Proceed Carefully in Bankruptcy Law

by Anne Massie Nelson

EVEN DURING THIS TIME OF record personal wealth, the waiting rooms of bankruptcy lawyers are full of people who can no longer escape the bill collectors. Hat in hand, they come to the lawyer wondering which chapter of the bankruptcy code comes after "The End."

Bankruptcy gives people a chance at a fresh start, but few emerge from the process completely satisfied. When debts outlive the bankruptcy or property is lost, clients look for someone to blame, "and they rarely look in the mirror," says Mark Bromley, whose practice with Kinney & Urban, in Lancaster, is about 50 percent bankruptcy.

Lawyers who practice in other areas and suggest bankruptcy as a remedy to a client or who take a bankruptcy case to accommodate a long-term client are flirting with danger. Legal malpractice claim statistics show that lawyers who do not routinely practice bankruptcy law are more likely to make mistakes.

"Before you advise someone to take the cleansing waters of bankruptcy, you had better know where the pitfalls are," says Paul G. Swanson of the Oshkosh firm of Steinhilber, Swanson, Mares, Marone & McDermott.

To reduce your liability, Bromley and Swanson recommend that you become knowledgeable about bankruptcy law and its many nuances, educate clients about the process and their responsibilities, and document all information exchanged between the client and your firm.

Perhaps the most important skill you can develop is knowing when to ask for advice or when to refer the matter to an experienced bankruptcy practitioner. "Bankruptcy law is of sufficient complexity that even those of us who practice it daily have to study the code and apply it to the facts. If you apply the same law to different facts, the outcome will be different," Bromley says.

Become Knowledgeable

The traditional methods of developing competency - attending continuing legal education seminars, consulting reference manuals, using client questionnaires and checklists, reading specialty publications - apply to the complex and continually changing area of bankruptcy law. Lawyers who concentrate their practices in other areas need to know enough about bankruptcy law to competently advise clients who are considering bankruptcy.

"For example, if you tell a divorce client, 'Don't worry about the property settlement, you can wipe that out in bankruptcy,' you need to know that the way you handle something now may make it a nondischargeable asset later," Swanson says.

Lawyers and their clients fall into traps when they:

1) Neglect to properly convert assets to exempt assets before filing bankruptcy. "If you don't advise clients to convert nonexempt assets to exempt assets, you could be accused of not zealously representing your clients. On the other hand, the actions of clients who maximize exemptions will be closely scrutinized," Bromley points out. "Exemption planning is like the difference between tax avoidance and tax evasion. You are walking on thin ice."

Failing to perfect the asset conversion also can cause problems. For example, if clients purchase a home but don't live in it, they could lose the $40,000 homestead exemption allowed by law.

2) Undervalue exempt assets or fail to list assets. In Payne v. Woods, 13 BCD 991, the debtors undervalued their exempt household goods. When a fire destroyed the items, the insurance company paid the actual cash value of the items. The bankruptcy court held that the debtors were entitled only to the value they claimed, with the balance going to their bankruptcy estate to pay debts.

Undervaluing or failing to list assets is a client error rather than the lawyer's error, at least in theory. Proving that the lawyer was not colluding with the client could be difficult if a question arises later.

3) Overlook tax obligations when planning for bankruptcy. Taxes become dischargeable debts two years after the tax return is filed, but not until three years after the date (including extensions) the taxes are due. "Debtors who must sell business assets often will incur capital gains taxes. You may need to advise them to wait three years to file bankruptcy. Otherwise, the unpaid tax obligation will outlive the bankruptcy," says Bromley.

Educate Clients

Paradoxically, as you become more proficient in a complex area of law, you may need more frequent reminders to speak in terms your clients can understand. The language you use every day is not easily comprehended nor retained by the person who has never filed bankruptcy and never plans to again.

Here are some points you need to communicate to clients:

1) You must tell the whole truth. Clients need to know that falsifying bankruptcy documents they sign under oath is perjury. Deceptively converting assets, tricking creditors into delaying debt collection, or deliberately converting assets to create insolvency is bankruptcy fraud. Using credit to acquire exempt assets or converting assets after entry of a large judgment is suspect and will lead to closer scrutiny, according to Bromley.

"Telling clients 'You could go to jail or pay a fine if you lie' usually gets their attention," he says.

2) You may not keep income that is not yours. Once the bankruptcy petition is filed, all assets become part of the client's estate, just as though he or she had died. The bankruptcy trustee is the only person with access to the assets, including accounts receivable or other money owed to the petitioner before the filing. "This can be a problem for small business owners who are tempted to use receivables from the business to pay bills," Bromley notes. In rare cases, the court allows the bankruptcy petitioner to continue farming or operating a business to preserve the value of the estate; however, profits from the ongoing concern go to the trustee.

3) Even a windfall can be bad news. An inheritance, property settlement from a divorce, proceeds from a life insurance policy, or any significant gifts received within 180 days of filing the bankruptcy petition must be reported to the bankruptcy court and trustee. "You need to ask your client if he or she has any reason to expect an inheritance or gift," advises Bromley.

For example, if the client is filing for reorganization under chapters 12 or 13, assets acquired in this way while the plan is in effect are included in the bankruptcy. "The client may then question why you did not recommend filing for liquidation under Chapter 7, where the client would be in and out of bankruptcy and could keep any inheritance or gift received after 180 days," Bromley says.

Document Your Work

Get the client's statement of financial affairs in writing. Require clients to complete and sign a questionnaire, listing all known assets and liabilities. The questionnaire should include a statement that the information is factual and complete, to the best of the clients' knowledge. Bromley uses a questionnaire that closely follows the bankruptcy schedule plus some specific questions he has developed during 20 years of practice.

Send clients an informed consent letter. "In the medical malpractice context, 'informed consent' requires that the physician recommending a procedure disclose the significant risks known to reasonably well-qualified practitioners, the probability of success, alternative procedures, and any other information needed for a reasonable person to make an informed decision," Bromley explains.

Lawyers recommending bankruptcy procedures need to make similar disclosures to avoid being held liable for damages. For a sample informed consent letter, see the accompanying sidebar.

Confirm in writing when you refer a client to another attorney. This letter should clearly state that you are no longer representing the client. For example, you might write: "Thank you for meeting with me recently to discuss your financial situation. I have referred you to Attorney Smith, who is knowledgeable about bankruptcy, which may be an appropriate course for you to consider. Please let me know if I can assist you with other matters in the future."

Wisconsin Lawyer