Monday, November 01, 2010

Unhappily Ever After: Family Law Issues in Bankruptcy

This paper was originally presented to the West Texas Bankruptcy Institute on October 29, 2010.

Love and marriage,
Love and marriage
Go together
Like a horse and carriage
This I tell you brother
You can't have one without the other

--Frank Sinatra

While love and marriage may go together, divorce and bankruptcy are frequently companions as well. Spouses who have had financial difficulties prior to divorce will find that they only get worse once they split up. Then there are the couples who enjoy fighting so much that they will take the battle to any court they can find. The Bankruptcy Abuse Prevention and Consumer Protection Act shifted the battlefield in several areas, some of which are obvious and others of which are more subtle. This paper will examine the intersection between family law and bankruptcy law in the case of three recurring fact patterns:

(a) The couple who has gotten divorced where one spouse files bankruptcy to try to escape the consequences of the divorce (the “Pursued Ex-Spouse”);

(b) The couple who is still together where only one spouse files bankruptcy (the “Dilemma of the Non-Filing Spouse”); and

(c) The couple who transfers assets to the non-filing spouse (the “Friendly Break-Up).

However, before getting into the specific scenarios, it is necessary to define some terms. There are two types of marital-related debts in bankruptcy: Domestic Support Obligations and everything else. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 replaced the prior category of alimony, maintenance and support with the newly defined term of Domestic Support Obligation. The defined term “Domestic Support Obligation” appears in 11 U.S.C. §362(b)(2), 507(a)(1), 523(a)(5), 1129(a)(14) and 1325(a)(8).

Under 11 U.S.C. §101(14A):

(14A) The term “domestic support obligation” means a debt that accrues before, on, or after the date of the order for relief in a case under this title, including interest that accrues on that debt as provided under applicable nonbankruptcy law notwithstanding any other provision of this title, that is—

(A) owed to or recoverable by—

(i) a spouse, former spouse, or child of the debtor or such child’s parent, legal guardian, or responsible relative; or

(ii) a governmental unit;

(B) in the nature of alimony, maintenance, or support (including assistance provided by a governmental unit) of such spouse, former spouse, or child of the debtor or such child’s parent, without regard to whether such debt is expressly so designated;

(C) established or subject to establishment before, on, or after the date of the order for relief in a case under this title, by reason of applicable provisions of—

(i) a separation agreement, divorce decree, or property settlement agreement;

(ii) an order of a court of record; or

(iii) a determination made in accordance with applicable nonbankruptcy law by a governmental unit; and

(D) not assigned to a nongovernmental entity, unless that obligation is assigned voluntarily by the spouse, former spouse, child of the debtor, or such child’s parent, legal guardian, or responsible relative for the purpose of collecting the debt.

This definition contains a lot to digest. However, at its core, it still covers alimony, maintenance and support. The following chart summarizes the boundaries of a Domestic Support Obligation (DSO):

Who May Assert a DSO?

A spouse, former spouse, or child of the debtor or such child’s parent, legal guardian, or responsible relative or a governmental unit. While it is not expressly set out in the statute, some courts hold that an attorney for a spouse or child may also assert a Domestic Support Obligation.

What Can Make Up a DSO?

A debt in the nature of alimony, maintenance, or support (including assistance provided by a governmental unit)

When Can a DSO Arise?

Before, on or after the date of the petition.

Where Can a DSO Arise?

In a separation agreement, divorce decree, or property settlement agreement; an order of a court of record; or a determination made in accordance with applicable nonbankruptcy law by a governmental unit.

What Is Not a DSO?

A debt assigned to a nongovernmental entity, unless that obligation is assigned voluntarily for the purpose of collecting the debt.

Non-DSO marital debts are only referenced in 11 U.S.C. §523(a)(15). It applies to debts owed:

(15) to a spouse, former spouse, or child of the debtor and not of the kind described in paragraph (5) that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit.

Using the same format, Non-DSO marital debts can be summarized as follows:

Who May Assert a Non-DSO marital debt?

A spouse, former spouse, or child of the debtor.

What Can Make Up a Non- DSO marital debt?

A debt that is not a DSO.

When Can a DSO Arise?

Before the date of the petition.

Where Can a DSO Arise?

In the course of a divorce or separation or in connection with a separation agreement, divorce decree or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit.

