Bankruptcy & Divorce: a Marriage of Inconvenience
| Publication year | 2014 |
| Pages | 31 |
Hon. Robert D. Berger
[31]
The client for whom you concluded a divorce one year ago returns to your office. She tells you that she has just received a notice from the bankruptcy court that her ex-husband filed a Chapter 7 bankruptcy in Kansas within the last 30 days.
Under the marital settlement agreement incorporated into the divorce decree, the ex-husband is to pay child support for their two minor children, including 50 percent of the children’s on-going medical expenses. The debts divided in the divorce were jointly owed and all property was jointly owned. The ex-husband is to pay the following: a second mortgage note on the marital residence that was awarded to your client and in which she lives with their minor children; $30, 000 in joint credit card debts; the joint loan on the automobile that was set over to him in the divorce and which he still owns; your attorney’s fees incurred representing her in the divorce; your attorney’s fees related to subsequent child custody proceedings; and guardian ad litem and psychologist’s fees incurred in custody proceedings.
Since you recently attended a divorce seminar, one hour of which was devoted to bankruptcy, you know that in bankruptcy, debts for a domestic support obligation (DSO)—i.e., debts arising from divorce proceedings that are in the nature of support—are not dischargeable under 11 U.S.C. § 523(a)(5).[1] You also recall that non-DSOs arising from family law proceedings[2] are not dischargeable under § 523(a)(15)[3] in a Chapter 7 bankruptcy.[4] Much of the interaction between family law and bankruptcy law evolves from these definitional launch points.
Since it appears that debts that arose in the divorce proceedings are not dischargeable under either of the above sections, you file an adversary proceeding in the bankruptcy case so the court can make such a determination.[5] As to discharge, you feel that it makes little difference whether a debt is formally categorized as a DSO, because all categories of debt owed to a former spouse arising from divorce proceedings are, since 2005, no longer dischargeable in a Chapter 7 bankruptcy. The bankruptcy attorney for the ex-husband agrees that his client’s obligations to your client are not dischargeable under these two provisions and a journalized settlement is reached wherein the bankruptcy court finds that the child support payments are not discharged under § 523(a)(5), and all other obligations under the divorce decree are not discharged under § 523(a)(15). The matter is quickly, amicably, and efficiently concluded, and you have protected your client from the effects of her ex-husband’s bankruptcy. Or have you?
Pitfalls ___ for the Unwary—The Bankruptcy Code’s Treatment of DSOs
The scope of this article is limited by necessity. There are volumes devoted to the interplay of bankruptcy and divorce.[6] So constrained, this article focuses on the dischargeability of family law debts in bankruptcy proceedings. A few of the important topics not discussed in this article include concurrent jurisdiction of the bankruptcy court and the state court, [7] abstention by the bankruptcy court, [8] the domestic relations exception to federal jurisdiction, [9] and the effect of an ex-spouse’s bankruptcy on his former spouse’s credit history.
State family law and federal bankruptcy law frequently involve countervailing policies. When these worlds collide, something has to give. From a financial perspective, aside from custody matters, divorce proceedings in the main are an economic process that allocate financial obligations and assets between the parties. Frequently, this is a negotiated transaction memorialized in a marital settlement agreement, and it is expected that the parties will fulfill their respective financial obligations under the agreement. In contrast, bankruptcy provides relief to the “honest but unfortunate debtor”[10] by discharging debts.
For a family law lawyer, much of the important work needed to address a possible bankruptcy of a client’s ex-spouse is performed during the divorce proceedings. There are two facets of particular importance. First, any settlement should be structured to reduce risk to one’s client if her soon to be ex-spouse files bankruptcy. To the extent possible, avoid allocating or creating non-support debt obligations from the ex-spouse to a client. Establish a client’s financial need for the assistance, and do not waive maintenance in an agreement. It is better [32] to allocate property or at least interests in property.[11] Second, it is important to instruct one’s client that there is only so much protection from a possible bankruptcy by her ex-spouse that may be accomplished in the divorce proceedings. This educational component prepares a client for a possible worst-case scenario; it may also make her more flexible with regard to settlement by focusing on property rights at the expense of reducing division of debt and creating new debt obligations from the ex-spouse to her.
