This past week, I attended a two-day training by the American Academy of Matrimonial Lawyers. It covered various topical issues in our profession. Programs like this are always great to refresh memory regarding issues we don’t necessarily deal with in every case. One refresher course covered the intersection of bankruptcy and divorce. I wanted to share key points from this reeducation.
Bankruptcy and Divorce. A basic education on bankruptcy is a good start. Bankruptcy is a legal process to eliminate debt. It becomes necessary when paying it off in full is impossible. Bankruptcy is governed by federal law, while divorce falls under state law. However, the two often overlap. There are three types of bankruptcy that individuals typically utilize. By far, the most popular is Chapter 7, a liquidation bankruptcy. The individual’s property is liquidated, except for a few protected types. The proceeds pay off the debt. This is the quickest type and does not include a payment plan.
Alternatively, a Chapter 13 case requires a 3 to 5-year payment plan. Most of these plans fail before completion. Most Chapter 13s eventually convert to Chapter 7’s. Chapter 11 bankruptcy is mainly for businesses. However, individuals with high debt or income may also qualify for it.
Financial Strain on Marriage. Financial difficulty is a common hardship in marriages. Many couples face this challenge at some point. We also know from our other discussions about divorce, that equitable distribution requires a fair allocation of all assets and debt of a marriage. So, before we go further, consider the importance of timing between a bankruptcy and a divorce. Certain situations require a strategic approach, especially regarding the timing and cooperation of spouses. This is critical in filing bankruptcy.
Bankruptcy can make Divorce Unfair. Let’s take an example to illustrate the point. Assume the marriage is irretrievably broken, so divorce is inevitable. Bankruptcy will not affect this outcome. The parties have $50,000 in joint credit card debt, $50,000 in a personal loan to the husband, and $50,000 in non-exempt assets. Without bankruptcy, a logical distribution would be $25,000 each to the husband and wife from the non-exempt assets. Then, distribute the $50,000 in credit card debt to the wife and the $50,000 in personal loan to the husband. Let’s assume the interest rates were comparable, making the distribution a fair one. So each spouse has $25,000 in assets and $50,000 in debt.
Now, let’s say the husband files a Chapter 7 bankruptcy. The bankruptcy trustee, who oversees the bankruptcy, takes possession of the $25,000 in non-exempt assets. Then the $25,000 proceeds pay off the husband’s personal loan. The remaining balance is then discharged.
In that example, the husband’s result is that he has no exempt property and no debt. He is at net zero. The wife, on the other hand, is still at negative $25,000 net. Considering the bankruptcy, is that a fair result in the divorce? Maybe a better question is, if the parties had collaborated on the best possible outcome for both parties, given the divorce and bankruptcy, was a better result available?
Why Not Work Together to Maximize the Bankruptcy in the Divorce? Now, you may be thinking, why not just give all the debt to the husband and all the assets to the wife? The debt would discharge 100%, and the wife would receive the maximum assets. The husband would face no detriment. Makes sense, right? Well… Yes and no.
First, there may be a limitation on a distribution’s effectiveness if they debt is in both parties’ names. While one party may discharge debt in bankruptcy, if the other party is also responsible, the creditor may still pursue him or her, regardless of what’s in the divorce agreement. You will also recall from a couple paragraphs ago, a trustee oversees the bankruptcy estate. That is an experienced bankruptcy lawyer, trying to find assets for the bankruptcy estate, overseeing the administration of the process. Part of the trustee’s job is to identify questionable or fraudulent transfers. In certain circumstances, the trustee can force money transferred, even for a long period leading up to the bankruptcy filing, back into the bankruptcy estate.
That does make sense. Logically, people who know their assets will be taken and liquidated are likely to transfer them before this happens. The bad news for those individuals is the trustee will be looking for this. The good news is, certain types of transfers cannot be reversed. One example is transferring money to pay a DSO.
A DSO is an obligation the spouse has to pay support, such as alimony or child support. So, when the divorce lawyers understand the limitations of the bankruptcy code, they may be creative in crafting an agreement that best benefits their clients, reducing the risk of transfers reversed through the bankruptcy. Aside from DSO transfers, there may be additional opportunity to maximize the marital estate through an agreement on alimony, child support, and/or equitable distribution. Being overly ambitious in these areas can be risky. Federal common law addresses whether a transfer is support or property. If it’s a property transfer, the bankruptcy trustee may seize it. The saying “pigs get fat, hogs get slaughtered” is fitting here.
Each practice area has its own complexity. Attorneys rarely have experience in both divorce litigation and bankruptcy law. It is important, therefore, that you choose a divorce lawyer with a thorough understanding of how divorce law in bankruptcy law intersect. If you have a heavy debt load and are contemplating bankruptcy in addition to divorce, bring these issues up in your divorce attorney consultation.
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