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A Bankruptcy Primer for Matrimonial Attorneys

By Paul Hollender
Reprinted from the Richmond County Bar Bulletin

Bankruptcy: the very word increases the blood pressure of matrimonial lawyers. It generates confusion, frustration, and sometimes anger. But it doesn’t have to be that way.

The Intersection of Matrimonial Law with Bankruptcy Law Matrimonial Law intersects with Bankruptcy Law in three basic ways. The first question is “What is the procedural impact of a bankruptcy filing?” The second is “What is the bankruptcy impact upon property distribution?” The third, is ” what debts get discharged?”

Automatic Stay

The filing of a bankruptcy petition invokes the Automatic Stay of the Bankruptcy Code. This statutory injunction essentially prevents any collection activity against the debtor. It does not, however, prevent the debtor from proceeding with litigation as plaintiff; nor does it prevent a non-debtor spouse from enforcing rights the non-debtor has in certain property (such as a vested interest in the debtor’s pension).

To prevent hardship to litigants in specified matrimonial proceedings, however, the Code exempts certain activities from the scope of the Stay. These include (i) the commencement or continuation of a paternity action; (ii) the commencement or continuation of an action or proceeding to establish or modify alimony,maintenance, or support; and (iii) the collection of alimony, maintenance or support from property that is not “property of the estate.”

Property of the Estate is a defined term under the Bankruptcy Code. When a debtor files a petition under chapter 7 (individual liquidation: “straight bankruptcy”) post-petition earnings, and most other assets acquired after the bankruptcy filing, do not become part of the bankruptcy estate. They belong to the individual or business and are fair targets for enforcement of awards of alimony, maintenance, and support.

When a debtor files a petition under chapter 11 (reorganization; usually used for businesses or for individuals with more than $750,000 in mortgages or more than $250,000 in unsecured debts), the question of whether post-petition earnings belong to the individual debtor, or to the chapter 11 bankruptcy estate is more esoteric. When this author represented the late Paolo Gucci in his personal chapter 11 reorganization, Mr. Gucci’s post-petition earnings derived from various license agreements. The question of whether they constituted personal service income (which Mr. Gucci was entitled to retain), or proceeds from a pre-petition executory contract (which belonged to the estate) is one which engendered sufficient uncertainty as to lead to substantial settlement negotiations between the parties.

In a chapter 13 (wage-earner “mini-reorganization”), post-petition earnings remain property of the bankruptcy estate until the payment plan (usually 3-5 years) is completed. In such a situation the party seeking enforcement must apply to the bankruptcy court for permission to lift the automatic stay to proceed against post-petition earnings.

As to enforcement of financial orders not related to support, permission of the bankruptcy court must first be obtained. When one spouse is trying to enforce such an order, and causes the commitment of the other, an interesting question arises: is the pursuing party guilty of a violation of the automatic stay if the person being pursued subsequently files bankruptcy, or is already subject to bankruptcy protection? In re Maloney the author represented one such husband and tried to extricate him from the Bronx House of Detention by filing a bankruptcy petition. It did not work. The Bankruptcy Judge, after reviewing the transcript of the Supreme Court contempt hearing, ruled that the debtor had been found guilty of criminal contempt, not civil contempt. In other words, the matrimonial court was entitled to take action to establish its own authority, notwithstanding that Mrs. Maloney was not allowed to take steps to collect a pre-petition debt.

Counsel should be aware that the automatic stay is not perpetual in duration. When pursuing the debtor’s property, the creditor is stayed only until the debtor receives a discharge, the case is closed, or the case is dismissed. At that time, either the debt is discharged, and the discharge injunction takes over from the automatic stay, or, if the debt is non-dischargeable (see below), and the creditor is free to pursue the debtor’s property, to the extent it is not claimed by the trustee.

When pursuing “Property of the Estate” (e.g. post-petition earnings of a chapter 13 debtor), the automatic stay lasts until the property is no longer “property of the estate” (i.e. until the final payment is made under the plan, and the debtor receives his discharge).

What this all means can be summarized as follows: regardless of whether a bankruptcy case is commenced before or after matrimonial or support proceedings, the automatic stay stops collection efforts (as to both support proceedings and equitable distribution awards), except as to post-petition earnings of a chapter 7 debtor, or other non-estate property, which is being pursued to enforce a support-related award.

As a general rule, a matrimonial action where the only relief sought is the divorce itself is not affected by the automatic stay.

The non-debtor’s remedy, when faced with the Automatic Stay of §362(a) is to move for relief from the stay, under §362(d). Although no motion is required for actions excepted from the stay, under §362(b), a motion for relief from the stay should be made to commence other actions, if the bankruptcy filing occurred first. Action taken in violation of the automatic stay is considered void ab initio. In some cases, courts have been known to treat such actions as merely voidable, giving rise to an opportunity for the creditor to seek to annul the stay (thereby validating the action as of the date taken); but the risk of an adverse decision would appear to make the better practice be to seek bankruptcy court permission, when uncertain whether the stay applies.

