Attorney’s Fees For Fraudulent Transfer Deemed Not Dischargeable

One of the most interesting and talked about creditor-debtor — and thus asset protection — cases in recent years was the one which was the subject of my article Lawyer, Law Firm And Bank Exposed To Civil RICO And Other Liability For Assisting A Debtor Post-Claim In Kruse (Nov. 24, 2021). As the article title suggests, this case involves a debtor who engaged in a number of transfers after a car wreck with the specific purpose of defeating the judgment enforcement rights of the very seriously injured victim in that accident. Today, we examine a subsequent ruling in that case which further illustrates that post-claim planning can not only fail, but also put the debtor in a much worse position than if nothing had been done at all.

Christina Kruse won a judgment in excess of $2.5 million against Steven Weller arising out of a auto accident. Later, Kruse brought a fraudulent transfer lawsuit against Weller and others to set aside Weller’s post-claim transfers of his assets to family member and a newly-created LLC. The Iowa state court ultimately entered an order in 2018 which set aside these fraudulent transfers. These are the background facts.

More salient to today’s discussion, Kruse’s attorney Justin Swaim filed a fee affidavit and the Iowa state court awarded Kruse the amount of $100,000 in attorney fees.

Meanwhile, Weller filed a voluntary Chapter 7 bankruptcy petition in the U.S. Bankruptcy Court for the Southern District of Iowa. If successful, this petition would have wiped out Kruse’s $100,000 attorney fees award. To prevent this, Kruse, along with Swaim and his law firm (to whom the fees were ultimately owed), filed an adversary action in the bankruptcy court to declare the attorney fees to be non-dischargeable. Weller objected to the adversary action, and Kruse moved for summary judgment which resulted in the opinion in In re Weller (Kruse v. Weller), Case No. 22-30011-ALS (Bk.S.D. Iowa, March 6, 2023), which will next be discussed.

Kruse argued that because the attorneys fees were awarded pursuant to her fraudulent transfer action, those fees were not dischargeable under the U.S. Bankruptcy Code. Weller argued in his defense that he relied upon the advice of his counsel in making the transfers, and then reversed the transfers once he learned the advice he had received was bad. All this raised issues under two bankruptcy statutes, 11 U.S.C § 523(a)(2)(A) and 523(a)(6) and each shall be examined in turn.

Section 523(a)(2)(A) reads:

“(a) A discharge . . . not discharge an individual debtor from any debt — * * *

“(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by—

“(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition . . ..”

The phrase “actual fraud” has been interpreted by court decisions to include fraudulent transfers under the intent test, which is UVTA § 4(a), and which basically has only one element: The debtor made the transfer with the intent of defeating the collection rights of a creditor.

That Weller intended to defraud Kruse was the finding of the Iowa state court in Kruse’s fraudulent transfer action, and the bankruptcy court would hold that finding to be dispositive in this non-dischargeability action as well. If the underlying action resulting in a finding of “actual fraud” results in an attorney fees award, then the attorney fees are not dischargeable as well. Thus, under § 523(a)(2)(A), Weller’s discharge of the attorney fees award would be denied.

The other statute involved here is § 523(a)(6) which reads:

“(a) A discharge . . . does not discharge an individual debtor from any debt — * * *

“(6) for willful and malicious injury by the debtor to another entity or to the property of another entity . . ..”

This section does not require anything like a finding of fraud, only that the debtor meant to hurt somebody or their property (the “willful” part), and did indeed end up wrongfully hurting them (the “malicious injury” part). This has been interpreted to mean that where a debtor intends to and does harm the collection rights of a creditor, a “willful and malicious injury by the debtor” has occurred.

Here too, the Iowa state court had made a finding in awarding the attorney’s fees in the first place that Weller had acted with the desire to hurt Kruse’s collection rights, and did in fact harm those collection rights, and thus the Iowa state court’s prior findings would be dispositive here as well.

In the end, the bankruptcy court overruled Weller’s objections and held that Kruse’s $100,000 attorney’s fee award could not be discharged.

ANALYSIS

The biggest lesson of this case is something that I’ve preached for a long time: Fraudulent transfers can not only fail to protect assets, but they can easily put the debtor into a much worse position than if they had never done anything at all. That’s exactly the outcome of this case: Weller’s attempts to transfer his assets away was avoided by the Iowa state court, which also awarded Kruse $100,000 in attorney’s fees, and those fees were not dischargeable which effectively means that Weller can never discharge them.

Yet, some asset protection planners continue to tell their clients a big fat lie: “So what if you make a fraudulent transfer, since it only gets unwound and you’re not any worse off than if you had not tried.” As this case shows, nothing could be further from the truth. If you hear somebody tell you that, you should run because they are either deliberately lying or, most likely, they really don’t have any clue about that they are yacking about.

Another lesson of this case goes to Weller’s defense that he did not have the requisite intent for the attorney fee award to not be dischargeable because he relied upon the advice of his counsel, and then attempted to unwind his transfers when he discovered that he had received bad advice. The bankruptcy court simply overlooked this defense and did not even mention it in the opinion for a simple reason: It is not a defense to non-dischargeability under § 523(a). Weller might have a good claim for malpractice against his attorney for giving him the bad advice in the first place, but that is for another case if he decides to pursue it. Here, before the bankruptcy court, it just doesn’t matter. If a debtor had the intent, they lose their discharge, and it doesn’t matter one whit how they came to that intent.

Attorney opinion letters are of dubious value in fraudulent transfer cases generally, because they similarly do not negate intent there either. What those opinion letters can do, however, is to attempt to mitigate any claims of punitive damages that a creditor might attempt to tack on to a fraudulent transfer judgment. That too is a discussion for another day.

For a debtor, losing a right to the discharge of a debt is an awful thing because that means the debtor can never get rid of the debt by any means other than either paying it in full or settling with the creditor, and the creditor usually has little incentive to settle. Over the years, I’ve had to represent folks in judgment enforcement proceedings who had debts that were not discharged, and their stories of being perpetually hounded by their creditors were heartbreaking. On the other hand, what they had done to render their debt not dischargeable in the first place was usually something that would dispel much sympathy for them — they made their own bed and are now being forced to lie in it. Bankruptcy judges will often bend over backwards to give a debtor a discharge, in line with the often-stated purpose of the bankruptcy procedure to give debtors a “fresh start” in their financial lives. Thus, when a bankruptcy judge does deny a discharge, it is usually because the debtor has done something really awful.

The courts have held that fraudulent transfers are one of those things. Take heed.