Bankruptcy Procedure in the Context of Turnover and Preference Law
BB&K Attorney Cathy Ta Authors a Look at Bankruptcy Law for Los Angeles Lawyer
By Cathy Ta
In the course of collections activities, a creditor can become singularly focused on aggressively pursuing enforcement of a debt by levying against the debtor’s property or by demanding and receiving payment from the debtor. However, if and when a debtor files for bankruptcy, the creditor may become the target of unwanted litigation when it levied against or received property that, through the mere occurrence of the debtor’s bankruptcy filing, is considered property of the bankruptcy estate. Thus, the creditor becomes part of the bankruptcy estate trustee’s litigation efforts to marshal property back into the bankruptcy estate under either turnover or preference law, depending on whether the creditor’s collections activities extinguished the debtor’s interest in property prior to the bankruptcy filing.
To put a bankruptcy estate trustee’s marshaling efforts against a creditor into context, it is helpful to understand that today’s bankruptcy law exists to provide a debtor a financial “fresh start” from burdensome debts. As stated by the Supreme Court in 1934, the law’s purpose has both a public and a private interest, in that “it gives to the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.”1
To provide this fresh start, modern bankruptcy law has been formulated as an exchange between a debtor and his creditors of assets for a discharge. This exchange is rooted in Congressional legislation passed in 1833, abolishing the English-originated legal practice of imprisonment for debt and paving the way for today’s decriminalization of bankruptcy.2 Fundamental to effectuating this modern exchange are the several ways in which the current Bankruptcy Code provides for the maximization and marshaling of a debtor’s assets from the way in which property of the estate is broadly defined to turnover and preference law provisions. These recovery tools are designed to maximize payment to creditors on a ratable basis, so that when a discharge is ultimately granted to a debtor, the exchange is not only modern, but fair.3
Property of the Estate
Under the Bankruptcy Code, a major tool for maximizing a bankruptcy estate is how property of the estate is defined, which includes 1) all nonexempt “legal or equitable interests of the debtor in property,” as of the bankruptcy filing—otherwise known as the petition date,4 2) all interests of the debtor and the debtor’s spouse in community property as of the petition date,5 and 3) certain property that the debtor acquires (or becomes entitled to acquire) within 180 days after the petition date.6
Property of the estate is also defined to take into account a trustee’s marshaling work against creditors by including property in which a debtor has no possessory interests as of the petition date but which the trustee recovers from creditors.7 Moreover, the term “property” has been generously construed to include “all kinds of property, including causes of action, disputed, contingent or reversionary interests, and all other forms of property.”8
Turnover and Preference Law
A bankruptcy estate trustee has two principal tools to recover property that was levied by or paid to a creditor prior to the petition date. They are turnover and preference law.
Under the Bankruptcy Code, turnover law is focused on bringing back property of the estate that is in the hands of a third party so that the bankruptcy estate trustee may monetize the property for the benefit of the bankruptcy estate and its creditors. Specifically, turnover law applies when a noncustodian9 entity10 is in possession, custody, or control of estate property at any time during the case, and the property is of a type that a trustee may use, sell, or lease, to the benefit of creditors.11 Unless the property is of inconsequential value or benefit to the estate, the entity is required to deliver and turn over the property or its value to the trustee.12
In fact, this turnover power has been construed to allow a trustee to recover property or its value from a creditor who once had, but no longer has, possession, custody, or control of the property at the time a turnover motion is filed.13Current possession, custody, or control is not required, but possession, custody, or control at any time during the case is sufficient.14 By allowing a trustee to seek recovery from any creditor so long as it had possession, custody, or control of estate property at some point during the case reinforces the principles underlying turnover law, which are to marshal assets back into the bankruptcy estate and to affirmatively require a creditor to turn over estate property that comes into the creditor’s possession.
Similarly, preference law is aimed at bringing back property of the estate into the hands of a third party, but unlike property subject to turnover law, this property had been transferred to the third party prior to the petition date. Additionally, preference law serves the additional purpose of guarding against a debtor who, while sliding into bankruptcy, favored one creditor over another by making a payment or other transfer to that creditor. Preference law avoids the preferential transfer so that the recovered property may be marshaled back into the bankruptcy estate to be redistributed ratably among its creditors.
Specifically, under the Bankruptcy Code, any transfer made by a debtor within 90 days of the petition date15 is statutorily defined as preferential if and when the transfer is made to or for the benefit of a creditor, for or on account of an antecedent debt, and the result of which enables the creditor to receive more than it would have received—in a Chapter 7 liquidation, had the transfer not been made— and in the bankruptcy case, as otherwise provided for under the Bankruptcy Code.16
There are some defenses, for example new value, ordinary course of business, and contemporaneous exchange.17 However, in essence, under preference law, a creditor is targeted for recovery on account of a certain payment or transfer statutorily defined as preferential so that assets may be marshaled back into the estate for a ratable distribution to creditors.
