Chapter Fifteen Bankruptcy

• Library: Marital Litigation in South Carolina (SCBar) (2020 Ed.)

Chapter Fifteen BANKRUPTCY¹

A. In General

The purpose of this chapter is to give family court practitioners a basic understanding of bankruptcy law and procedure. Bankruptcy practice is a specialty field in which unique rules of procedure, rapid dockets, short time periods for taking critical actions, local rules of procedure, local forms for pleadings and unpublished court opinions² all play important roles. Substantial rights can be gained or lost in bankruptcy proceedings on a little as 14 to 21 days' notice by mail. With very limited exceptions, attorneys must be admitted to practice in the Federal District Court and Bankruptcy Court to appear for clients in a bankruptcy case. Family court practitioners who believe their clients or their clients' spouses have filed or may file bankruptcy should consult a bankruptcy specialist.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Public Law No. 109-8 (BAPCPA) became law on April 20, 2005. Many important protections for the alimony, support, and marital property creditor were added to the Bankruptcy Code by BAPCPA.

The interplay between South Carolina domestic relations, domestic support, and marital property laws with the U.S. Bankruptcy Code, the Federal Rules of Bankruptcy Procedure and related Federal Statutes is exceptionally complex. The materials in this chapter will help identify some of the potential bankruptcy issues related to domestic proceedings.³

The bankruptcy laws are designed to give the "honest but unfortunate" debtor a "fresh start," allowing him to begin anew without the burden of insolvency. Grogan v. Garner, 498 U.S. 279, 286-87, 111 S.Ct. 654, 112 L.Ed.2d 755 (1991). In exchange, the debtor owes full disclosure and full cooperation to the Trustee in providing fair (meaning equal) treatment among similarly situated creditors. The Bankruptcy Code gives individual debtors two ways to deal with debt loads that are too heavy for them to manage: (1) by providing a structure for paying all or part of their debts through court-approved plans, or (2) by liquidating their non-exempt assets, even if this does not produce enough cash to fully pay off their debts. The Bankruptcy Code provides for liquidation in cases under its Chapter 7 and a financial restructuring (which can include an orderly liquidation) under its Chapters 11, 12 and 13. Under all chapters, the goal of a bankruptcy case is to receive a "discharge" or a kind of permanent injunction prohibiting the recovery of debt from the debtor or the debtor's non-exempt property except to the extent provided in a confirmed plan, if any.

The Bankruptcy Code contains a list of19 categories of debt that are not dischargeable in bankruptcy. 11 U.S.C. § 523(a). Within those categories, the Bankruptcy Code makes some debts automatically dischargeable. These include domestic support obligations (alimony and child support). 11 U.S.C. § 523(a)(5). They also include some interspousal property division debts⁴ and most current taxes. Some debts, including fraud and intentional injury to persons or property, are nondischargeable only if a timely suit is filed to declare those debts nondischargeable. 11 U.S.C. § 523(c)(1).

Although the exceptions to discharge are to be narrowly construed, so as to effect the "fresh start" purpose of bankruptcy, bankruptcy laws favor enforcement of familial support obligations over a "fresh start" of the debtor. "[T]he Bankruptcy Code 'departs from the general policy of absolution or fresh start' in order to 'enforce an overriding public policy favoring the enforcement of familial obligations.'" In re Robb, 23 F.3d 895, 897, (4th Cir. 1994); In re Sampson, 997 F.2d 717, 721 (10th Cir. 1993), citing Shaver v. Shaver, 736 F.2d 1314, 1315-16 (9th Cir.1984). This implements the U.S. Supreme Court holding that "a support obligation is a 'natural duty' rather than a mere debt." Audubon v. Shufeldt, 181 U.S. 575, 577, 21 S.Ct. 735, 45 L.Ed. 1009 (1901).

Bankruptcy proceedings under Chapters 7, 11, 12, or 13 do not release debtors from what is now defined as a "domestic support obligation" discussed in more detail below. 11 U.S.C. § 101(14A). The claims of the domestic support creditor have priority in payment by the Trustee or under a plan over all other unsecured creditors including the debtor's taxes. 11 U.S.C. § 507(a)(1).

