Alabama Bankruptcy Lawyer Blog

Debtors write checks, then file Chapter 7 with the balance shown on Schedule B, but before outstanding checks have cleared their account. Is the balance in the bank on the date of filing an asset of the Bankruptcy Estate? Clearly it is, but that is not the problem. By the time the Trustee looks into it, the checks have cleared, and the question becomes: Does the trustee seek recovery, and from whom does the trustee recover the money---the debtor(s), or, the recipient of the funds evidenced by the check?

First a practical comment. Most debtors in Chapter 7 aren't going to have much of a bank balance, or they wouldn't be in Chapter 7. So from a pragmatic point of view, in the vast majority of cases the money at issue is not enough to warrant a turnover action. But, I need something to talk about in this post, so play along with me and assume the debtor had a large bank balance just before filing, wrote out several large checks, and one or more had not cleared. Rather than my pursuing payments as a preference, for which the recipient may have defenses, I would rather just say those were estate funds, now give them back, or lose your discharge (in the event of the debtors) or get sued for turnover (in the case of the recipient). So let's look at some law.

Here's the opening paragraph of In re Pyatt, 486 F.3d 423 (8th Cir. 2007):

"Gary Wayne Pyatt filed a voluntary petition for chapter 7 bankruptcy relief. His petition did not list several checks which had been written prior to his filing but not yet honored. The trustee moved to compel Pyatt to turn over to the estate the value of these checks which amounted to $1938.76. The bankruptcy court granted the motion, and Pyatt appealed to the bankruptcy appellate panel1 which reversed. Pyatt v. Brown (In re Pyatt), 348 B.R. 783 (8th Cir. BAP 2006). The trustee appeals, and we affirm."

So the 8th Circuit did not allow the Trustee to recover the funds from the debtor. The court's reasoning was that by the time the Trustee sought turnover, the debtor no longer had control of or possession of the funds. The checks had long since cleared. The debtor therefore had nothing at that time to turnover. Trustee argued that the critical date was the petition date--that if debtor controlled it then, that was sufficient. The court disagreed, however, and did not allow recovery from the debtor. Trustee would have to recover the funds from the recipient.

Now to the point of all this. In a recent decision out of Florida Middle, In re Brubaker,2010 WL 1260131 (Bkrtcy.M.D.Fla), Judge Paskay saw it differently. The court first found that the balance in the bank accounts on the petition date were property of the Bankruptcy Estate. The money did not leave the account when the checks were written or delivered, but when they were paid or honored by debtors' bank. Fine. What happens next?

The court, though sympathetic to pro se debtors who exhibited no indicia of bad faith, held that the debtors were required to turn over the non-exempt portion of the bank account, in the amount that existed on the petition date, and without any reduction for checks that cleared after the bankruptcy was filed.

Harsh result? I don't think so. The debtors controlled the checkbook and controlled the timing of writing and delivering checks as well as the timing of the filing of their bankruptcy. While they may not have been acting in bad faith, they were nevertheless driving the train, and should bear the burden of any derailments.

You're in the business of selling equipment, and want to cash in by financing, but don't want the hassle of preparing security agreements, filing financing statements, and heaven forbid, repossessing and disposing of collateral in a commercially reasonable manner. So you and your lawyer come up with the idea of leasing instead. Since title never passes, you just go get your equipment if they don't pay.

Right? Well, maybe not!

The age old issue is simply this: if it is a true lease, then fine. Title does not pass, and in case of bankruptcy, the equipment is not part of the bankruptcy estate. If, however, the lease is a disguised conditional sales agreement, then as trustee my next question is "show me your financing statement." Most of the time, there is no financing statement, the property enters the bankruptcy estate, and the "lessor" is now an unsecured creditor.
Here are examples of what I look for as trustee when examining leases, along with a little law for good measure. Note that no one factor is necessarily conclusive, and the courts will look at the totality of the circumstances to determine the intent of the parties.

1. Nominal value purchase option: at the end of the lease term, the "lessee" has the option of purchasing the leased property for nominal value. This is one big red flag. The value at the end of the term should bear some reasonable relationship to the actual value of the property at term's end.

