by S. Ward Greene
Greene & Markley, P.C.

  "It's real simple, Ward. You must refuse to give any asset protection advice." My partner and I had been discussing the recent Oregon Supreme Court case of Granewich v. Harding, 329 Or 47 (1999), which held that attorneys may be liable to third parties when they assist their clients in committing "tortious" conduct. His warning was the product of his observations of some dangerous trends in both state and federal court whenever pre- bankruptcy planning has been scrutinized by appellate judges.

My partner's advice was sound, if the role of a debtor's attorney were merely to show the client how to fill out bankruptcy schedules and the statement of affairs. However, to assist a beleaguered debtor in lawfully preserving and protecting the maximum amount of property, a lawyer can do much more; but at what risk?

In this article, I will touch briefly on some of the cases which create or identify potential problems for debtors and their attorneys. The waters are, indeed, infested with sharks. Heedless of all the dangers, I will then offer some suggestions for permissible planning alternatives. Then you're on your own.

Perhaps the seminal case in this area is Wudrick v. Clements, 451 F2d 988 (9th Cir 1971). That case stands for the simple proposition that it is permissible (practically patriotic) for a debtor to purposefully convert non-exempt assets into exempt assets on the eve of bankruptcy. The Ninth Circuit recognized the importance of a "fresh start" for debtors and acknowledged that state and federal legislatures had created classifications of certain types and amounts of assets which were necessary for a grubstake for the debtor. Although the issue was not mentioned, the facts of the case show that the debtors intended to hinder their creditors. Apparently, that caused no problem.

In the more recent case of In re Bernard, 96 F3d 1279 (9th Cir 1996), the Court of Appeals made it clear that, under 727(a)(2)(A), any transfer during the year prior to filing, with intent to hinder or delay a creditor, is sufficient to deny the discharge. The Bernard court also held that a debtor need not succeed in harming creditors to warrant a denial of discharge. Moreover, depletion of estate assets is not a prerequisite to a denial of discharge under the Bernard decision. The Bernard case can be read to support the proposition that just moving assets from one bank to another, if the transfer is coupled with an effort to fend off a creditor, would be enough to deny the debtors a discharge. The breadth of the holding is frightening whenever a debtor asks what can be done to preserve the greatest amount of his or her assets.

A number of courts have had occasion to consider whether "advice of counsel" prior to filing bankruptcy should be considered as a defense when deciding whether to deny a discharge or impose other penalties on the debtor. The leading case on this subject in the Ninth Circuit is In re Adeeb, 787 F2d 1339 (9th Cir 1986). Mr. Adeeb was being threatened by one of his creditors when some unsophisticated attorney suggested that he transfer all his real property to "third parties who could be trusted." Luckily for Mr. Adeeb, a bankruptcy attorney later advised him to reverse the transfers and to disclose them to his creditors. He met with a number of his creditors and revealed the fraudulent transfers, stating that he was in the process of reversing them. Shortly thereafter, an involuntary petition in bankruptcy was filed against Mr. Adeeb and the bankruptcy court denied his discharge pursuant to 11 USC § 727(a)(2)(A).

Mr. Adeeb argued that he lacked actual intent to hinder or delay his creditors because he had relied on the advice of an attorney. Although acknowledging that such reliance may have a bearing on wrongful intent, the court held that a debtor's reliance must be in good faith. Because Mr. Adeeb knew that the purpose of the transfer was to hinder or delay a creditor, he was precluded from raising the defense of good-faith reliance on the advice of counsel. (Because the court wanted to encourage curative action by debtors in Mr. Adeeb's position, the court ruled that the discharge would not be denied if all fraudulent transfers were undone.)

In a more recent case, In re Rice, 109 BR 405 (Bkrtcy ED Calif 1989), a debtor's bankruptcy attorney advised him to "draw as much money as he could out of his bank account and spend it." During the denial of discharge litigation, the court focused on the limits of legal advice obtained in contemplation of bankruptcy. The court ruled that whenever a debtor deliberately spends money to prevent it from falling into the hands of a bankruptcy trustee or creditors he is, a fortiori, committing waste and hindering or delaying his creditors. Under those circumstances, advice from a bankruptcy attorney would not create a safe harbor. The Rice court acknowledged that certain types of pre- bankruptcy exemption planning may be permissible. But it "necessarily entails limits and is not to be construed as a license to waste assets." p. 409. The implication is clear that attorneys are permitted to assist their clients in reasonable exemption planning. To the extent that planning results in the debtor emerging from bankruptcy with an increased stake of exempt property, a debtor apparently may rely in good faith on the advice of his attorney.

