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Bankruptcy is meant to give you a fresh start by helping you with your debts. Depending on the type of bankruptcy you file, those debts may be wiped out, or you may repay them over time according to a court-approved payment plan. In either case, a main concern in any bankruptcy is fair treatment of your creditors.
The bankruptcy laws give bankruptcy trustees tools to help make sure your creditors are treated fairly. One is the ability to void or set aside certain transfers of and liens against your property. Bankruptcy debtors and creditors alike should know how these avoidance powers work.
Avoidance Actions and Powers
A trustee files an avoidance action or proceeding to set aside or avoid a transaction. It’s a special legal action where the trustee asks the court to undo or invalidate, among other things, transfers of or liens against your property that may have popped up before or after you filed for bankruptcy.
The bankruptcy strong-arm statute gives a trustee the power to step into some of your creditors’ shoes to undo a transaction so that all of your creditors can benefit. The statute covers a few possible situations, but it’s most commonly used in three: unperfected liens on personal property, real property transactions and unsecured creditors’ claims.
At the time you file for bankruptcy, the trustee is treated as someone with a judicial lien against your personal property, even though the trustee doesn’t really in fact have such a lien. A judicial lien is one authorized by a court, such as one to enforce payment of a court judgment against you. It’s a strong lien and has high priority in a bankruptcy.
If a creditor with a lien against your property doesn’t perfect its lien, or perfects it improperly, before you file for bankruptcy, the trustee can avoid it. The process for perfecting liens is set by the laws in your state. For example, say you borrow money from a bank and use your boat as collateral. You later file for bankruptcy. If the bank’s lien on the boat isn’t perfected at the time you file for bankruptcy, the trustee can avoid it.
The net effect is that the boat can be used to pay the claims of all of your unsecured creditors. The bank will likely get a share, but not nearly as much as it would have been paid if it had perfected its lien against the boat.
Real Property Transfers
Nearly the same thing happens when it comes to real property. When you file for bankruptcy, the strong-arm statute makes the trustee a bona fide purchaser of real property. As such, the trustee can avoid a mortgage or deed of trust on your real property if it wasn’t properly recorded before you filed for bankruptcy.
For example, say that several months before you filed for bankruptcy you bought some land as an investment and gave a bank a mortgage. The bank didn’t record the mortgage in the county records office where the land is located. So, someone who was looking to buy the land probably wouldn’t find the bank’s mortgage and wouldn’t know about its claim. It doesn’t matter that your land wasn’t in fact for sale!
Again, the trustee can avoid the mortgage, and the land can be used to pay your unsecured creditors’ claims.
Using the same bankruptcy statute, the trustee can stand in the shoes of a real, identifiable unsecured creditor if that creditor could have raised a state law claim against you.
The most common example is a fraudulent conveyance. In practically every state, if you transfer money or property to someone else with the intention of frustrating, hindering or delaying a creditor’s efforts to collect a debt you owe, the creditor can ask a court to undo the transfer. The trustee can step into that creditor’s shoes and do the same.
For example, say you’ve made the decision to file for bankruptcy, and a few months before filing, you give all your money and assets to your spouse as a “gift.” You then file for bankruptcy before your creditors discover the transfer and before they can file a lawsuit against you. The trustee can step in and have the transfer set aside. The property and assets can then be used to pay all of your unsecured creditors’ claims.
The trustee, however, has to identify a real unsecured creditor who was harmed by the transfer. This makes it different than the other two situations where the trustee steps into the shoes of a hypothetical lien holder or bona fide purchaser.
When Will a Trustee Use the Strong-Arm Statute?
As a practical matter, trustees won’t use the strong-arm powers unless there’s a significant amount of money or property at stake. It’s not worth the time and expense of an avoidance action to go after something that won’t benefit most if not all creditors. So, trustees typically look very carefully at real estate mortgages and liens on major personal property items, like cars and business equipment.
The trustee’s duty is to protect creditors, and they’ll do that even if it costs some creditors dearly, or even if it costs you. After all, voided liens and transfers can mean the loss of property or higher repayments for you.
Both creditors and bankruptcy debtors can take steps to protect themselves. Creditors should make sure their security interests are in order. Debtors should check with their attorneys before transferring or encumbering property before filing, and should tell their attorneys about any irregularities they may notice in liens and mortgages.
Questions for Your Attorney
- Is a trustee appointed in every bankruptcy case?
- Can I use the strong-arm law if a trustee refuses to?
- Can a trustee reopen a bankruptcy case to use the strong-arm law?