There are two statutory grounds for stay relief from the automatic stay.

If the movant is trying to take some action against property (e.g. the non-debtor spouse holds a mortgage on the debtor’s property which is not being timely paid), the movant must demonstrate either that the property has no equity and is not needed for the debtor to reorganize; or either (a) that current payments are not being made, (b) the property is depreciating in value, or (c) that non-payments of senior liens is depleting the equity.

On the other hand, if the movant is simply trying to proceed with some type of matrimonial action, “cause” must be shown. The bankruptcy courts generally allow matrimonial action is to proceed on the issue of divorce and on the issue of ownership of property but once the debtor’s property rights are established, the bankruptcy court will make the ultimate determination as to whether the debtor is entitled to an exemption as to all or part of the property, and whether the debtor or the bankruptcy estate (i.e. the creditors) receives that property.

The debtor’s remedy for a perceived violation of the stay is a motion under §362(e), which can lead not only to recovery of compensatory damages (including costs and attorneys fees), but of punitive damages as well. The trigger for establishing liability is that the pursuer’s conduct is “willful”. The standard of wilfulness, however is a very low one. It is not necessary to establish that the actor was intending to cause harm; only that he knew of the bankruptcy stay and acted with indifference to it.

Property Distribution
As indicated above, any interest the debtor has in property constitutes “property of the estate.” This would include contingent interests in personal injury law suits, even if recovery does not occur until after the bankruptcy case is filed. It also includes the interest the debtor may have in tenancy by the entireties property. Contrary to state law, such property could be sold by a bankruptcy trustee, provided court approval was obtained. Thus, upon the filing of a bankruptcy petition, an aggressive non-debtor spouse could conceivably offer the bankruptcy Trustee to purchase the Trustee’s right, title, and interest in the subject premises, and oust the debtor from possession.

It is also worth noting that certain assets acquired within six months after bankruptcy filing still belong to the bankruptcy estate. Thus, a spouse anticipating a substantial equitable distribution award should carefully consider the timing of a bankruptcy filing. Likewise, any life insurance proceeds or inheritance received within six months after bankruptcy filing, will pass to creditors as well. The attorney who recommends too quick a bankruptcy may end up on the defensive.

Although all property must be scheduled, the debtor is entitled to certain exemptions. These include a homestead exemption of $10,000, $7,500 in personal injury proceeds, normal household possessions, and up to $2,400 in equity in a motor vehicle.

Any party may file an objection to the debtor’s claim of exemptions within 30 days after the close of the creditors meeting; absent such objection, the debtor is entitled to retain all property claimed as exempt, even if it turns out to be very valuable.

If the parties to a matrimonial action dispute ownership to certain property, the Bankruptcy Court will usually allow the State Court to determine ownership, leaving the Bankruptcy Court jurisdiction to determine disposition of the Debtor’s interest. This would include determination in State Court of the parties’ respective equitable distribution rights.

Once the Bankruptcy Estate is established, that Estate is distributed in a fixed manner. Costs of administration (i.e. Trustee commission and professional fees for the estate) are first. Alimony, maintenance and support are now accorded a special priority, even ahead of tax creditors. Thus, notwithstanding any stay of enforcement against property of the estate, the Code actually grants support creditors a favored position in receiving marshaled assets.

Dischargeable Debts
In general, all scheduled unsecured debts are discharged in a bankruptcy case. There are, however, enumerated debts which are non-dischargeable. Obligations to pay alimony, maintenance and support, for example, cannot be excused. This provision, however, has a caveat: the bankruptcy court can determine whether an obligation denominated to be alimony, maintenance, or support, is to be treated, in fact, as such. Conversely, the non-debtor spouse is free to come into bankruptcy court to seek a determination that a specified obligation should be construed as constituting “alimony, maintenance, or support,” thus rendering it non-dischargeable. Under §523(d), however, the party unsuccessfully asserting that a “consumer debt”is non-dischargeable, may be held liable for the debtor’s counsel fees opposing such action. If a bankruptcy court holds that the debt in dispute qualifies as a “consumer debt”, this provision might apply.

Both the State and Federal Courts have concurrent jurisdiction to determine whether a particular debt is dischargeable (i.e. whether or not it is for “support”), but the question itself must be determined by Federal Law. Courts rely strongly upon the wording of the underlying agreement, thus the draftsman should take the possibility of bankruptcy into account. Key determinants are whether the provision is included in a section dealing with property settlement or support; whether the payment terminates upon the ex-spouse’s death or remarriage; and whether the provision expressly or inferably relates to living expenses.

In determining whether an obligation is for support, some courts look to the intent or effect of the award, the need for support, and the form of the award.