I. The Pursued Ex-Spouse

The best advice that you could give to someone contemplating bankruptcy to escape obligations arising from a divorce is don’t. Generally bankruptcy will afford very little relief from divorce-related obligations and in some cases a debtor will be much worse off in bankruptcy court than in state court.

A. The Automatic Stay

The first thing that the Pursued Ex-Spouse will notice is that many actions related to a divorce may continue to proceed notwithstanding the automatic stay. Under 11 U.S.C. §362(b)(2), the automatic stay does not apply to:

(2) under subsection (a)—

(A) of the commencement or continuation of a civil action or proceeding—

(i) for the establishment of paternity;

(ii) for the establishment or modification of an order for domestic support obligations;

(iii) concerning child custody or visitation;

(iv) for the dissolution of a marriage, except to the extent that such proceeding seeks to determine the division of property that is property of the estate; or

(v) regarding domestic violence;

(B) of the collection of a domestic support obligation from property that is not property of the estate;

(C) with respect to the withholding of income that is property of the estate or property of the debtor for payment of a domestic support obligation under a judicial or administrative order or a statute;

(D) of the withholding, suspension, or restriction of a driver’s license, a professional or occupational license, or a recreational license, under State law, as specified in section 466(a)(16) of the Social Security Act;

(E) of the reporting of overdue support owed by a parent to any consumer reporting agency as specified in section 466(a)(7) of the Social Security Act;

(F) of the interception of a tax refund, as specified in sections 464 and 466(a)(3) of the Social Security Act or under an analogous State law; or

(G) of the enforcement of a medical obligation, as specified under title IV of the Social Security Act;

Most aspects of a divorce proceeding are not subject to the automatic stay. The non-bankruptcy court can issue orders establishing or modifying DSOs, establishing child custody and visitation and dissolving the marriage. The only thing that the non-bankruptcy court cannot do is determine the division of property of the estate.

If a DSO is already owed, §362(b)(2)(B) provides that wage withholding may continue and the creditor may collect the DSO from property that is not property of the estate, such as post-petition earnings in a chapter 7 proceeding or exempt property. In one recent case, the Bankruptcy Court found that a DSO creditor’s attempts to collect from exempt property did not violate the automatic stay because the debts were non-dischargeable and the automatic stay contains an exception for collecting DSOs from property which is not property of the estate. In re MacGibbon, 383 B.R. 749 (Bankr. W.D. Wash. 2008).

Section 362(b)(2)(C) goes further, allowing withholding from property of the estate under a judicial or administrative order or statute. In re Gellington, 363 B.R. 497 (Bankr. N.D. Tex. 2007)(although finding that garnishment by state violated confirmed chapter 13 plan).

In another case, the Court found that the State’s suspension of the debtor’s driver’s license for failure to pay support fell within the exception of section 362(b)(2)(D). In re Penaran, 424 B.R. 868 (Bankr. D. Kan. 2010).

B. Dischargeability of Divorce-Related Obligations

The Pursued Ex-Spouse will also learn that it is difficult if not impossible to discharge marital debts. The provisions governing dischargeability have evolved substantially over the years. When the Bankruptcy Code was adopted in 1979, obligations for alimony and support were non-dischargeable, but property settlement debts could be discharged. In 1994, the Bankruptcy Code was amended to include 11 U.S.C. §523(a)(15), which provided that divorce debts other than alimony and support would be non-dischargeable if a timely adversary proceeding was filed and a balancing test was not met. Finally, in 2005, the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 amended Section 523(a)(15) to eliminate the balancing test as well as the requirement to file an adversary proceeding. Thus, property settlement debts have gone from being always dischargeable to never dischargeable.

Given the broad scope of Sections 523(a)(5) and (a)(15) are there any marital debts which can be discharged in bankruptcy?

1. One narrow exception is that non-DSO marital debts may be discharged in chapter 13 proceedings, but not chapter 11 cases. Under 11 U.S.C. §1328(a)(2), debts under Section 523(a)(5)(DSOs) are expressly made non-dischargeable, but there is no similar provision for Section 523(a)(15). In re Young, 425 B.R. 811 (Bankr. E.D. Tex. 2010). On the other hand, 11 U.S.C. §1141(d)(2) provides that the discharge of an individual chapter 11 debtor does not extend to any debts covered by Section 523.

