Conversion of nonexempt to exempt property is not, per se, fraudulent or unlawful. [In re Daniel, 771 F2d 1352 (CA9 1985); HR.Rep. No. 595, 95^th Cong., 1st Sess. 361 (1977); S.Rep. No. 989, 95^th Cong. 2d Sess. 76 (1978)] However, pre-bankruptcy planning, including conversion of nonexempt to exempt property is an area into which only the uninformed rush; the informed enter slowly and cautiously.

As a rule, conversion of nonexempt to exempt property does not present a problem unless, within one year of the date preceding filing, a debtor converts the property with an "intent to hinder, delay or defraud a creditor." [BC §§ 548(a)(1); 727(a)(2); see Matter of Love, 341 F2d 680 (CA9 1965)] Unfortunately, the line of demarcation between legitimate pre-bankruptcy planning and transfers with the intent to hinder, delay or defraud is anything but sharp, clearly defined, and straight--it is indistinct, wavy and, only too frequently, elusive. Pre-bankruptcy planning pits maximization of exemption benefits provided by law against the risk that conversion of nonexempt to exempt property will result in denial of the claim of exemption, avoidance of the transfer, a denial of discharge, or some combination. The consequences of a mistake can be disastrous!

The purpose of this article is to alert practitioners involved in pre-bankruptcy planning with some of the pitfalls involved, starting with an analysis with the language of the Code: "intent to hinder, delay or defraud."

First, note that "hinder, delay or defraud" is in the disjunctive; consequently, if the transfer is made with the requisite intent to either "hinder" or "delay" or "defraud" it is proscribed. Although often used almost synonymously or interchangeably, each has a somewhat different meaning. As commonly used, "hinder" is to make slow or difficult a process, stressing causing harmful or annoying interference; "delay" is to stop, detain or hold back in time, usually by interference; and "defraud" is to deprive of something by deception or fraud. Thus, one may "hinder" without delaying or defrauding or "delay" without fraud. [In re Adeeb, 787 F2d 1339 (CA9 1986)] On the other hand, although theoretically possible, it is difficult to conceive that "defrauding" a creditor would not also have the effect of hindrance and delay.

Second, as a practical matter, any transfer of nonexempt property to exempt property has the effect of hindering or delaying a creditor. However, it is not the effect of the transfer that governs, but the intent of the debtor in making the transfer. Conversely, the "no harm--no foul" rule does not apply; the fact that no creditor was injured by the debtor's action is irrelevant. [In re Adeeb, supra] A debtor, at least one represented by reasonably competent counsel, is not likely to testify that the intent was other than a legitimate attempt to make full use of what the law expressly sanctions -- the keeping of exempt property. Moreover, the conversion of nonexempt to exempt property standing alone does not establish wrongful intent; extrinsic evidence, which may be circumstantial, is required to establish that element. Accordingly, one must focus any inquiry in this area on those factors that constitute an indicia or badge of wrongful intent. [In re Carey, 938 F2d 1073 (CA10 1991)]

Before getting to the specific cases let us review several "basic" rules in this area. (1) The law to be applied may differ: if state exemptions are elected, state law is determinative of whether the exemption is allowed but federal bankruptcy standards always apply in determining discharge. [Norwest Bank, Nebraska v. Tveten, 848 F2d 871 (CA8 1988)] (2) The burden of proof when a claim of exemption or discharge is at issue is on the objecting party. [FRBP 4003(c); 4005] (3) Both exemptions and exceptions to discharge are construed liberally in favor of the debtor and strictly against the objecting party. [Augustine v. United States, 675 F.2d 582 (CA3 1982) (federal exemptions); Gutterman v. First National Bank of Anchorage, 597 P.2d 969 (Alaska 1979) (Alaska exemptions); In re Adeeb, supra (discharge)] (4) Although the standard applied in determining whether to allow an exemption claim or to deny discharge may be the same, the breadth of the factual inquiry differs. When a exemption claim is at issue, only the transaction(s) related to the exemption claim are relevant. On the other hand, when discharge is at issue, the entire panoply of the debtor's course of transactions is brought under scrutiny, including activities unrelated to the exempt property. [Matter of Armstrong, 931 F2d 1233 (CA8 1991)]

At this point it is appropriate to enter two caveats. First, the cases in this area are fact specific and generally involve a combination of factors. Second, the reader is reminded that, as usual with these articles, the cases cited are neither exhaustive nor all-inclusive; they are merely representative.