Although the Automatic Stay stops efforts to proceed against estate property to enforce awards of alimony, maintenance or support (note, there is no prohibition against proceeding against non-estate property), even property that had been property of the estate is subject to pursuit after the debtor has received a discharge, or the case is dismissed. At that point, property which has not been administered by the Trustee re-vests in the debtor and is subject to execution to enforce these non-dischargeable debts to the same extent as it would have been, absent the intervening bankruptcy.

Any other debts relating to a matrimonial dispute (e.g. property settlement or an equitable distribution award), are automatically discharged, unless, within two months after the first creditors meeting (which meeting is usually held about one month after bankruptcy filing), the non-debtor spouse commences an adversary proceeding in bankruptcy court, in which the court finds that the debtor spouse can afford to make payment on this obligation, or after balancing the equities, the court finds that the harm to the non-debtor, or the windfall to the debtor substantially outweighs the benefit of discharge.

Non-matrimonially related debts between spouses (e.g. loans, guarantees, business debts, rights of contribution for joint liability in contract or tort) are not given this hybrid protection against discharge, and are subject to the same rules as if the non-debtor spouse were an unrelated creditor.

One caveat, however, is that some courts have held that a non-debtor spouse has the right, post-petition, to move to rescind a property agreement that provided a right to do so in the event of breach.

Other debts, non matrimonially specific, may be excepted from discharge as well. These may, in some circumstances have an impact on a bankruptcy case, and include debts incurred based upon: false representations, false financial statements, fraud while acting in a fiduciary capacity, embezzlement, larceny, intentional torts, certain fines and penalties, educational loans not older than 7 years, drug- or alcohol-related auto accidents, or criminal restitution.

Also, taxes less than three years old, credit card checks used to pay such taxes, and post-petition condo maintenance fees for debtors continuing to reside in or rent-out such units will survive bankruptcy, as well as debts which are not listed in the debtor’s bankruptcy schedules (unless the creditor finds out about the bankruptcy anyway, in enough time to protect his interests).

Denial of Discharge
The debtor is under an obligation to provide accurate schedules to the bankruptcy court of assets, liabilities, exemptions and financial affairs, and to appear at a creditors meeting to provide the trustee and creditors with sworn testimony as to his financial affairs. The penalty for failing to comply with these obligations is the denial of discharge, in general, giving all creditors the right to pursue the debtor’s post-bankruptcy assets as if he had never filed bankruptcy. At the same time, the debtor will still be pursued by the bankruptcy trustee, who will be attempting to marshal the debtor’s pre-petition assets to pay the creditors. The non-debtor spouse is often in a peculiarly good position to know whether the debtor has honestly answered these questions, and consequently, to take strategic advantage of this fact.

Beware the Trustee
Matrimonial attorneys must also be aware that the bankruptcy trustee has the power to set aside transactions which occurred before bankruptcy. Payments to a non-debtor spouse, on account of old debts, within a year before bankruptcy, can be recovered by the trustee as Preferences. Transfers of assets for less than fair consideration can be challenged for up to six years as Fraudulent Conveyances. These issues usually arise when one party agrees to give up their interest in the marital residence, or some other property as part of a separation agreement. These rules allow for pre-bankruptcy planning for the knowledgeable, but can serve as traps for the unwary.

Joint Bankruptcy
Although the issues discussed above assume only one spouse is in bankruptcy, a completely different bankruptcy scenario is often employed.

One of the principal causes of matrimonial difficulties is financial problems of one or both spouses. The financial difficulties are not only substantial hurdles in themselves, they often create the emotional and relationship difficulties which precipitate matrimonial disharmony.

The best matrimonial attorneys often work in conjunction with a bankruptcy specialist. A joint bankruptcy can sometimes avoid the need for a divorce; or, if divorce is the undeniable objective, a joint bankruptcy can eliminate burdensome debt, and allow limited resources to be directed towards essential expenses needed to maintain two separate households, where the same income was previously insufficient to maintain one. The joint bankruptcy also eliminates the need for post-divorce litigation as to which party is liable on former marital debts; which debts were discharged; and whether the debtor spouse, although not liable to the creditor, may still remain liable to the non-debtor spouse for the same debt.

In sum, bankruptcy law need not be the dreaded unknown for matrimonial practitioners. While the bankruptcy of one spouse can temporarily disrupt a matrimonial proceeding, there are procedures for carrying on both proceedings simultaneously, to dispose of issues in a logical, orderly fashion.

The fact that certain debts could be dischargeable, will lead negotiating attorneys to anticipate these risks. Knowledge of bankruptcy can be an important planning and strategic tool in divorce situations, whether one spouse, or both, avail themselves of the opportunities.

Paul Hollender, a member of the firm of Corash and Hollender, PC, is a Board Certified (ABBC) Bankruptcy Attorney, with offices in Staten Island, Manhattan, and North Brunswick, N.J. He gratefully acknowledges the help of his associate Marylou Ducey Martin, who assisted in the preparation of this article.

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