2. Some courts have found that third party debts are dischargeable. Prior to BAPCPA, the Fifth Circuit took an expansive view of what debts could fall within §523(a)(5), finding that debts owed to third parties, such as attorneys and guardians were nondischargeable so long as they were in the nature of support. Matter of Hudson, 107 F.3d 353 (5th Cir. 1997); Matter of Dvorak, 986 F.2d 940 (5th Cir. 1993). While the Fifth Circuit has not addressed the amendments made to §523(a)(5), several lower courts have found that the reference in the amended statute to debts “owed to or recoverable by (i) a spouse, former spouse, or child of the debtor or such child’s parent, legal guardian, or responsible relative; or (ii) a governmental unit” excludes debts owed to anyone not mentioned. Section 523(a)(15) is even more narrow, referring to debts owed to “a spouse, former spouse or child.”

In one case, the Court found that “(t)he Plain Meaning rule requires that assignees, like attorneys, are excluded from protection accorded members of the immediate family.” In re Thompson, 2009 Bankr. LEXIS 2985 (Bankr. D. Md. 2009)(construing §523(a)(15)). Judge Michael Lynn has also taken a plain meaning approach to the parties covered by sections 523(a)(5) and (a)(15). In a case involving a claim by a debtor’s ex-spouse to recover attorney’s fees, he noted that the law firm was not one of the parties listed in the statute.

Even assuming the Final Judgment is a debt "in the nature of alimony, maintenance, or support," the Firm is not Debtor's spouse, Debtor's former spouse, or Debtor's child; nor Debtor's child's parent, legal guardian, or responsible relative; nor a governmental unit. As none of these, the Firm does not fall within the ambit of section 101(14A) and is not an entity to whom a "domestic support obligation" may be owed under section 523(a)(5). Similarly, only a debt "to a spouse, former spouse, or child of the debtor" is non-dischargeable under section 523(a)(15) (emphasis added). Thus, applying the plain meaning rule, the Firm is not an entity to which may be owed a non-dischargeable divorce-related debt.

In re Brooks, 371 B.R. 761, 764-65 (Bankr. N.D. Tex. 2007). Judge Lynn reached the same result in a case involving a claim by an attorney ad litem, finding that an attorney ad litem was not the same as a guardian and thus was not covered by the statute. In re Densmore, 2009 Bankr. LEXIS 3416 (Bankr. N.D. Tex. 2009).

However, other courts have found that BAPCPA did not change prior case law which did not limit claims to the specific persons listed.

In line with those recent cases that continue to rely on Kline, this Court rejects any argument that BAPCPA's additional wording weakens the dispositive impact of Kline on the instant case. The partial phrases "owed to or recoverable by" clarify but do not alter the type of debt previously characterized as nondischargeable and entitled to priority under pre-BAPCPA law. Furthermore, the fact that BAPCPA does not add attorneys to the expanded list of specific payees does not overrule Kline. Attorneys were not mentioned as payees in the pre-BAPCPA statute under which Kline was decided, but the Eighth Circuit ruled that a fee owed to an attorney could nevertheless be a nondischargeable support debt. For these reasons, this Court will follow the rule established by Kline as binding precedent.

In re Andrews, 2010 Bankr. LEXIS 2071 (Bankr. W.D. Ark. 2010) at 11-12. Interestingly, Andrews suggests that the reason the attorney’s fees would be non-dischargeable is because they would take money needed for support away from the spouse, so that in the event that the spouse was not liable for the attorney’s fees (such as if limitations had run), that the fees might not be support. Other post-BAPCPA cases treating debts to parties not specifically named as non-dischargeable include In re Blackwell, 2010 Bankr. LEXIS 1918 (Bankr. M.D. Fl. 2010); In re Burnes, 405 B.R. 654, 659 (Bankr. W.D. Mo. 2009); In re Johnson, 397 B.R. 289, 296 (Bankr. M. D. N.C. 2008). While there is not definitive appellate precedent yet, the broad view of sections 523(a)(5) and(a)(15) seems to be the majority position at this time.

3. A debtor’s obligation to pay attorney’s fees to her own lawyer did not qualify as a DSO. In re Young, 425 B.R. 811 (Bankr. E.D. Tex. 2010).

4. A debtor’s obligation to refund excess payments of child support did not qualify as a DSO. In re Vanhook, 496 B.R. 296 (Bankr. N.D. Ill. 2010). In this case, the non-debtor paid child support to the debtor until it was determined that he was not the parent. At that point, the state court ordered repayment of the child support. While the obligation to pay child support was in the nature of alimony, maintenance or support, the repayment order was not.