2. Lessee bears risk of loss or damage: if under the lease, the lessee bears all risk of loss, then by inference lessor has essentially conveyed its interest in the property and passed it to lessee, who bears all risk of loss. Or, there is an option to renew the lease for nominal consideration for the remaining economic life of the property; same thing as buy it for nominal value.

3. Lessee bears all maintenance responsibility: this is self-explanatory, and the rationale is the same as #2.

4. Lessee pays all insurance and taxes.

5. The lease is personally guaranteed: why, you might ask, does this matter? If the transaction is truly a lease, and title never passes and you can go pick up your goods, why do you need a guaranty? The presence of a personal guaranty may not alone be sufficient, but it sure makes my nose twitch. See, In re Wakefield, 217 B.R. 967,971 (Bkrtcy. M.D. Ga. 1998)

6. Can the lessee walk away: if the lessee can walk away with no obligation to pay for the goods, this is an almost conclusive indication of a "true lease." Frankly, however, I have never seen such a lease.

Now for some law. First, the question of whether a transaction is a lease of secured transaction will always be one of state law. This implicates some choice of law issues, but that is another subject for another day. And in most every case, it won't matter a great deal because the starting point will be the Uniform Commercial Code.

Your statutory law is Ala. Code, Section 7-1-203, entitled "Lease distinguished from security interest," which is substantively identical to former Section 7-1-201(37).

For a very well reasoned review of the factors to be considered, see the opinion of Judge Keith Lundin in In re Puckett,, 60 B.R. 223 (Bkrtcy. M.D. Tenn. 1986). Closer to home, see Judge Cohen's opinion in In re Winston,181 B.R. 589 (Bkrtcy. N.D. Ala. 1995).

For the view of the IRS, see REV. RUL. 55-540, 55-2 C.B. 39, setting out nine plus factors to consider in distinguishing between a conditional sales agreement and a lease.

And here are the factors considered notable by Professor Barkley Clarke in his often cited treatise The Law of Secured Transactions:, which I set out in the event you don't have immediate access to this treatise:

(1) Is the lessee obligated contractually to pay the full purchase price? If so, the transaction smacks of purchase financing. Some cases use this factor as the only necessary evidence of a disguised secured transaction.

(2) Is there a purchase option and, if so is it nominal? In assessing this critical factor under U.C.C. Section 1-201(37), the court should compare the option price with the anticipated fair market value of the property at the time of exercise, as viewed from the inception of the transaction. Alternatively, the courts have compared the option price with total rentals over the lease term or with the original cost of the goods. The bottom line is the economic reality of transaction, that is, would any lessee in its right mind fail to exercise the purchase option?

(3) Is the lease term equivalent to the economic life of the good? IF it is, there [**16] is no meaningful residual value for the lessor, thus suggesting a financing arrangement rather than a true bailment lease.

(4) At the expiration of the initial lease term, can the lessee renew indefinitely or for a period extending through the economic life of the goods? This factor is of course closely related to the prior two.

(5) Does the lessor retain any meaningful residual value in the goods? When the lessor parts with any residual value because of a termination adjustment clause in an open-end lease which allows the lessor to sell the goods at termination or default, collect any deficiency, or turn over any surplus to the lessee, the transaction looks more like a financing arrangement. In effect, the lessee is guaranteeing the residual value of the leased goods.

This should get you started. And again, let me emphasize that no one factor is conclusive. The court will examine the totality of circumstances and determine what the parties to the transaction intended--a true lease, or a conditional sales contract disguised as a lease. If the latter, you better be perfected.

Thanks for reading.

Judge Williams ruled this week that funds set aside as deferred compensation for certain Colonial Bank employees constitutes property of the bankruptcy estate. The former employees, who were upper management and well-paid employees, may file claims along with other general unsecured creditors. Click here for the Memorandum Opinion.

The deferred compensation plan was what is known as a "top hat" plan. This is a non-qualified plan available only to certain key employees (hence, "top hat"), and is largely exempt from ERISA regulation. Its principle purpose is to defer compensation to a time when it may be taxed at a more favorable rate. Good luck with that!

