The Bankruptcy Code has what is known as the “strong arm clause.” It allows the trustee to avoid or cut off claims against the debtor’s property such as unperfected security interests, improper liens, and other undisclosed claims that existed before the bankruptcy petition was filed. In the case of the unperfected security interests, creditors that claim to have security interests can have those rights avoided or set aside by the trustee using Section 544(a) of the Code. The trustee can use the strong-arm powers if there was an actual creditor who could challenge a transaction, or a hypothetical creditor. If there could have been a creditor who could have challenged a transaction, the trustee can step into that hypothetical creditor’s place and have the transaction set aside.
This section of the Code also permits the trustee to set aside transactions which are in violation of state law and are unfair to creditors. For example, under a states fraudulent transfer law, the trustee could step into the place of one of the debtor’s unsecured creditors and challenge the debtor’s transfer of real property to a spouse, other relative another person which was made with the intent to frustrate, delay, or hinder a creditor’s efforts to collect on their debts.
A fraudulent transfer is any transfer of property by the debtor with the intent to hinder, delay, or defraud creditors or the trustee. Actual transfers of money or property to hide it from creditors or the trustee is one form of fraudulent transfer. Another typical fraudulent transfer includes conveying title to real estate or placing such property into a trust. Intent can be inferred, and based on the totality of the circumstances. A trustee can recover fraudulent transfers that occurred within one year of the bankruptcy filing, or under applicable state fraudulent transfer laws. In Washington State the look-back period is four years. The trustee can sue the beneficiary of the transfer either for the value of the property or its return.
A trustee can also avoid and recover preferences, which are defined as transfers of money or property by the debtor to or for the benefit of a creditor on account of a pre-existing debt made at a time when the debtor is insolvent, and the transfer allows the creditor to receive more than would otherwise be entitled to from the estate had the transfer not been made. Such a transfer made within 90 days of the bankruptcy filing, or within one year if the creditor is an insider, is recoverable. No fraudulent intent is required in such cases. It is the timing and effect of the transfer that is the controlling factor. Typically, a trustee will send a letter demanding repayment of the preference before filing a lawsuit. Trustees will usually settle the preference claim to avoid the cost of litigation.
There are exceptions to preference liability. Even if the trustee can prove all of the elements of a preferential transfer, the creditor may be excepted from liability if: (1) the transfer was a contemporaneous exchange for value; (2) the transfer was made in the ordinary course of business between the creditor and debtor or was made according to ordinary business terms/industry standards; (3) new value was given in exchange for the payment; (4) security interests given to secure a new value; (5) the creditor is fully secured or has a perfected statutory lien, or; (6) the payments are less than $600 in aggregate, or $5,000 in non-consumer cases.
A debtor in a Chapter 11 case, as a debtor-in-possession, has all of the powers and obligations of a Chapter 7 trustee, including the duty to investigate and avoid fraudulent transfers and preferences if the estate is insolvent. The debtor-in-possession may shirk this duty because it requires the debtor to sue the people the debtor just transferred property to in the first place. Failure of a debtor-in-possession to pursue avoidance and the recovery of fraudulent transfers or preferences is grounds for appointment of a trustee.