The U.S. Court of Appeals for the Fifth Circuit recently held that the collection of garnished wages earned during the 90 days prior to the filing of a bankruptcy petition is an avoidable transfer, even if the garnishment was served before the 90-day preference period.
The ruling creates a potential split with the Second, Seventh, and Eleventh Circuits, with the Fifth Circuit joining with the Sixth Circuit on the issue.
A copy of the opinion in Tower Credit v. Schott is available at: Link to Opinion.
A creditor obtained a money judgment in state court against the debtor and served a garnishment order on the debtor’s employer in January 2012. In November 2012, the debtor filed a Chapter 7 bankruptcy proceeding in the Bankruptcy Court for the Middle District of Louisiana.
In 2014, the bankruptcy trustee filed an adversary proceeding seeking to recover the money collected under the garnishment order within the 90 days prior to the filing of the petition pursuant to 11 U.S.C. § 547(b).
The bankruptcy court granted summary judgment in the bankruptcy trustee’s favor and the district court affirmed on appeal. The creditor appealed to the Fifth Circuit, arguing that “the garnished wages should be considered transferred on the date the garnishment order was served, before the preference period, and therefore that the trustee is not entitled to recover them.”
The Fifth Circuit began by citing the text of 11 U.S.C. § 547(b), noting that issue was the fourth element of § 547(b), which states that “[t]he trustee may avoid any transfer of an interest of the debtor in property … (4) made—(A) on or within 90 days before the filing of the petition…”
The Court explained, “What constitutes a transfer and when it is complete is a matter of federal law[,] [while] [s]tate law generally determines the nature of the property interests involved in purported transfers, but only ‘[i]n the absence of controlling federal law.’”
The Fifth Circuit further explained, “Section 547(e) provides the governing principles that determine the timing of a transfer … [and] a transfer is generally made at the time it is ‘perfected,’ … which, in the context of non-real property, occurs when ‘a creditor on a simple contract cannot acquire a judicial lien that is superior to the interest of the transferee.’ However, § 547(e)(3) qualifies that general principle and provides that ‘a transfer is not made until the debtor has acquired rights in the property transferred.’”
The Court cited in support its ruling in In re Latham from 1987, which held that “[a] lien that is perfected outside the preference period does not attach to property rights transferred to the Debtor during the preference period,” and Tabita v. IRS, a 1984 bankruptcy case out of the Eastern District of Pennsylvania, which held that “wages earned within [the] preference period are subject to preference even though [the] writ of attachment was served beyond the preference period.”
The Fifth Circuit then cited a 1934 Supreme Court of the United States ruling in Local Loan Co. v. Hunt, in which the Supreme Court held, “in the context of a bankruptcy discharge dispute, ‘[t]he earning power of an individual is the power to create property, but it is not translated into property within the meaning of the Bankruptcy Act until it has brought earnings into existence.’”
Thus, the Fifth Circuit reasoned, citing the Sixth Circuit’s 2001 ruling in In re Morehead, “in the wage garnishment context, a debtor cannot logically obtain rights in her future wages until she performs the services that entitle her to receive those wages. … The Morehead court therefore held that ‘when wages are earned during the preference period, transfer of those wages pursuant to garnishment order is avoidable under … § 547(b).’” Because the debtor “had not earned the disputed wages before the ninety-day preference period, he had acquired no rights to those wages and, under § 547(e)(3), could not have transferred such rights to [the creditor] prior to the preference period.”
The creditor cited three case in which the Second, Seventh, and Eleventh Circuits “held that a transfer of garnished wages occurred at the time the garnishment was served on the employer,” but the Court distinguished them because two of them did not address “the effect of § 547(e)(3), and both predated [the Supreme Court’s decision] that federal law governs the determination of whether and when a transfer occurred.”
The Fifth Circuit disagreed with the Seventh Circuit’s ruling, which held “that the execution of a garnishment acted as a novation of all of the debtor’s interests in the wages under Indiana law so that there could not have been a transfer within the preference period … [and § 547(e)(3) was] inapplicable because the debtor ‘will never acquire rights in the portion of his or her wages to be garnished in the future’ as those were ‘irrevocably transferred to the garnishment plaintiff.’”
The Fifth Circuit explained that the Seventh Circuit’s conclusion “conflicts with § 547(e)(3)’s instruction that no transfer of an interest in property is made before the debtor acquires rights in the property,” the Seventh Circuit’s case was also decided before the Supreme Court’s decision that federal law governs the determination of whether and when a transfer occurs, and the Seventh Circuit itself held in 1995 that earlier “cases holding that a transfer occurs when a notice of garnishment is served … did not survive the Supreme Court’s decision.”
Given that “[t]he Supreme Court precedent and the overwhelming weight of persuasive authority applying § 547(e)(3) make clear that a debtor’s wages cannot be transferred until they are earned,” the Fifth Circuit held that “a creditor’s collection of garnished wages earned during the preference period is an avoidable transfer made during the preference period even if the garnishment was served prior to that period …” and affirmed the district court’s judgment.