As a practical matter, if the parties’ financial situation is desperate, it may be advisable for both of them to file bankruptcy or to seek other financial relief.[12] That alternative may also facilitate a divorce settlement between the parties because elimination of debt as a result of their receipt of a discharge in bankruptcy will obviously diminish allocation of debt as an issue. Of course, whether a husband and wife should file bankruptcy—and the timing of any filing, pre or post divorce—is a significant decision that should be undertaken after a considered evaluation of the alternatives.[13] In the end, reality should drive the decision-making. Even the most novel and assertive legal theories will not alter a desperate financial situation in which a client’s ex-spouse simply cannot afford to satisfy his financial obligations.
In bankruptcy, debts are subject to discharge, but property rights are not.[14] However, property rights may be subject to modification or termination.[15] When a debtor receives a discharge in bankruptcy, § 524 of the Bankruptcy Code permanently enjoins the collection (from the debtor) of any debts that were not excepted from discharge. The terms “discharge” and “dischargeability” are often confused but they have distinct meanings:[16]
The term discharge refers to the operation of the Bankruptcy Code provision (§ 727 in a Chapter 7 case) that effects a general discharge of the debtor’s prepetition debts. The term dischargeability refers to the operation of the Code provision, § 523, that excepts particular debts from the general discharge provision of the Code. Under § 523, certain kinds of debts are delineated as being nondischargeable, meaning that those debts are not operated on by the general discharge and therefore remain collectable outside of bankruptcy.[17]
Until a debtor receives a bankruptcy discharge, even the collection of nondischargeable debts is stayed, [18] although there are family law-related exceptions, such as collection of DSOs that do not involve property of the bankruptcy estate.[19]
From a bankruptcy discharge perspective, the focus is to determine which family law debts are nondischargeable DSOs under § 523(a)(5) and which debts are non-DSOs that fall within the ambit of § 523(a)(15). From the non-debtor ex-spouse’s perspective, it is always beneficial for debts to be classified as nondischargeable support obligations under § 523(a)(5) because that exception applies to all chapters of the Bankruptcy Code.[20] Whether a debt is a DSO is determined by inquiry into the parties’ shared intent at the time of the marital settlement agreement, the substance of the divorce obligation, whether the purpose and effect of the obligation is to provide support to a spouse, a spouse’s need for support, and what function the obligation is intended to serve.[21] The relevant date for that determination is the date of the divorce, and any change in circumstances of the parties thereafter cannot be considered.[22] If the divorce was litigated (as opposed to the court merely adopting the parties’ mutual marital settlement agreement), then it is the intent of the state court judge that is considered. The inquiry is whether the state court judge believed and found that the debt was in fact for support, or whether that debt was established by the court merely as a means of fairly dividing the parties’ assets and liabilities.[23]
The 2005 Amendments expanded the definition of what is in the nature of support to include debts owed to obligees such as a legal guardian, responsible relative, or a governmental unit. The definition applies whether the liabilities are established before or after the bankruptcy, and it includes an administrative determination by a governmental unit. If the debt is not discharged, then the associated interest, both pre- and post-bankruptcy, is likewise not discharged.[24] Section 523(a) exceptions to discharge usually are strictly construed in favor of the debtor; however, that rule does not apply to DSOs.[25] The burden of proof to demonstrate nondischargeability is by a preponderance of the evidence and rests with the objecting creditor.[26] The burden for the objecting creditor is both to establish the existence of the underlying debt and to demonstrate that the debt is of a kind contemplated under the exceptions to discharge.[27]
Section 523(a)(5) excepts DSOs from discharge. Section 523(a)(15) excepts from discharge non-DSOs that arise in family law proceedings, such as the division of debts and property. However, as previously noted, § 523(a)(15) does not apply to Chapter 13 (wage earner) bankruptcies. In the above scenario, the attorney likely committed an error by agreeing to a journal entry that found most of the obligations under the divorce proceedings were not...
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