5. While a hold-harmless agreement in a pre-petition divorce decree could be non-dischargeable under §523(a)(15), a hold harmless with regard to debts previously discharged in bankruptcy proceeding was an improper attempt to re-impose liability. In re Heilman, 430 B.R. 213 (9th Cir. BAP 2010). The court rejected the argument that the post-petition divorce decree imposed a new obligation.

C. Exemptions

Yet another unpleasant consequence for the Pursued Ex-Spouse is that his exempt property may be reached to collect Domestic Support Obligations. Section 522(c)(1) was amended by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005. The old language stated that property exempted under section 522 was not liable except for “a debt of a kind specified in section 523(a)(1) or 523(a)(5) of this title.” The amended language stated that property exempted under section 522 was not liable except for “a debt of a kind specified in paragraph (1) or (5) of section 523(a) (in which case notwithstanding any provision of applicable nonbankruptcy law to the contrary, such property shall be liable for a debt of a kind specified in section 523(a)(5)).”

The amendment was apparently intended to legislatively overrule the result in In re Davis, 170 F.3d 475 (5th Cir. 1999). The Hon. Alan A. Ahart, “The Liability of Property Exempted in Bankruptcy for Pre-Petition Domestic Support Obligations After BAPCPA: Debtors Beware,” 81 Am. Bankr. L.J. 233 (Summer 2007). In the Davis case, an en banc Fifth Circuit held that the prior version of Sec. 522(c)(1) was not sufficient to pre-empt Texas law to the contrary. The amendment states that the property shall be liable “notwithstanding any provision of applicable non-bankruptcy law to the contrary.” This shows an express intent to pre-empt non-bankruptcy law. Furthermore, the amendment closely tracks a suggestion made by the Bankruptcy Judge in the Davis case as to how Congress could amend the statute to allow creditors to execute upon exempt property to satisfy domestic support obligations:

Had Congress intended to make exempt property liable for § 523(a)(5) family support obligations, it could have affirmatively legislated. For example, if Congress was concerned that the states have not adequately provided mechanisms for the collection of family support obligations, it could amend subsection § 522(c)(1) to read (boldface):

(c) Unless the case is dismissed, property exempted under this section is not liable during or after the case for any debt of the debtor that arose, or that is determined under section 502 of this title as if such debt had arisen, before the commencement of the case.

(1) Notwithstanding this or any other federal or state injunction of liability for exempt property, exempt property shall be liable for debts of a kind specified in section 523(a)(5) of this title.

Rather than affirmatively subjecting exempt property to liability for family support obligations, Congress did not extend the injunction against liability for family support obligations. This permits states like Texas to enact broader injunctions of liability of exempt property, protecting exempt property even from non-discharged family support obligations.

In re Davis, 170 B.R. 892, 898 (Bankr. N.D. Tex. 1994), aff’d, 188 B.R. 544 (N.D. Tex. 1995), aff’d en banc, 170 F.3d 475 (5th Cir. 1999). In his article, Judge Ahart also notes that the legislative history supports this interpretation. See n. 20.

Several bankruptcy courts have ruled that Sec. 522(c)(1) does not allow a trustee to liquidate exempt property to satisfy a domestic support obligation. In re Duggan, 2007 Bankr. LEXIS 2750 (Bankr. M.D. Fl. 2007) and cases cited therein. However, these same cases suggest, or explicitly hold, that a domestic support creditor could do so.

In In re Quezada, 368 B.R. 44 (Bankr. S.D. Fl. 2007), the Court stated:

New §522(c) (1) creates a federal right entitling DSO creditors to execute against exempt assets even if those assets would be protected from execution under state law. Although, in theory, a state court judge is perfectly capable of applying federal law, in practical terms, it appears awkward for a DSO creditor to seek relief in state court to pursue assets which are exempt from execution under state law.

These potential practical problems have no effect on the statutory analysis which controls this decision. Moreover, the lack of authority for a trustee to administer exempt property does not mean that the bankruptcy court lacks jurisdiction if a DSO creditor seeks to enforce a DSO claim against exempt property in the bankruptcy court. Under
28 U.S.C. § 1334(b) the district courts have "original but not exclusive jurisdiction of civil proceedings arising under title 11, or arising in or related to cases under title 11." Section 522(c) (1) grants DSO creditors a federal right of action against exempt property. This federal right trumps state law which may otherwise shield the asset from execution. Since this federal right is provided in the Bankruptcy Code, a proceeding to enforce that right would be a proceeding arising under title 11, thus creating jurisdiction under § 1334(b).