The respondents did not take issue with the legal premise that the assets of top hat plans are not excluded from the bankruptcy estate. This seems well settled. Instead, they argued that the plan at issue did not meet the requirements for a "top hat" plan. They lost. For additional comment by former employees, you might want to read the article in the Montgomery Advertiser's June 29 issue.

The result is no doubt a hard pill to swallow for the unfortunate non-recipients of the deferred compensation. And at first blush, my concern was whether the employees had been adequately informed (remember, these are highly placed employees). But, from my reading of the findings set out in Judge Williams' opinion, it should have been obvious from plan materials that the funds were not set aside or otherwise protected, and remained assets of the company which were at risk. I suppose the caveat to take from this ruling is to read any plan materials carefully, and consult with your attorney, accountant or tax/investment professional to be sure you appreciate the risks and the potential advantages fully.

As a Chapter 7 Trustee, I consistently encounter questions involving the allocation of tax refunds between a spouse who filed Chapter 7, and one who didn't, where a joint return is filed. My interpretation of the law is pretty simple: the source of the refund will be excess withholdings. The refund should therefore be pro-rated based upon the percentage of withholdings attributable to each spouse. If a spouse does not pay anything in, he or she is not entitled to the refund.

So what does this say to the spouse who does not work outside the home, but nevertheless provides a valuable contribution? Not much, I'm afraid, except that neither the law nor the life guarantees a result that is altogether fair to every one all the time

The basis of my position is Gordon v. United States, 757 F.2d 1157, 1160 (11th Cir. 1985). Gordon is, admittedly, a tax case. The court reasoned that the question of "who owns what" part of a tax refund depends upon who paid in what withholdings. "Where spouses claim a refund under a joint return, the refund is divided between the spouses, with each receiving a percentage of the refund equivalent to his or her proportion of the withheld tax payments. See, e.g., Rosen v. United States, 397 F. Supp. 342 (E.D.Pa.1975); United States v. Mooney, 400 F. Supp. 98 (N.D.Tex.1975)."

The issue has also been addressed in a bankruptcy context in the Middle District of Florida, where the court held:

"The filing of a joint tax return does not affect the underlying property interests of the parties. U.S. v. Elam, 112 F.3d 1036, 1038 (9th Cir. 1997). Spouses filing a joint return have separate interests in any overpayment, the interest of each depending upon his or her income, i.e., an overpayment is apportionable to a spouse to the extent that he or she contributed to the overpaid tax." Rosen v. United States, 397 F. Supp. 342, 343 (E.D. Pa. 1975). See also Gordon v. United States, 757 F.2d 1157, 1160 (11th Cir. 1985) ("Where spouses claim a refund under a joint return, the refund is divided between the spouses, with each receiving a percentage of the refund equivalent to his or her proportion of the withheld tax payments."); Gens v. United States, 230 Ct. Cl. 42, 673 F.2d 366, 368 (Ct. Cl. 1982), cert. denied, 459 U.S. 906, 74 L. Ed. 2d 167, 103 S. Ct. 209 (1982), and reh'g denied, 459 U.S. 1081, 74 L. Ed. 2d 642, 103 S. Ct. 503 (1981) (holding that Wife was not entitled to any part of the overpayment for failure of proof that she paid any part of it). Claimant's interest in the refund check therefore equals the amount which she contributed to the 1991 income taxes."
In re Jones, 219 B.R. 631, 635 (Bankr. M.D.Fla. 1998).

So back to my simple formula: ownership of tax refunds directly correlates to the amount contributed to withholdings by each taxpayer. This position does strike me as wholly consistent with the rationale of the court in Gordon.

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Just reading this one causes all twelve of my hairs to stand on end. The case is Marathon Petroleum Co. v. Cohen [In re Delco Oil, Inc.], Case No. 09-11759, 2010 U. S. App. LEXIS 5452 (March 16, 2010). Here is what happened.

