BANKRUPTCY AND DIVORCE
If one party to a divorce is considering filing a bankruptcy, it is important to know that a bankruptcy can have devastating, if not catastrophic, effects on a divorce. Some of the very important things to remember about the intersection (or collision) of bankruptcy and divorce are:
These are only some highlights as to how a bankruptcy can affect divorce. More about each of these issues is discussed below. This information is intended to help you be aware of the possibly catastrophic impact of a bankruptcy on a divorce and is not intended to be legal advice as to your particular circumstances. If a bankruptcy is likely, then you should seek the advice and counsel of a bankruptcy attorney.
From the date of filing of a bankruptcy, there is an automatic 90 stay of all actions against the debtor. There are several exceptions to the automatic stay that relate to family law matters. The automatic stay does not stop the commencement or continuation of a civil action for:
Essentially, the divorce is stayed as to all property issues while the bankruptcy is pending, although other issues, such as support, custody and visitation, and in some instances, collection of support obligations, may continue.
PROPERTY OF THE BANKRUPTCY ESTATE:
“Property of the bankruptcy estate” is defined in the Bankruptcy Code. Property of the estate is created when a bankruptcy petition is filed. It includes all legal and equitable interests of the debtor in property, including all interest of the debtor and debtor’s spouse in community property that is under their sole, equal, or joint management or control or liable for an allowable claim against the debtor. What this means is that one spouse can have his/her bankruptcy dispose of all nonexempt community property. This is one of the main reasons it is so important to consider whether a party intends to file bankruptcy as that may affect how a divorce is litigated or settled.
DOMESTIC SUPPORT OBLIGATIONS (“DSO”)
What constitutes a DSO is defined in the Bankruptcy Code. A DSO is:
Unless the bankruptcy court determines that a support obligation is a “DOMESTIC SUPPORT OBLIGATION,” collection during the 90 stay or from property of the estate at anytime, is not allowed and is sanctionable conduct.
IS AN OBLIGATION A DSO OR IS IT A PROPERTY SETTLEMENT EQUALIZATION PAYMENT DISGUISED AS A DSO?
The bankruptcy court will look behind how a payment is described in the Martial Settlement Agreement or a Judgment to determine whether it is a DSO under Bankruptcy Code, as opposed to a property settlement or equalization payment. This is a question of bankruptcy law; not a question of California family law. The bankruptcy court will consider the parties’ intent or the state court’s intent and the purpose of the obligation in light of the parties’ circumstances at that the time of the DSO. The bankruptcy court will consider several factors, including:
A DSO also includes obligations "in the nature of support." This includes attorney fee awards when the fees were incurred in litigating support, expert witness fees incurred in determining support, etc. In addition, a DSO can be owed to a third party, such as the nonbankruptcy-filing party’s expert or attorney.
The reason having a bona fide DSO is so important is (1) because DSOs are not dischargeable in a Chapter 7 bankruptcy and (2) DSOs have a very high priority when a Chapter 7 trustee disburses funds to creditors. The a DSO creditor must file a claim in the bankruptcy. If there is any question that your support order is a DSO, you can file a Declarative Relief action in the bankruptcy case to have the court make a determination as to whether your order is a DSO and entitled to preference and will be nondischargeable in Chapter 7 bankruptcy.
Other family law obligations, other than DSOs, are also nondischargeable in a Chapter 7 bankruptcy; however, they are treated as general, unsecured creditors for disbursement purposes and do not have any priority when funds are disbursed in a Chapter 7 bankruptcy. These obligations are treated the same as credit card debt would be treated.
UNWINDING PRE-PETITION PAYMENTS
The Chapter 7 trustee can avoid or unwind certain pre-petition payments. Trustees have two primary avoidance powers: (1) Preferences; and (2) Fraudulent conveyances.
PREFERENCES: A preference is a pre-petition transfer of the debtor’s property to a creditor within 90 days of the bankruptcy filing (a year if the transfer is to an insider), on an antecedent debt while the debtor is insolvent. A Chapter 7 trustee can avoid preferential payments and obtain a judgment against the creditor who received those payments. However, a payment of a bona fide DSO IS NOT an avoidable preferential payment. In settling a family law case, parties must be very cautious regarding pre-petition payment of an equalization payment in the division of community property because non-DSO payments (such as an equalization payment) could determined by the bankruptcy court to be preferential payments, and parties will need to find an affirmative defense to protect these payments.
FRAUDULENT CONVEYANCES: A Chapter 7 trustee may also avoid fraudulent conveyances or transfers, both under the Bankruptcy Code’s fraudulent conveyances law and California’s Uniform Fraudulent Transfer Act. Fraudulent conveyances include:
Payments and property transfers made under Martial Settlement Agreements or judgments may be avoided as fraudulent conveyances if the payments/transfers are done with the intent to hinder, delay, or defraud creditors. An excellent example of a fraudulent conveyance that was avoided by the bankruptcy court was the In Re Beverly bankruptcy case. In that case an attorney was facing a large malpractice lawsuit. There were only two very large assets in his divorce: (1) $1,000,000 in an ERISA Retirement account and a house worth $1,000,000. Funds in an ERISA account are not “property of the bankruptcy estate.” The Martial Settlement Agreement awarded the ERISA $1,000,000 retirement to him and the nonexempt home worth $1,000,000 to his wife. He then filed a Chapter 7 bankruptcy to avoid liability under the lawsuit claiming as his property only the $1,000,000 ERISA account. The bankruptcy court found that this division of his and his wife’s community property was undertaken with the intent to hinder, delay or defraud his creditors and the bankruptcy court set it aside, thereby making the nonexempt $1,000,000 house available to satisfy creditors claims. In addition to that, the bankruptcy court also denied his Chapter 7 discharge because of this fraudulent conduct. This case is an excellent example of how you settle your divorce cases, when a bankruptcy is likely, can have disastrous consequences.
IMPORTANT CHAPTER 13 ISSUES
Chapter 13 is only available to individuals, and it requires that the Chapter 13 debtor make monthly payments to a Chapter 13 trustee who disburses those funds to creditors under a Chapter 13 plan. Chapter 13 plan will not be approved if the Chapter 13 debtor is delinquent on a DSO that becomes payable after the petition filing date, if the DSO is required by a judicial or administrative order. The Chapter 13 plan must pay the DSO in full (although this provision can be waived by the creditor). The Chapter 13 debtor will receive a Chapter 13 discharge only if he is current on his/her post-petition DSOs.
Further, the scope of the Chapter 13 discharge is greater than the Chapter 7 discharge. While DSOs are non-dischargeable in a Chapter 13, non-DSO family law obligations, such as an equalization payment on the division of property, are dischargeable in Chapter 13. The remedies for the DSO creditor is to object to the Chapter 13 Plan. The DSO creditor can also object if the Chapter 13 debtor is not current on DSO payments.
THIS ARTICLE IS FOR INFORMATION ONLY AND IS NOT INTENDED AS LEGAL ADVICE FOR PARTICULAR, INDIVIDUAL CASES. This article is a general statement of how bankruptcy and family law intersect. It is not intended to be legal advice pertaining to any particular individual case. You are advised to seek legal counsel in both bankruptcy law and family law to advise you concerning your matters.