The bankruptcy process cannot be used as a device for defrauding creditors. The Fourth Circuit Court of Appeals affirmed the dismissal of a bankruptcy case where the debtor's sole purpose for filing bankruptcy was to favor certain creditors and defraud his former wife. In re Kestell, 99 F.3d 146 (4th Cir. 1996). More than half of the man's debt was a dischargeable lump sum owed to his former wife pursuant to their divorce decree. He tried to use a check from his employer for accrued sick leave to reimburse creditors he thought worthy of priority, while ignoring the debt to his wife (and without informing the bankruptcy Trustee). The Fourth Circuit Court of Appeals concluded that the debtor's actions constituted "substantial abuse" of the bankruptcy process. See also In re Prosser, No. 87-1185 (Bankr. D.S.C. 1989), in which the debtor transferred property to his ex-wife pursuant to a property settlement and divorce decree. He later remarried his former spouse. The bankruptcy court ruled that these transfers were done with the intent to defraud creditors and ordered that the transfers be rescinded and the property turned over to the Chapter 7 Trustee.

B. Overview of the Bankruptcy Chapters

1. Chapter 7

Chapter 7 (11 U.S.C. §§ 701 et seq.) bankruptcy cases involve the liquidation of the debtor's non-exempt assets. An individual, a husband and wife together, a legal entity, or a partnership may elect to file for relief and protection under Chapter 7. As with cases under all chapters, debtors must disclose all assets and liabilities, and individual debtors may claim exemptions pursuant to applicable South Carolina statutes and non-bankruptcy federal statutes that protect certain property from creditors and the Trustee in Bankruptcy. On filing of a Chapter 7 case, a "bankruptcy estate" is created consisting of all of the non-exempt assets of the debtor(s). 11 U.S.C. § 541. A Chapter 7 Trustee is appointed to administer the bankruptcy estate and to determine whether there is equity in the debtor's non-exempt assets that is available for liquidation and distribution to creditors.

In cases under Chapter 7, creditors holding a valid lien or mortgage on an asset of the debtor are either allowed to recovery and liquidate that collateral for payment of their claims or the Trustee will sell the collateral and use the funds to pay the secured claim leaving the remainder for the estate. Secured creditors with insufficient collateral to pay their claims in full are allowed to file an unsecured claim for the amount of their debt in excess of the value of their collateral. Any funds produced by liquidating the assets of the estate are first applied to the expenses of administering and liquidating the bankruptcy estate. Priority creditors are paid next. BAPCPA gave domestic support obligations first priority. After domestic support obligations, the remaining priority debts are paid including debts such as tax claims and some unpaid wages. Unsecured creditors share any remaining assets, if any, on a pro rata basis.

If the Trustee determines that there will be funds available from liquidation of the debtor's non-exempt assets, the case is deemed an "asset case." After the Trustee liquidates the non-exempt assets, the claims of those creditors who have filed claims are paid. However, most Chapter 7 cases are "no asset" cases due to the liens that encumber the debtor's property and the debtor's exemptions. Creditors will not receive a distribution from the bankruptcy court in a "no asset" case, and the debtor will retain all property, subject to the claims of secured creditors.

2. Chapter 13

Chapter 13 (11 U.S.C. §§ 1301 et seq.) bankruptcy cases called "Adjustment Of Debts Of An Individual With Regular Income," and may be filed by an individual, or a husband and wife together, if the debtor has a regular source of income. Legal entities cannot file a Chapter 13 bankruptcy case, only individuals. The debtor proposes a plan to repay creditors over a three-to-five year period by making payments to a Chapter 13 Trustee, who in turn distributes the money to creditors. The local rules of the South Carolina Bankruptcy Court require all creditors, whether holding secured or unsecured claims, to file a proof of claim to receive any distribution from the Chapter 13 Trustee. SC LBR 3015-1, local rules of the U.S. Bankruptcy Court for the District of South Carolina. Only the debtor may propose a plan in a Chapter 13, not the creditors. There are limits on how much a person can owe and still seek Chapter 13 protection. 11 U.S.C. § 109. These amounts are adjusted every three years. If the debtor's debts exceed those limits the case must be filed under another available chapter, usually Chapter 11 or Chapter 7.

Long-term secured debt such as mortgage indebtedness may continue to be paid outside the plan (that is, not through the Trustee). Pre-bankruptcy arrearages on long-term debt must be paid through the Chapter 13 Trustee. All short-term secured debt (less than five years), all tax debt, and all priority unsecured debt will usually be paid through the plan.

Secured debt payable through the plan (not long-term debt), with the exception of mortgages secured by the debtor's principal residence and certain purchase money secured debts, may be modified by reducing the interest rate and by extending the number of payments. Under 11 U.S.C. § 506(a), a secured creditor (other than the holder of a mortgage on the debtor's principal residence and certain purchase money secured debts) is entitled to receive only the value of the secured property. (However, if the creditor is...