This past week I attended a two-day training by the American Academy of Matrimonial Lawyers on a variety of topical issues in our profession. Programs like this are always great to refresh memory of issues we don’t necessarily deal with in every case. One of the refresher courses dealt with the intersection of bankruptcy and divorce, so I figured I would share some key points from this fresh reeducation.
Bankruptcy and Divorce. A basic education on bankruptcy is a good start. Bankruptcy is the legal mechanism to dispose of debt when paying it off in full has essentially grown beyond your reach. Bankruptcy is federal law, whereas divorce is state law, yet the two are so often interwoven. There are three types of bankruptcy that individuals typically utilize. By far, the most popular is Chapter 7, a liquidation bankruptcy. This is the type of bankruptcy in which an individual’s property is liquidated, with the exception of a handful of protected property types, and used to pay off 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 which fail at some point before they conclude. Most Chapter 13s eventually convert to chapter 7’s. Chapter 11 bankruptcy is typically relegated to businesses, but if an individual’s debt or income is high enough, there may be a reason to put an individual debtor through and 11.
Financial Strain on Marriage. Taking a step back, we know financial difficulty is a common hardship faced in marriages. 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. There are all sorts of situations that require a strategic approach, particularly focused on the timing and cooperation of the spouses, as they pertain to the filing of a bankruptcy.
Bankruptcy can Make Divorce Unfair. Let’s take an example to illustrate the point. Let’s say for this example that the marriage is irretrievably broken and that the divorce would be inevitable whether bankruptcy was filed or not. So, let’s say in this example that the parties have a $50,000 in joint credit card debt, another $50,000 in a personal loan to the husband only, and non-exempt assets valued at $50,000. If there is no bankruptcy, a logical distribution would be to distribute the non-exempt assets, $25,000 each to each the husband and the wife. 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 husband’s personal loan is paid with the proceeds of the $25,000 and the remaining balance is 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? Then 100% of the debt would have been discharged and the wife would have received the maximum assets without any detriment to the husband. 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 are going to be taken away and liquidated are likely to try to transfer them out of their names prior to this occurring. The bad news for those individuals is the bankruptcy trustee will be looking for this. The good news is, there are certain types of transfers that cannot be reversed. One such type is when money is transferred for the payment of what is called 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. Getting too ambitious in these areas can be risky as there is an entire body of federal common law devoted to whether a transfer is in the nature of support or whether it is in the nature of a property transfer, the latter of which would make it more likely to be taken by the bankruptcy trustee. The expression “pigs get fat, hogs get slaughtered” it’s fitting here.
Every practice area has its complexity and it is uncommon for an attorney to be well experienced 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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