In re Quezada, at 49. Thus, it is possible that both the ex-spouse and the Trustee could attempt to administer exempt property for the benefit of the DSO creditor.

II. The Dilemma of the Non-Filing Spouse

While joint petitions between husband and wife are common, there is no requirement that couples file together. When just one spouse files, it may be a calculated tactical move or it may be that the spouses are estranged. Whatever the reason, the decision can have serious consequences for the non-filing spouse.

A. Property of the Estate and the Disappearing Homestead

When a debtor files bankruptcy, the bankruptcy estate includes “all interests of the debtor and the debtor’s spouse in community property as of the commencement of the case that is . . . under the sole, equal or joint management and control of the debtor.” 11 U.S.C. §541(a)(2)(emphasis added). The practical effect of this section when only one spouse files bankruptcy is that the non-filing spouse loses control of all joint management community property owned by the couple.

Furthermore, the debtor is given the sole right to claim exempt property. 11 U.S.C. §522(l). This means that the non-filing spouse will lose control over the decision to exempt joint community property (although the statute allows a dependent of the debtor to claim exemptions if the debtor fails to do so).

Several cases illustrate the dilemma of the non-filing spouse. Musso v. Otashko, 468 F.3d 99 (2nd Cir. 2006) is an extreme example. The marriage of Tanya and Vladimir Otashko was short and stormy. Married in Russia in 1992, they came to the United States, where they separated in 1997. Prior to separating, Vladimir purchased a home on Staten Island for $400,000 cash and a mortgage for $400,000. He then encumbered the property with a line of credit in favor of a Russian bank. A New York District Court found that the line of credit transaction was a fraudulent transfer designed to transfer marital assets out of the United States. Tanya then filed for divorce. After lengthy proceedings, the matrimonial court ruled that Tanya be awarded all of the marital assets, along with substantial sums for support and counsel fees. However, before the state court could enter the decree, Vladimir’s Russian creditor filed an involuntary petition against him. The order for relief was entered before the divorce decree. On appeal, the Second Circuit ruled that prior to entry of the divorce decree that the property remained joint community property. As a result, the bankruptcy trustee obtained superior title to the property to the detriment of Tanya.

Kim v. Kim, No. 3:09-CV-1082-N (N.D. Tex. 8/11/10) is another example of the pitfalls to the non-filing spouse. The Kims owned a homestead which would have been fully exempt under Texas law. However, Mr.Kim’s creditors filed an involuntary bankruptcy against him and objected to the exemption under §522(p) because the homestead was acquired within 1,215 days and had equity of more than $136,875. The District Court affirmed the Bankruptcy Court’s ruling that Mrs. Kim had no separate homestead interest entitled to protection. To add insult to injury, if the couple had filed together, they would have been entitled to an exemption of $273,750. However, because the involuntary petition was filed against only one of the spouses, they were only entitled to a single exemption.

In In re Douglass, 2008 WL 2944568 (Bankr. W.D. Tex. 2008), a husband filed a chapter 13 petition without the joinder of his wife. The homestead property was contaminated. The husband made a tactical decision not to claim the property as exempt and to cram down the value of the property (which could only be accomplished if it was not the principal residence). Years later, the house could be safely occupied once more and the wife returned to the property. If the husband had completed his chapter 13 plan, the couple would have been able to retain the property upon receiving a discharge. However, the husband sought to sell the property in order to pay off his plan early. The wife sought to be compensated for the value of her homestead interest under Texas law. The Bankruptcy Court ruled, as a matter of law, that the non-filing spouse was bound by the husband’s choice of exemptions and could not assert her own homestead interest.

Even the conclusion of a divorce is not enough to protect the ex-spouse where the parties continued to be co-tenants in former marital assets. In In re Keefe, 2009 Bankr. LEXIS 1205 (Bankr. E.D. Va. 2010), the Bankruptcy Court found that the trustee could seek a §363(h) sale of the property which was still jointly owned. However, the major difference in Keefe was that the ex-spouse was entitled to her share of the proceeds from the sale.

