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On Feb. 4, the Ninth Circuit U.S. Court of Appeals, in a 2-to-1 opinion, affirmed a long-standing pre-bankruptcy planning strategy of converting non-exempt assets to exempt assets shortly before filing a petition in bankruptcy, In re Steven H. Stern, 00-56526. This decision will give comfort to attorneys who represent individual debtors and advise their clients to follow the above strategy. When an individual debtor files a petition in bankruptcy, particularly under Chapter 7, his or her assets come under the jurisdiction of the bankruptcy court. The debtor is entitled to list and claim under federal and state law certain assets that are exempt from the court’s jurisdiction. If no one objects to the claimed exemptions (or if after an objection the court allows the exemptions), the listed assets are no longer part of the debtor’s bankruptcy estate and revest in the debtor. There are myriad exemptions under both federal and state law, but the philosophy behind the exemption laws is to allow a debtor to shield essential, life-supporting assets from creditors as good social policy. In the bankruptcy context, exemptions are seen as part of the process of allowing an honest debtor to obtain a “fresh start.” For decades it has been a common practice among bankruptcy practitioners who represent individual debtors to rearrange the debtor’s assets prior to filing bankruptcy in order to maximize the debtor’s exempt assets. This often requires that the debtor convert non-exempt assets into exempt assets. This may involve selling a non-exempt asset and purchasing an exempt asset or transferring money from a non-exempt account into an exempt account. In the Stern case, on the eve of filing bankruptcy the debtor transferred a presumably sizable amount of money from a non-exempt Individual Retirement Account into an exempt profit-sharing plan maintained by his wholly owned corporation. (The opinion does not disclose the size of the account, but the dissent refers to it as substantially all of the debtor’s property. The opinion also does not explain why the IRA was nonexempt.) A judgment creditor and the trustee in bankruptcy objected to the transfer on the ground that it was fraudulent and should be set aside with the funds becoming part of the bankruptcy estate. The bankruptcy court granted summary judgment in favor of the debtor’s exemption claim, and that decision was affirmed on appeal by the district court. The Ninth Circuit, following a 32-year-old decision, Wudrick v. Clements, 451 F.2d 988 (1971), also affirmed and held that the mere transfer of a nonexempt asset to an exempt asset standing alone is not a fraudulent transfer. The court suggested that if other elements of fraud were present, the transfer might be fraudulent; but it agreed with the bankruptcy court that the trustee had not produced such evidence. Bankruptcy trustees have chafed under the Wudrick decision for decades and have frequently sought ways to evade its holding. They have had some success in other circuits in carving out exceptions to the rule enunciated in Wudrick, to the point where in some cases the exceptions seem to have swallowed the rule. E.g., In re Krantz, 97 B.R. 514 (Bkrtcy. N.D. Iowa 1989), cited in the dissenting opinion in Stern. Trustees and courts who have sought ways around the Wudrick rule often have done so in cases where the amount of the property transferred was substantial, as compared to Wudrick where the debtor borrowed $1,300 on a nonexempt vehicle and deposited the money in an exempt credit union account. Indeed, the court in Krantz rather candidly admitted that the size of the transaction was a factor in finding an exception to the general rule. 97 B.R. at 524-6. One senses that the same issue bothered the dissenting judge in Stern, who as noted above, described the assets transferred to the exempt plan as substantially all the debtor’s assets. It is difficult to justify an exception to the rule enunciated in Wudrick based on the size of the transaction. If the state in question allows substantial exemptions (in some states the debtor’s residence may be exempted to its full value regardless of the amount), a rule that denies the right to transfer assets to take advantage of such liberal allowances has a feel of judicial policy-making based only on particular judges’ sensibilities. Furthermore, with a greatly inflated dollar as compared to its value in 1971, what might have seemed inconsequential then may appear substantial now. In sum, the amount of the money transferred does not seem a principled basis on which to draw a distinction between allowing debtors to take or not take advantage of exemption laws provided for their benefit. Where to draw the line seems clearly to be legislative function. In any event, the Stern decision reassures the bankruptcy bar that the practice long followed by it of advising prospective bankruptcy debtor to transfer assets into exempt categories before filing bankruptcy remains a viable strategy. In fact, most practitioners probably would consider it negligent not to provide such advice to a client planning to file bankruptcy, especially after Stern. John T. Hansen is a partner in the San Francisco office of Nossaman, Guthner, Knox & Elliott. He is co-chair of the firm’s bankruptcy practice.

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