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Turnover that Check

posted by Bob Lawless

A blog reader (Michael L. Gompertz) alerted me to a recent decision from the U.S. Court of Appeals for the Eighth Circuit, which sits in St. Louis. For the nonlawyers who read the blog, us legal types really care about decisions from the courts of appeals because they are just below the U.S. Supreme Court in the legal hierarchy and because the U.S. Supreme Court hears so few cases. Thus, the U.S. Courts of Appeal are really the final arbiter for many important legal issues.

This particular case (Brown v. Pyatt, No. 06-3404 (8th Cir. May 23, 2007)) struck me as interesting not so much for the decision itself but for the unintended consequences its legal strategy may suggest. Judging from the alignment of interests on the friend of the court briefs, consumer bankruptcy attorneys might view the decision as a win, but I wonder whether that is true. To understand, first I need to explain the facts.

The debtor had written $1,600 in checks shortly before he filed bankruptcy. The record is not clear why the checks were written, but apparently the debtor had written the checks to creditors. Perhaps the checks went to help pay car loans and hence to help the debtor keep his cars after filing bankruptcy. The key fact to understand is that at the moment of bankruptcy the checks still had not been presented to the bank. Hence, the checks represented money that belonged to the debtor at the moment of filing, and anything that belongs to the debtor at the moment of filing becomes property of the bankruptcy estate.

Using this reasoning, the bankruptcy trustee sued the debtor to recover the $1,600 because the Bankruptcy Code requires any entity to turnover to the trustee any property of the bankruptcy estate. By the time of the trustee's lawsuit the creditors had now cashed the checks, and the debtor reasoned he was no longer in possession of property of the bankruptcy estate. The debtor said the bankruptcy trustee had to pursue the creditors for the money as they were the ones who now had it. The legal issue came down to the question of whether the person sued for the turnover of the estate property had to be in possession of the property at the time of the lawsuit. The practical consequence of the debtor's position is that the bankruptcy trustee would have to pursue several creditors in several lawsuits for small amounts of money rather than pursue the debtor in one lawsuit. The hassle and expense (plus some procedural rules) would probably cause the trustee not to bring these separate lawsuits.

Consumer bankruptcy attorneys had filed an amicus or "friend of the court" brief on behalf of the debtor, and bankruptcy trustees had filed an amicus brief on behalf of the trustee. In the end, the court sided with the debtor, meaning consumer bankruptcy attorneys got their way. The court's decision would endorse the tactic of paying relatively small amounts to a few favored creditors just before filing bankruptcy. Although the trustee could pursue the creditors, he or she probably will not in many cases.

I wonder whether such a tactic is really a victory for consumer debtors. Might it be grounds for denial of the discharge in bankruptcy? Section 727(a)(2) says "a court shall grant the debtor a discharge unless . . .  the debtor with intent to hinder, delay, or defraud . . . an officer of the estate charged with custody of property under [the Bankruptcy Code] has transferred, removed . . . or concealed . . . property of the debtor within one year before the date of the filing of the petition." Does not this language described exactly what happened in the Pyatt case? Did not the debtor write several checks on the eve of bankruptcy precisely so as to make those funds beyond the practical ability of a trustee to reach them?

Inquiring minds want to know. Comments are open.

Comments

If the check was to repay a loan from the debtor's brother-in-law, that would be one thing. However, it is hard to imagine a court denying discharge because a debtor made payments on legitimate debts to unrelated third parties arising out of arms length transactions. I'm not sure where one would stop with such a theory. If the payments are less than $600 to each creditor, they are not even recoverable as preferences, so I can't see being able to brand them as wrongful enough to deny discharge.

In Brown v. Pyatt, the 8th Circuit applied a very restrictive approach to the turnover obligation under section 542(a). The 8th Circuit denied turnover because by the time turnover was sought, the checks had already been cashed and the debtor was not THEN in possession or control of estate property or proceeds of estate property. The 8th Circuit primarily relied on a 1948 Supreme Court opinion, Maggio v. Zeitz, for its restrictive approach to the turnover obligation.

Bob Lawless does not refer to Maggio v. Zeitz in his post. Was the 8th Circuit correct in concluding that Maggio is still good law? In 1948, there was no provision in the bankruptcy statute comparable to section 542.

Another recent case on turnover was Nichols v. Birdsell (9th Cir. May 9, 2007). This case views the turnover obligation much more broadly and the debtor was the losing party. In Nichols, the debtor/taxpayer first filed his income tax return--making an IRREVOCABLE election to apply his overpayment to the next year's income tax liability--and later filed for bankruptcy. Thus, when the bankruptcy petition was filed, all the debtor had was a tax credit to be applied against the next year's tax liability. The debtor did not have cash or an immediate right to payment from the IRS. The 9th Circuit nonetheless concluded that the debtor had an obligation under section 542(a) to turn over to the trustee "the value of" the tax credit, which was held to be property of the estate. The Court held that a turnover obligation existed because the debtor held property of the estate (the tax credit) "during the case" and section 542(a) imposes an obligation to turn over estate property or the "the value of" estate property. Although the tax credit could not itself be transferred to the trustee, its value could be transferred to the trustee. In Nichols v. Birdsell, there was no allegation that the debtor had fraudulently or improperly deprived the estate of money by filing a tax return in which he elected to apply the overpayment to the next year's liability, rather than receiving a refund.

The 9th Circuit erred in not even considering the 1948 Supreme Court opinion (Maggo v. Zeitz) in its analysis. The two decisions are in conflict. The 8th Circuit relies on Maggio v. Zeitz. The 9th Circuit fails to mention that case.

There was, however, a secondary rationale used by the 8th Circuit that might provide a (rather weak) basis for reconciling the two decisions. The secondary rationale of the 8th Circuit was that the trustee could have--and SHOULD have--filed adversary proceedings under section 549 to recover the payments from the parties who cashed the debtor's checks post-petition. Such an avoidance action would NOT have been possible in the 9th Circuit case, Nichols v. Birdsell, because in that case the debtor/taxpayer had not made any transfer to the IRS (either pre-petition or post-petition) that could be avoided. There is no transfer to the IRS when a taxpayer elects to apply his overpayment to the next year's liability.

1. Federal-exemption states and some others have a wild-card exemption that would nearly always moot out a penny-ante case like this. That is good public policy.
2. Isn't money, especially in the electronic age, as fungible a commodity as ever there was? If the money in the bank belonged to the estate as of filing, and the debtor took it away, why should he escape liability based on who he paid money to in the process?
3. I believe Professor Lawless sets up a strawman and then pulverizes it. Debtors make payments like this because life goes on, even when you are filing bankruptcy. Before or after this case, I find hard to imagine that a well advised debtor would follow this course of action as a deliberate creditor-thwarting strategy. In particular, in the post above and a quick scan of the decision, I find no indication that Mr. Pyatt had any improper intention whatever to hinder, delay or defraud anyone.

1. Federal-exemption states and some others have a wild-card exemption that would nearly always moot out a penny-ante case like this. That is good public policy.
2. Isn't money, especially in the electronic age, as fungible a commodity as ever there was? If the money in the bank belonged to the estate as of filing, and the debtor took it away, why should he escape liability based on who he paid money to in the process?
3. I believe Professor Lawless sets up a strawman and then pulverizes it. Debtors make payments like this because life goes on, even when you are filing bankruptcy. Before or after this case, I find hard to imagine that a well advised debtor would follow this course of action as a deliberate creditor-thwarting strategy. In particular, in the post above and a quick scan of the decision, I find no indication that Mr. Pyatt had any improper intention whatever to hinder, delay or defraud anyone.

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