B. The Community Discharge Is Not Much of a Discharge

One small benefit to the non-filing spouse is the community discharge under §524(a)(3). This subsection provides that property acquired post-petition which is described in §541(a)(2)(that is, property under the sole or joint management of the filing spouse) is not liable for community claims. However, this section provides only an in rem discharge of the community property. It does not relieve that non-filing spouse from any personal liability.

C. When Will It Be Better for Only One Spouse to File?

While the cases cited above indicate the perils of only one spouse filing, there can be significant benefits. Where one spouse is liable for most of the debts and the other spouse has significant sole management or separate property, the spouse with the property will do well to remain outside of bankruptcy. However, as illustrated above, the non-filing spouse must bear the risk of loss of control over all joint property.

III. The Friendly Break-Up

Sometimes splitting spouses can remain very friendly, so friendly that their creditors might accuse them of collaborating to hide assets from creditors. Under 11 U.S.C. §541(a)(2), property of the estate includes all interests of the debtor and the debtor’s spouse that is under the sole, equal or joint management and control of the debtor. Under Texas law, married couples hold most of their property acquired during marriage as community property. Texas Fam. Code §3.002. However, community property can be transformed into separate property through gift, partition or a divorce. Tex. Fam. Code §3.001, 4.102 and 7.001. Where only one spouse is liable for the debts and there is significant non-exempt community property, spouses might be motivated to put all the good assets in the name of the non-liable spouse.

Whether this strategy works depends on when and how it is done. For example, a gift made on the eve of bankruptcy would be easily avoidable as a fraudulent conveyance. The most interesting scenarios are posed by partition and divorce.

It is worth noting that cases on marital property depend heavily on state law. As a result, the result in a case filed in Louisiana or New York might not be the same as for a case subject to Texas law.

A. Partition

Bankruptcy law will respect a legally valid partition between spouses.

We agree with the prevailing view that former community property which has been partitioned and classified as separate property of the debtor's former spouse under state law prior to the commencement of the case does not pass into the bankruptcy estate. Under section 541(a)(2) only "interests of the debtor and the debtor's spouse in community property as of the commencement of the case" may become part of the estate. Anderson's property interest in her separate property home was created and defined by state law prior to the commencement of this bankruptcy case. Unless the characterization of the property by state law conflicts with the Bankruptcy Code, "there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding." (citation omitted). We see no such conflict between the plain meaning of section 541(a)(2) of the Bankruptcy Code and the classification of Anderson's home as her separate property under state law prior to the commencement of the Debtor's bankruptcy case.

Matter of Robertson, 203 F.3d 855, 862 (5th Cir. 2000)(applying Louisiana law).

In Texas, Family Code §4.102 allows couples to partition their marital assets into separate property. However, there is a major limitation. Family Code §4.106(a) provides that: "A provision of a partition or exchange agreement made under this subchapter is void with respect to the rights of a preexisting creditor whose rights are intended to be defrauded by it."

The word “void” has serious implications as evidenced by Hinsley v. Boudloche, 201 F.3d 638 (5th Cir. 2000). Mr. and Mrs. Hinsley executed partition agreements in January and February 1989. Judgments were entered against Mr. Hinsley in 1989 and 1992. Being a patient man, he waited until 1995 to file bankruptcy. At this point, the partition agreements were some six years in the past and would have been beyond the general statute of limitations for avoiding fraudulent transfers.

The Bankruptcy Trustee sued to avoid the partition. The first time the Trustee only sued Mr. Hinsley, resulting in the judgment being ineffectual against Mrs. Hinsley. The second time, the Trustee sued Mrs. Hinsley and was granted summary judgment by the District Court. The District Court rejected a defense of statute of limitations, finding that limitations never began to run because the transfers were void.

The Court of Appeals found that summary judgment was proper because fraudulent intent could be proven as a matter of law based on badges of fraud. In this case, the transfer was made to an insider for less than reasonably equivalent value while insolvent.

The Fifth Circuit held that even if the four year statute of limitations applied, Mrs. Hinsley had failed to establish when the cause of action accrued and therefore had failed to prove her affirmative defense. The Court of Appeals held that she was required to establish an issue of material fact on when the cause of action accrued and to show that the transfer was not concealed from creditors (even though the partitions were recorded). Thus, it seems likely that either limitations never runs on a fraudulent partition agreement or a partitioning spouse with existing creditors must advertise the existence of the partition in order for limitations to begin to run.