Whether a trustee uses turnover or preference law against a creditor will depend on whether there was a transfer in ownership or title of property. If there was an incomplete transfer, the debtor and the estate would retain some identifiable property interest that would be included in the broadly defined property of the estate, and turnover law would apply. If there was a complete transfer in ownership or title, the debtor and the estate would not maintain any identifiable property interest to be included in property of the estate. In this circumstance, the property must be recovered first through avoidance of the transfer before the property may be included in property of the estate.18
Whether there was a transfer in ownership or title of property prior to the petition date will depend on state law. While bankruptcy law provides for what a debtor’s interests in property is included in property of the estate, it is state law that determines the extent of a debtor’s interests, if any, in property itself.19
In re Churchill Nut Co. is an unusual case that highlights how turnover and preference law are two sides of the same coin.20 In this case, a walnut grower delivered 236 tons of walnuts to the debtor, a nut processor, for processing. After receiving minimal payment, the grower sued the debtor for damages and to foreclose on its producer’s lien. The grower obtained a judgment in its favor and thereafter obtained a writ of execution. The sheriff levied on the writ by seizing 166 tons of shelled nuts from the debtor, but before the actual sale of nuts, the debtor filed for bankruptcy. The bankruptcy court found that under California law when the sheriff seized the shelled nuts, possession was transferred to the benefit of the grower. However, this transfer did not extinguish the debtor’s interest in the shelled nuts because 1) they were still subject to other producers’ liens and 2) they were tangible property with uncertain value that had to be liquidated into money in order to effectuate a title transfer. As a result, the grower and the sheriff, as a custodian of the debtor’s property, were ordered to turn over the shelled nuts to the bankruptcy estate trustee.
Had the sheriff completed the sale prior to the debtor’s bankruptcy filing, so that the only duty left for the sheriff would be to turn over money to the grower,21 the sale would have extinguished the debtor’s interest prior to the bankruptcy filing and placed the money outside of turnover law. Nevertheless, the sale would be subject to avoidance under preference law as the sale would be a preferential transfer from the debtor to the grower.
In contrast to In re Churchill Nut Company, in which there was a money asset involved, In re Paul22 was a case in which the California State Board of Equalization levied the debtor’s bank accounts—a money asset— prior to the petition date. The bankruptcy court held that under California law, at the moment the notice of levy was served, ownership of the funds transferred to the Board. As a result, the bankruptcy court concluded that the funds were not property of the estate and therefore would only be recoverable as a preferential transfer.
Even when a money asset is involved, however, there may be a scenario in which a creditor’s levying activities will not terminate or overcome a debtor’s interest in the money asset because the debtor’s interest may be special or superior to any one creditor’s claim. In Hernandez23, the sheriff levied funds on behalf of a judgment creditor but had yet to turn them over to the creditor when the bankruptcy was filed. The Bankruptcy Appellate Panel for the Ninth Circuit U.S. Court of Appeals found that the levied funds were exempt Social Security benefits; therefore, ownership had not transferred. “Because debtor had an exempt property interest in the [Social Security] funds, we conclude that [the creditor’s] levy did not operate to extinguish those interests.”24
Another distinctive and nuanced scenario involving levying a money asset is a wage garnishment. In the Carlsen case,25 the IRS levied wages that had been earned prepetition. Because in California a wage garnishment merely creates a lien and does not divest the debtor of all interest in the wages, the bankruptcy court held that the garnished wages constituted property of the estate. The court determined that the IRS had a duty to take positive action to halt the post-petition continuation of the garnishment, and it had to return the garnished wages.26
To the extent a collection activity creates a lien, a lien may be subject to avoidance under preference law unless the lien is perfected prior to the 90-day preference period. In the Hilde case,27 the Ninth Circuit U.S. Court of Appeals found that under California law a lien is created on all of the debtor’s nonexempt personal property from the date of an order to appear for a debtor’s examination once the debtor is served with the order, otherwise known as an ORAP lien. Likewise, an ORAP lien is created on the debtor’s personal property in the hands of a third party when the third party is served with a notice of the order.28 If a turnover order is issued at the end of the debtor’s examination, another lien is created that relates back to the ORAP lien. Therefore, if a bankruptcy proceeding is filed more than 90 days after an ORAP lien is created, the ORAP lien is not avoidable under preference law and has priority over the claim of a bankruptcy trustee. In this case, the Ninth Circuit held that the ORAP lien was not avoidable because it was created more than 90 days prior to the petition date and therefore attached to all of the debtor’s nonexempt personal property in the bankruptcy.29
Under California law, creditors are within their rights and powers to proceed against a debtor to enforce and collect on debts. How - ever, creditors should be aware that should a debtor file for bankruptcy, all that a creditor may have completed, whether it be levying on property or receiving payment on the debt, may be subject to unwinding, and the creditor may be required to return property included in property of the estate. A bankruptcy estate trustee, or a debtor-in-possession in a Chapter 11 reorganization case,30 under turnover or preference law, would be tasked in the fundamental work of marshaling property of the estate for the benefit of the bankruptcy estate and its creditors, as an essential part of modern bankruptcy law.