The factors the courts rely on in determining whether an intent to "hinder, delay or defraud" exists include: (1) concealment of the pre-bankruptcy conversions [In re Smiley, 864 F2d 562 (CA7 1989); (2) misrepresentations made to creditors regarding the transactions [McCormick v. Security State Bank, 822 F2d 806 (CA8 1987); (3) proximity in time between the conversion and the filing [In re Reed, 700 F2d 986 (CA5 1983)]; (4) continued use of or retention of a beneficial or economic interest in the converted nonexempt property by the debtor or members of debtors family [In re Cadarette, 601 F2d 648 (CA2 1979); Matter of Swift, 3 F3d 929 (CA5 1993)]; (5) intra-family transfers [Matter of Swift, supra; In re Wojalta, 113 BR 332 (Bkrtcy.ED.Mich 1990)]; (6) conversion in close proximity to or in anticipation of the entry of a judgment against the debtor [In re Schmit, 71 BR 587 (Bkrtcy.D.Minn 1987)]; (7) obtaining credit to acquire exempt property [In re Reed, supra]; (8) borrowing against nonexempt property and using the proceeds to reduce the debt on exempt property, thereby increasing the equity [Matter of Smiley, supra; but see Wudrick v. Clements, 451 F2d 988 (CA9 1971)]; (9) conveyances for less than adequate consideration [Panauska v. Johnson, 880 F2d 78 (CA8 1989)]; (10) conversion coupled with "wastrel spending" [Matter of Bowyer, 916 F2d 1056 (CA5 1990); and (10) monetary value of the nonexempt property converted [Norwest Bank, Nebraska v. Tveten, supra].

Although, as noted above, each case is fact specific and generally include several factors, what appear to be common threads are: (1) attempts to conceal the transactions and (2) the monetary amount involved.

Activity designed to conceal the transactions is frequently treated by the courts as ipso facto conclusive evidence of an intent to hinder, delay or defraud. However, the courts also usually require some active concealment--passive concealment alone being insufficient. While one does not necessarily have an obligation to volunteer information to creditors, activity designed to conceal from, or the providing of incomplete or misleading information to, creditors is most definitely frowned upon.

Going too far is perhaps best illustrated by two frequently quoted homilies: "pigs get fattened, hogs get slaughtered" or "when a pig becomes a hog, it is slaughtered." In short, while it may be all right to be piggish, do not get hoggish -- it leads to the slaughterhouse! One court has noted, "[a]s the finder of fact, the bankruptcy court has the primary duty to distinguish hogs from pigs." [Matter of Swift, supra]

Clients engaging in pre-bankruptcy planning are well-advised that if one is to err, err on the side of caution. Clients should be emphatically advised: (1) do not try to hide the transactions, (2) do not over do it and (3) if in doubt, don't. Although clients generally resist unpleasant advice, should he or she be denied the claimed exemption and a discharge (the "bankruptcy death penalty") will be an even less pleasant message. Also, playing the game too close to the line can result in a no-win situation for the debtor. The cost of defending the transactions against an attack by one or more creditors may exceed the economic benefit derived from pre-bankruptcy conversion of nonexempt to exempt property. This "net bottom-line" aspect is only too frequently overlooked or ignored. While it may benefit debtor's counsel (assuming he or she is paid for the services rendered), it is of no benefit to a debtor to increase exemptions by $5,000 and spend $5,000, or more, successfully defending against an adversary action to bar discharge.

Finally, the "advice of counsel" defense must be considered. In general, a debtor who, in good faith and after making a full and complete disclosure of all relevant facts, acts on the advice of his or her attorney lacks the requisite intent to hinder, delay or defraud. [In re Adeeb, supra] However, if both counsel and debtor are aware that the intent of the transaction(s) is to hinder, delay or defraud a creditor, the defense is inapplicable. [Id.] Also, where the debtor is sophisticated, experienced and well-versed in financial matters, the court may reject the "advice of counsel" defense. [See Cummings v. Sea Lion Corporation, 3 ABR 371 (D.Ak 1994)] Moreover, if the advice is not well-grounded in law or fact (assuming a full and complete disclosure of the relevant facts), the attorney may wind up with an unhappy malpractice carrier as well as an irate client.

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