Partition can be used to exclude property from the bankruptcy estate. However, it must almost certainly be accomplished prior to incurring the debts which result in bankruptcy. As a result, this must be a very long-term strategy and won’t succeed for someone already in financial difficulty.

B. Divorce

One consequence of divorce is that the court divides the community property between the parties. Tex. Fam. Code §7.001. Property which was once community property becomes separate property. The court has the discretion to grant an unequal distribution of community property, Tex. Fam. Code §7.001, so that creditors may find that the pool of assets they could recover from is quite diminished. This creates the opportunity for mischief when a couple with financial difficulties and substantial community property attempts to use the divorce process to accomplish what could not be done with a partition of assets. This is known as a “friendly divorce.”

At the outset, there are two limitations on this strategy. First, a divorce court can allocate liabilities as between the spouses, but cannot relieve a spouse of liability as to the creditor. Blake v. Amoco Federal Credit Union, 900 S.W.2d 108 (Tex. App—Houston [14th Dist.], 1995, no writ). Thus, if both spouses have guaranteed a business debt, awarding the debt to one spouse will not relieve the other spouse from liability. Second, the divorce court cannot award property to one spouse free and clear of liens. Boyd v. Ghent, 57 S.W. 25 (Tex. 1900). Both of these rules recognize that a legal proceeding cannot alter the rights of non-parties.

Some Texas cases go further and hold that former community property remains liable for “community debts.” Stewart Title Company v. Huddleston, 598 S.W.2d 321 (Tex. Civ. App.—San Antonio, 1980, writ ref. n.r.e)(“A spouse who receives property which would, absent a divorce, be subject to the claims of creditors remains personally liable, and the property so received remains subject to being taken to satisfy the claims of the community creditors.”). When the Texas Family Code was adopted, it did not include a category for “community claims.” As a result, these cases may no longer be valid.

Thus, where only one spouse is liable and the community property is not subject to a lien, property can be effectively placed beyond the reach of creditors. This was the scenario faced by the Fifth Circuit in Matter of Erlewine, 349 F.3d 305 (5th Cir. 2003). In that case, the state court awarded the husband a disproportionate share of the community property after a trial which lasted several days. The state court’s reasons for doing this included the fact that the husband received custody of the children, that the wife’s drug treatment had drained the community estate and the unreasonable position taken by the wife in the divorce action. The Trustee sought to set aside the unequal distribution as a fraudulent conveyance.

The Fifth Circuit agreed that the divorce decree affected a transfer, but found that there was reasonably equivalent value. The Court gave particular weight to the principle that a federal court should not set aside the result of a regularly conducted proceeding under state law. The Fifth Circuit drew on both its own opinion in In re Besing, 981 F.2d 1488 (5th Cir. 1993), which refused to set aside a dismissal of claims based on discovery abuse as a fraudulent transfer, and the Supreme Court’s opinion in BFP v. Resolution Trust Company, 511 U.S. 531 (1994), which refused to set aside a regularly conducted foreclosure action.

The Court distinguished the Hinsley case on the basis that the transfer was not made voluntarily, stating:

Whatever concerns might arise in other cases, the divorce before us--which was fully litigated, without any suggestion of collusion, sandbagging, or indeed any irregularity--should not be unwound by the federal courts merely because of its unequal division of marital property.

Erlewine, at 212-13. Thus, the Court left open the possibility that a collusive divorce decree could be set aside. In this context, a divorce settlement agreed to by the parties would likely be treated as a voluntary transfer. This raises the issue of how adverse the divorce must be. For example, if the wife put on evidence which would support an unequal distribution and the husband did not object, would this be considered collusive? What is the husband put on some defense, but didn’t introduce his most compelling evidence? Finally, there is the case where the wife puts on evidence and the husband’s evidence is excluded due to counsel’s malpractice. This claim would probably be barred by Besing.

The Ninth Circuit followed Erlewine in Matter of Bledsoe, 569 F.3d 1106 (9th Cir. 2009). Anything that the Fifth and Ninth Circuits agree upon is probably good law.


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Joshua Cottle said...

Helpful. An attorney is arguing his client is creditor-proof because her filing husband obtained a discharge. I immediately saw the in rem aspect of the provision cited, and doubted their claim's seriousness that she could be free from liability when other provisions of the Code make it explicit she's not; your blog helped reaffirm that view. Excellent structural view of these common divorce scenarios. Thanks!