The question becomes more difficult when the pre-bankruptcy planning relates to the protection or preservation of business assets. The goal is essentially the same, but the legal precedents are less clear. A bankruptcy court in Minnesota attempted to articulate a standard for permissible pre-bankruptcy planning which would also seem to apply to business assets. (In re Johnson, 124 BR 290 (Bkrtcy D Minn 1991)). In Johnson, the debtor had liquidated numerous non-exempt assets and bought exempt assets. (Although it was not an issue in that case, the court observed that the debtor had consulted with several attorneys about his deepening financial problems and had acquired a clear understanding of Minnesota exemption laws. That observation by the court raises a concern that there may be a backlash; if the soon-to-be debtor consults with a bankruptcy attorney before making any pre-bankruptcy transfers, he must have intended to put the assets outside the reach of his creditors.) While the issue in the Johnson case was the conversion of assets into exempt property, its discussion may apply to other situations as well. The court observed that some types of property which debtors attempt to preserve are well-suited to enable them to maintain a degree of personal economic security by continuing to carry on a past profession or trade. P. 295. Unfortunately for the debtor in the Johnson case, the evidence was clear that the debtor was simply to trying to put his money outside the reach of his creditors (he bought paid-up life insurance, which he later cashed in, but had no dependents; and he bought valuable musical instruments, stored in the basement, which he did not know how to play). His discharge was denied.

We don't know whether Mr. Adeeb or Mr. Rice or Mr. Johnson tried to blame their attorneys for their discharge problems. A little closer to home, we do have the example of debtors who were denied a discharge and later accused their attorneys of malpractice. In the case of Woodfield and Pearce, 978 F2d 516 (9th Cir 1992), the debtors transferred their business assets into a new corporation on the eve of bankruptcy. The transfer included franchises, equipment, fixtures, inventory and cash; the debtors received all of the stock in the corporation and listed it on their bankruptcy schedules. Although the bankruptcy court and the district court rejected the creditor's effort to deny their discharge, the 9th Circuit reversed. The issue of good-faith reliance on the advice of counsel was not discussed by the Court of Appeals. However, it is now public knowledge that the debtors subsequently sued their attorneys and received a substantial payment in settlement of their claims.

The cautious lawyer should ask herself whether she will be a malpractice target if the pre-bankruptcy planning done with her debtor-client proves to be unsuccessful. Of course, if the attorney is very careful in warning the client of the potential problems, can good-faith reliance on the attorney's advice ever be a defense? The Woodfield case is especially troublesome because the type of pre-bankruptcy planning done by the debtors in that case is not unusual. And it seems indisputable that the attorneys were trying to assist their clients to preserve the greatest amount of assets.

Another lawyer who was trying to help his clients protect their assets wound up in deep trouble with the Bar. In In re Hockett, 303 Or 150 (Or 1987), the lawyer represented debtors and their spouses in orchestrating their "friendly" divorces. Mr. Hockett's efforts yielded a 63-day suspension from the practice of law. In addition to the obvious conflict, the Supreme Court concluded that the lawyer violated DR 7-102(A)(7) which forbids a lawyer from assisting the client in conduct "the lawyer knows to be illegal or fraudulent." The court also concluded that by assisting the clients in creating fraudulent transfers, the lawyer was guilty of conduct involving dishonesty, a violation of DR-102(A)(4). It may come as no surprise that the property settlements in the divorces were both set aside in state court as fraudulent conveyances. It is not clear whether bankruptcies ensued, but there can be little doubt that the debtors would have been subject to a denial of discharge had they filed for bankruptcy within one year after the fraudulent transfers. These events also could have resulted in a malpractice claim against the attorney who participated in the scheme.

Now, to make matters worse, the Oregon Supreme Court in the Granewich case has added the possibility that the lawyer who provides pre-bankruptcy advice may be named as a defendant if a creditor sues the debtors for damages resulting from a fraudulent transfer. Although the Granewich case addressed claims by a minority shareholder that the majority shareholders and their lawyers were attempting a corporate squeeze out, the reasoning would apply equally well to pre-bankruptcy transfers. The lawyers in Granewich were alleged to have knowingly assisted the majority shareholders in breaching the fiduciary duties that they allegedly owed to the plaintiff. The court ruled that the lawyers need not have committed any tortious act, but would be held liable for "acting in concert" with another person who committed a tortious act. The Supreme Court disregarded the fact that the lawyers owed no duty to the minority shareholder. They even went so far as to say that the lawyers stand in no different position in relation to the plaintiff and anyone else and "their status as lawyers is irrelevant." What this decision will mean regarding litigation strategy and matters of privilege is still unclear. But it certainly creates another enormous risk for lawyers.

So what's a lawyer to do? I remember some years ago hearing a crusty old debtors' attorney (he was probably about my present age) speaking at a seminar about pre-bankruptcy transfers. He opined that, to avoid a denial of discharge, the debtor must have "an empty head and a pure heart." That is still a pretty good rule for avoiding dischargeability problems. Applying the rule to real life situations can be quite daunting. Especially so because the knowledgeable lawyer will make sure that the client does not have an empty head.

I want to offer some hypothetical situations and then discuss what I hope would be permissible pre-bankruptcy planning alternatives. Needless to say, every case stands on its own facts. I disclaim any responsibility if you or your clients get hammered for trying any of these tactics.

