of the waiver presented to the trial court. More importantly, however, she pointed out that even if evidence of the value of the waiver were presented, the bankruptcy court could not have considered the issue because an unperformed promise for future support does not constitute value in determining reasonable equiva-lence.20

THE LESSONS

Lesson #1: State the Value of All Assets in the MSA. When concluding an MSA, it is essential that the values of all assets affected be stated and carefully documented. Valuations must be given to business interests based upon sound accounting principles. Values should be assigned to the assumption of debt. In this case, the MSA did not contain detailed valu-ations of assets including the interest of the Debtor in his business.

Lesson #2: Assign Only Defendable Values. If one spouse is getting significantly more than the other, a subsequent bankruptcy filing by the "generous" spouse will result in the effective dismember-ment of the MSA by the bankruptcy trustee. This will open the door to future post-decree litigation for the spouse who had to disgorge the assets originally received. A practitioner should find a way to assign defendable values to all the assets to even out the distribution between the spouses. This becomes particularly challeng-ing when the value of the waiver of maintenance cannot be used to level the distribution.21

Lesson #3: Do Not Inflate Asset Values. The values assigned to the assets in the MSA are going to be proof of value in a subsequent bankruptcy petition filed within a reasonable period of time thereafter. Don’t plan on inflating values on the MSA and then claim the same asset is worth little or nothing in a subsequent bankruptcy petition a year later.

Lesson #4: Know the Pitfalls of Waiving Maintenance in Exchange for Hard Assets. The next time a new divorce client shows up at your office and says "just give her everything. I don’t care and just want it to be over with!" Remember, that’s no longer as simple as it sounds.

Given the current environment in the bankruptcy world, in which investigation of Debtor’s transfers and assets are greatly increased, it is critical to anticipate the potential bankruptcy filing of your opponent’s client when settling a divorce case. In the divorce arena, waivers of maintenance are frequently given in exchange for additional "hard assets." Given Judge Conlon’s ruling that a waiver of maintenance cannot be considered in determining reasonably equivalent value for a transfer, it becomes difficult to avoid a Trustee’s action to overturn an MSA when one party gets more "hard assets" than the other based upon a waiver of maintenance. It looks like the drafting of MSA’s just got a lot harder for my colleagues on the third floor and a target rich environment has opened for the panel trustees in the Northern District of Illinois.

1 For those of you who do not practice family law in DuPage County, IL, the third floor of the DuPage County Courthouse is home to the Domestic Relations Division of Eighteenth Judicial Circuit Court, DuPage County, Whea-ton, IL. It is there that many of my brethren at the Bar toil to bring sanity and justice to one of the most emotionally difficult areas of the law.

3 355 B.R. 710 (Bankr. N.D. Ill. 2006).

4 Knippen v. Grochocinski, Civil Action No. 07 C 1697, 2007 WL 1498906, 2007 U.S.Dist. LEXIS 36790 (N.D.Ill.,2007).

5 11 U.S.C. 548(a), 555(a) (West 2006).

6 740 ILCS 160/5, 6, 9(b) (West 2006).

7 11 U.S.C. 548. Section 548(a)(1) of the Bankruptcy Code provides as follows:

(a)(1) The trustee may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within one year before the date of the filing of the petition if the debtor voluntarily or in-voluntarily-

(A) made such transfer or incurred such obligation with actual intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made or such obligation was incurred, indebted; or

(B)(i) received less than a reasonably equivalent value in exchange for such transfer or obligation; and

(ii)(I) was insolvent on the date that such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation;

(II)was engaged in business or a transaction, or was about to engage in business or a transaction, for which any property remaining with the debtor was an unreasonably small capital; or

(III) intended to incur, or believed that the debtor would incur, debts that would be beyond the debtor’s ability to pay as such debts matured.

11 U.S.C. § 548 (a)(1)

8 In the Matter of FBN Food Services, Inc., 82 F3rd 1387, 1394 (7th Cir.-1996).

9 Id.

10 In re Cohen, 199 B.R. 709, 716-717 (B.A.P. 9th Cir. 1996)

11 In re Roti, 271 B.R. 281, 294 (Bankr. N.D. Ill. 2002).

12 11 U.S.C.A. § 548(a)(1)(B) (West 2006); Wieboldt Stores, Inc., v. Schottenstein, 94 B.R. 488, 505 (N.D. Ill. 1988); In re Dunbar, 313 B.R. 430, 434 (Bankr. C.D. Ill. 2004); see also Dunham v. Kisak, 192 F.3d 1104, 1109 (7th Cir. 1999).

13 Barber v. Golden Seed Co. 129 F3rd 382, 387 (7th Cir. 1997).

14 In re Apex Auto. Warehouse, L.P., 238 B.R. 758, 773 (Bankr. N.D. Ill. 1999).

15 11 U.S.C. § 544(b)(1) provides in pertinent part as follows:

[T]he trustee may avoid any transfer of an interest of the debtor in property… that is voidable under applicable law by a creditor holding an unsecured claim that is allowable under section 502 of this title or that is not allowable only under section 502 (e) of this title.

11 U.S.C. § 544 (b)(1). This section expressly authorizes a trustee to avoid a transfer voidable under applicable state law.

16 740 ILCS 160/1 et. seq. (West 2006).

17 Although Judge Squires ultimately found that the transfer constituted constructive fraud under Section 548 (a)(1)(B), the opinion contains a detailed and excellent discussion of the applicable sections of the Illinois Uniform Fraud-ulent Transfer Act (UFTA), 740 ICLS 160/5, 160/6 and 160/9 (b) and what the Trustee would have to prove if he attempted to overturn a fraudulent transfer more than one year after the filing of the Petition using Section 544 (b)(1) and UFTA in combination. The reader is strongly encouraged to read Judge Squires opinion in full.

18 Section 550 (a) and (b) provide in pertinent part:

(a) Except as otherwise provided in this section, to the extent that a transfer is avoided under section…548… of this title, the trustee may recover, for the benefit of the estate, the property transferred, or, if the court so orders, the value of such property, from –

(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or

(2) any immediate or mediate transferee of such initial transferee.

(b) The trustee may not recover under section (a)(2) of this section from-

(1) a transferee that takes for value, including satisfaction or securing of a present or antecedent debt, in good faith, and without knowledge of the voidability of the transfer avoided; or

(2) any immediate or mediate good faith transferee of such transferee. 11 U.S.C. § 550 (a) and (b)

19Knippen v. Grochocinski, Civil Action No. 07 C 1697, 2007 WL 1498906, 2007 U.S.Dist. LEXIS 36790 (N.D.Ill.,2007).

20 Id. (citing In re Mussa, 215 B.R. 158, 172 (Bankr. N.D. Ill. 1997)).

21 Id.

Kent A. Gaertner is a partner in the Wheaton law firm of Springer, Brown, Covey, Gaertner and Davis LLC. The firm practices exclusively in the areas of bank-ruptcy, reorgani-zations, and workouts representing debtors, creditors and bankruptcy trustees. Mr. Gaertner has been the Chairperson of the DCBA Bankruptcy Committee on several occasions and is a regular contributor to The Brief. Mr. Gaertner is currently the Second Vice President of the DCBA and has previously served for five years as a Director of the DCBA.


 
 
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