Bankruptcy Attorney Explains Arm's Length Transfers

Being a practicing somekeyword sure makes it easy to come up with blog post ideas. As usual, this is another post inspired by a client's question. The question was whether it was possible to sell assets in the time period leading up to a chapter 7 filing (in her case, the contemplated sale would occur about two months before filing). The answer was, of course, it depends (how else do bankruptcy attorneys ever answer a question?) on the amount the debtor receives for the item sold. If the item is sold at a price approaching or exceeding the market price, there is no problem. If it's given away or sold for below the market price, there probably will be an issue.

Section 544 of the Bankruptcy Code allows the bankruptcy trustee to "avoid" (undue) certain transfers of property made by the debtor in order to hinder creditors. These sorts of transfers most typically involve either gifts or sales to family or friends that are not made at "arm's length," i.e. they are made for less than the market price. A transaction is arm's length if a reasonable person would have made the same transaction as the one at issue with a total stranger. It turns out that it doesn't matter to the arm's length test whether the transfer is a sale or a gift. The concept is most easily explained using a hypothetical.


Hypothetical One: I own a baseball card collection with a market price of $20,000. Also imagine that I've used up all of my bankruptcy exemptions and I believe I'm going to have to turn over my collection to the chapter 7 trustee so it can be sold to pay off my unsecured creditors. However, I can't stand my creditors because they've been calling me daily about my overdue accounts. I figure, if I can't keep the collection I don't want the creditors to get it either. So I call my brother and offer to give the collection to him. He's never been one to look a gift horse in the mouth, so he accepts. How will the bankruptcy trustee treat this transaction (assume that I disclose it to her)?

Hypothetical Two: same facts, except instead of giving the collection to my brother, I sell it to him for $5,000. How will the bankruptcy trustee treat that transaction?

Analysis of Hypothetical One: the trustee will look at the transaction to determine if it was made at "arm's length." Would a reasonable person give away a $20,000 baseball card collection to a total stranger? Obviously not, therefore the giveaway is not an arm's length transaction. The trustee will seek to undue the gift using the powers given to her by Section 544. She will demand that my brother to turn over the collection to the bankruptcy estate. If he refuses, say because he believes the trustee has no power to make that demand because he wasn't the person who filed bankruptcy, the court will likely issue an order compelling him to turn over the collection anyway.

Analysis of Hypothetical Two: the trustee will ask whether a reasonable person would sell a $20,000 collection to a stranger for $5,000? Again, the answer is no. This sale was not an arm's length transfer. In this case, she will demand that my brother turn over the collection. Assuming he does so, she will then give him his $5,000 back.

In these examples, I had no other motive behind these transactions other than to reduce the amount available to pay back my creditors. These are exactly the sorts of transactions Section 544 is designed to undue. As a somekeyword, my advice if you're contemplating this sort of transaction is going to be don't bother. The trustee will avoid it anyway.

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