Assume that your new client is the sole shareholder of a small business corporation. He has guaranteed many of the corporation's debts and the creditors have grown impatient. The corporation is floundering, but may be able to hang on for a little while. What should he do?

Of course, a threshold question is whether the business itself can and should be saved. Assuming the answer is yes, the key creditors have to be identified and placated. If they have personal guaranties, the corporation should grant and perfect security interests in favor of the key creditors who hold personal guaranties. If the creditors won't cooperate, but the business is too small to warrant even a simple chapter 11, the owner should consider liquidating the corporation, distributing all the assets to himself, then filing a chapter 13. Beware of hidden tax consequences before your recommend this approach. Obviously, the client has to be careful that the mix of secured and unsecured debts will fit within the jurisdictional requirements of chapter 13. He may need to grant a security interest to an otherwise unsecured creditor to shift the mix of unsecured to secured debt so that he qualifies for chapter 13.

Because the ultimate solution may include a personal bankruptcy, the debtor must also consider personal exemption planning. His spouse should be alerted to the possible need for separate counsel. Depending upon how much time he has before the filing, he should consider segregating 25% of his net wages in a separate bank account which will be exempt, up to $7,500, under ORS 23.166. He should also maximize any retirement plan contributions and repay or restore any loans from his retirement plan. He should attempt to maximize his homestead exemption and all the other permissible statutory exemptions. All such transfers and transactions should be done with a pure heart. In other words, the debtor should have reasonable estate planning and exemption planning goals as the motivating force, not a desire to frustrate or hinder his creditors

By way of illustration, I want to offer a true story of a client I spoke to some years ago. He was a father of five young children. He had been involved in a serious auto accident. Although it was not his fault, he knew that as a result of some unusual circumstances, he might suffer huge liabilities. He had substantial assets which would be an easy target if anyone was successful in obtaining a judgment against him in the future. Although he had been married to the same woman for many years, all of their marital assets sat in his name. I explained to him that reasonable estate planning often requires that assets be divided equally between a husband and wife and may include the suggestion that any real property be held as tenants by the entireties. These are reasonable, rational transfers, not efforts to defraud a creditor.

This young man then inquired whether he was "allowed" to buy life insurance for his wife and kids. When I learned that he had no life insurance, I was appalled. The question of how much life or disability insurance was appropriate, whether it should be whole life or term, paid up or purchased on an installment plan, were all questions I suggested he discuss with an insurance agent. Again, I trust that, within reason, his decision (long overdue) to buy insurance would not be considered a fraudulent transfer.

Let's change our hypothetical. Assume the debtor operates a business as a sole proprietorship. He and 12 other people are employed by the business. He has invested everything in the business and, although the business is making money (like the goose laying little tiny golden eggs), his personal financial affairs are like a train wreck. He has been subsidizing the business by underpaying himself for the last three years, but has insufficient liquid assets to hold off his creditors. I believe he can form a new corporation or LLC and contribute all of the business assets to that entity in exchange for stock or membership. He may want to include other key employees in the planning and ownership of the business, but needs to be alert to securities issues. The new entity will assume the important liabilities of the business and will take all assets subject to any existing security interests. The entity will begin paying him fairly for his services and might want to consider an employment contract with him and other key employees.

Needless to say, all of these transfers will be fully disclosed on the Statement of Affairs and any resulting assets (i.e., stock or LLC membership) will be fully disclosed on his schedules. With any luck, he will be able to "buy back" the corporation from his trustee for a reasonable price. It is unlikely that any stranger would want to buy a closely held corporation. It is doubtful that the business assets would have much value if the corporation were liquidated and the secured debts all paid.

In all these examples and suggestions, some creditors will be hindered or delayed. However, it can be argued that the debtor's intent was to accomplish permissible estate planning and business planning goals; any detriment to the creditors would be purely incidental. Moreover, if properly structured, the creditors as a whole will be no worse off than they would have been had they been dealing with a debtor who had his "affairs in order." It is unlikely that the creditors relied on a lack of rational business and estate planning when they extended credit to the debtor.

There is no law that requires debtors to be sitting ducks for their creditors. Furthermore, there is no policy reason for letting a viable business collapse simply because its owner has become insolvent. So long as the pre-bankruptcy transfers are done in broad daylight, for reasonably equivalent values, and for the "right" reasons; and so long as the debtor is not a "hog" (you know the cliche), the transfers should withstand a challenge in the bankruptcy court. I believe it is a lawyer's duty to inform and educate his clients as to the alternatives and the risks attendant to each of the choices they might make. There is nothing negligent, dishonest or fraudulent about providing that service to your clients. But please be careful.

This article is intended to inform the reader of general legal principles applicable to the subject area. It is not intended to provide legal advice regarding specific problems or circumstances. Readers should not act upon this information without seeking competent legal counsel for their specific situation.