1 Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934) (emphasis in original).
2 Charles J. Tabb, The History of Bankruptcy Laws in the United States, 3 AM. BANKR. INST. L. REV. 5, 6, 16 (1995).
3 Ehring v. Western Cmty. Moneycenter (In re Ehring), 91 B.R. 897, 903 (B.A.P. 9th Cir. 1988).
4 11 U.S.C. §541(a)(1).
5 11 U.S.C. §541(a)(2) (all community property is included in property of the estate, except for community property that is under the sole management of the debtor’s spouse).
6 11 U.S.C. §541(a)(5).
7 11 U.S.C. §§541(a)(3), 542, 543, 547, 548, 550.
8 United States v. Sims (In re Feiler), 218 F. 3d 948 (citing S. REP. No. 989 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5868; H.R. REP. No. 595 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6323 (footnote omitted)).
9 The Bankruptcy Code provides a separate section for turnover of estate property by custodians. See 11 U.S.C. §543.
10 The term “entity” is defined as including person, estate, trust, governmental unit, and U.S. trustee. 11 U.S.C. §101(15).
11 11 U.S.C. §542(a).
13 Shapiro v. Henson, 739 F. 3d 1198, 1200-01 (9th Cir. 2014).
15 This 90-day preference period is extended to one year as to insider-creditors. 11 U.S.C. §547(b)(4)(b). See also11 U.S.C. §101(31) (“insider” is defined to include an individual debtor’s relatives, general partners, partnership, and corporation of which the debtor is a director, officer, or person in control, among others).
16 11 U.S.C. §547(b).
17 11 U.S.C. §547(c).
18 United States v. Whiting Pools, Inc., 462 U.S. 198, 209 (1983). See also In re Anaheim Elec. Motor, Inc., 137 B.R. 791, 794-96 (Bankr. C.D. Cal. 1992).
19 Paul v. State Bd. of Equalization (In re Paul), 85 B.R. 850, 853 (Bankr. E.D. Cal. 1988).
20 Richardson v. Wells Fargo Bank (In re Churchill Nut Co.), 251 B.R. 143 (Bankr. C.D. Cal. 2000) (the bankruptcy court also conducted a preference analysis to conclude that the shelled nuts constituted recoverable property of the estate, but its main reasoning was that a transfer of ownership had not occurred prior to the bankruptcy).
21 See also Ramirez v. Fuselier (In re Ramirez), 183 B.R. 583 (B.A.P. 9th Cir. 1995) (The B.A.P. reversed the bankruptcy court, finding that the California levy statute did not specify that a completed levy — in this case, an installation of a keeper on the premises by the Marshal — transfers ownership in property; the property had to be liquidated; and the property of client files was necessary for the attorney-debtor’s representation of clients. The B.AP. held that the judgment debtor retained a possessory and reversionary interest in all the levied property, thus the property constituted property of the estate. The B.A.P. remanded the case to determine whether the Marshal’s violation of the automatic stay was willful and whether actual and punitive damages were appropriate.)
22 In re Paul, 85 B.R. 850.
23 Collect Access LLC v. Hernandez (In re Hernandez), 483 B.R. 713 (B.A.P. 9th Cir. 2012).
24 Id. at 724.
25 Carlsen v. Internal Revenue Service (In re Carlsen), 63 B.R. 706 (Bankr. C.D. Cal 1986).
26 But see In re Crosier, No. LAX 90-52768 VZ, 1991 Bankr. LEXIS 1102 (Bankr. C.D. Cal. July 5, 1991) (The IRS levied the debtor’s IRA prior to the bankruptcy filing. The bankruptcy court held that the IRA was intangible property and that the levy transferred title and ownership to the IRS, thus the IRA was not property of the estate).
27 Southern Cal. Bank v. Zimmerman (In re Hilde), 120 F.3d 950 (9th Cir. 1997).
28 See CIV. PROC. CODE §§708.110(d), 708.120(c).
29 See, e.g., Dewhirst v. Citibank (In re Contractors Equipment Supply Co.), 861 F. 2d 241, 245 (9th Cir. 1988) (The debtor gave a creditor a security interest in its accounts receivable. The debtor then contracted with a company to provide equipment before filing bankruptcy. The debtor completed the order post-petition and the company paid the debtor direct instead of the creditor. The Ninth Circuit held that the accounts receivable were part of the estate because the assignment involved only a security interest, not a transfer title; therefore, the debtor retained an interest in the accounts receivable and was sufficient to bring the accounts receivable into the debtor’s reorganization estate.)
30 11 U.S.C. §1107(a) (a Chapter 11 debtor-in-possession shall have all the rights, powers, and duties of a trustee, except for the right to compensation).
This article originally appeared in the September 2016 edition of Los Angeles Lawyer magazine, a publication of the Los Angeles County Bar Association. Reprinted with permission.
Cathy Ta is no longer with BB&K. If you have questions about this issue please contact Caroline Djang at firstname.lastname@example.org.