Debtor files Chapter 11, and wants to fund continued operations with cash collateral and files a motion seeking court approval. The creditor secured in the cash collateral objects vehemently. The bankruptcy court takes about 3 weeks to rule, at which point it denies the debtor's motion to use cash collateral. In the meantime, the debtor has been purchasing product from Marathon, and paying for it (with the cash collateral), all post- petition. The case eventually converts to Chapter 7 (without cash collateral, the Chapter 11 case was toast), and the Chapter 7 trustee seeks recovery of the approximately $1.9 million paid to Marathon by debtor for the purchase of post-petition goods. The bankruptcy court agrees, holding that the payments were unauthorized post-petition transfers of estate property avoidable under Sections 549(a) and 363(c)(2). Score one (a big one) for the trustee; the11th Circuit affirms.

Section 549 of the Bankruptcy Code is an avoidance section specifically directed to post-petition transfers. It allows the trustee to avoid a post-petition transfer "that is authorized only under section 303(f) or 542(c) OR "that is not authorized under this title or by the court." Since the bankruptcy court did not approve the use of cash collateral, and did not authorize the the post-petition business arrangement with Marathon, the payments made to Marathon were recoverable by the Chapter 7 Trustee.

The lesson here was a tough one: if you want to sell to a Chapter 11 debtor, be sure to call creditor's counsel first, and avoid a very nasty learning experience. Post-petition transfers of estate property must be court authorized.

Here's something you don't see every day! About 8 months into a confirmed Chapter 13 plan, debtor-husband's mother dies leaving him (1) a $162,000 IRA; (2) $20,000 equity in real property; (3) $14,000 in a bank account; and, (4) a late model vehicle. Debtors blew most of it, then sought conversion from Chapter 13 to Chapter 7, ostensibly due to an impending job layoff. The case converted to Chapter 7, but the trustee sought a variety of remedies to recover the value of the inherited property.

Clearly, the inherited property was a post-confirmation asset of the Chapter 13 estate. When a Chapter 13 converts to 7, Section 348(f)(1)(A) provides that "property of the estate in the converted estate shall consist of property of the estate, as of the date of the filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion." In other words, the Chapter 7 estate essentially consists of what the debtor owned when the Chapter 13 was filed.

There is, however, an exception which I've only seen rarely applied. Section 348(f)(2) provides that if the conversion is made in "bad faith," the property of the Chapter 7 estate consists of everything at conversion. Judge Rhoades found from the totality of circumstances that the conversion in this case was in bad faith. The trustee was accordingly permitted to seek recovery of the dissipated assets on the theory the stay had been willfully violated, in addition to the traditionally asserted avoidance actions.

The case is In re Mullican,417 B.R. 389 (Bankr.E.D.Tex.2008), aff'd at 417 B.R. 408 (E.D.Tex. Aug. 4, 2009).

From my perspective as a trustee, the decision highlights the importance of inquiring into the motive behind conversion. In the vast majority of cases, the need is legitimate and most assuredly done in good faith. And fortunately for Chapter 7 trustees in the Middle District of Alabama, we have an excellent Chapter 13 trustee and staff who are good to alert us to any possible assets in converted cases. What makes this case distinct is the fact that the asset was acquired after the filing of the Chapter 13, which in most instances means the converting debtor gets to keep it. Thanks.

It is very common in Alabama, and I'm sure elsewhere (as you're about to read) for customers to create accounts that are payable on death to designated beneficiary. In a bankruptcy case out of Wisconsin, the debtor received such a distribution from an account owner who died 26 days after debtor filed bankruptcy. The trustee argued that the payment was a "bequest, devise or inheritance" under 541(a)(5)(A), and therefore property of the estate. It was a nice try.

The court in In re Holter, 401 B.R. 372 (Bankr. W.D. Wis. 2009), applying state law, held that the terms "bequest," "devise" and "inheritance" meant property that passed by will or by intestate succession. The POD account was a contractual payment that just happened to be triggered by the death of the account's owner. The payment was on a contract right, and since it accrued post-petition, it was not property of the bankruptcy estate. And again, while it was a good try on the part of the trustee, the legal conclusions of the bankruptcy judge strike me as pretty solid.