BANKRUPTCY DISCHARGE ISSUES AND FAMILY LAW

by Marlene G. Weinstein

The benefit of filing for protection under Title 11 of the United States Code, more commonly referred to as the “Bankruptcy Code” (hereinafter “the code”), is derived from the discharge injunction provided by 11 U.S.C. § 524. The liability of marital property, both separate and community, for debts incurred before, during and after marriage and/or separation, is set forth in Division 4 of the California Family Code (hereinafter “Family Code”), Part 3, Sections 900 through 1000. The division of property between spouses is discussed in Division 7 of the Family Code, Sections 2500 through 2600. The intersection of these state and federal code sections raise various issues when only one spouse files for protection under the code, whether or not the parties are involved in dissolution of their marriage. This article is intended as an overview of some of those issues.

THE BANKRUPTCY DISCHARGE

The specifics of the discharge granted to a debtor is dependent on whether a case is filed under Chapter 7, 9, 11, 12, or 13. Upon receiving a discharge, a debtor is discharged from any personal liability to repay debts to creditors who were listed in the bankruptcy schedules as creditors, unless the creditor’s debt was executed from discharge under 11 U.S.C. § 523. It is not necessary for a specific debt to be listed—just the creditor. Creditors should be aware that under certain circumstances their debts may be discharged, whether such debts are liquidated, disputed or contingent, even if they were not listed in the bankruptcy schedules as long as they received notice or had actual knowledge of the bankruptcy.

When a couple is happily married and only one spouse files for protection under the Code (hereinafter “debtor”), the parties have usually determined that it is in their mutual best interest for only one party to file since they are generally seeking to discharge obligations to third-party creditors. As discussed below, the discharge injunction provides both the debtor and the non-filing spouse or ex-spouse (hereinafter “spouse”) with a certain amount of protection from creditors in a community property state.

However, when a couple is involved in a dissolution of their marriage, it is very often the case that the debtor is seeking to discharge not only his debts to third-party creditors, but also his obligations to his/her spouse. Said obligations may be for such things as reimbursement, the payment of specific community property debts, and/or an equalizing payment, indemnification or hold harmless obligation under the provisions of a marital settlement agreement or court judgment. In these cases the discharge injunction shields the debtor from the spouse unless the debt is nondischargeable pursuant to 11U.S.C. §523(a)(5), or a spouse files a complaint in Bankruptcy Court seeking a determination that the debtor’s obligations are nondischargeable on other grounds.

In addition to the nondischargeability of support obligations, a spouse can assert that the debtor’s obligations to the spouse should be excepted from discharge on the following grounds—misrepresentation or fraud [§523(a)(2)]; breach of fiduciary duty [§523(a)(4)]; willful or malicious injury [§523(a)(6)]; and/or that “the debt was incurred by the debtor in the course of a divorce or separation in connection with a separation agreement, divorce decree or other order of a court of record…”[§523(a)(15)]”. However, unless the spouse files a complaint against the debtor in Bankruptcy Court within 60 days of the first date set for the meeting of creditors, with the exception of §523(a)(5) debts, a debtor’s obligations to a spouse are discharged and the spouse is forever barred from seeking collection of the debts from the debtor.

THE DISCHARGE INJUNCTION

Although most family law attorneys are familiar with the effect of the automatic stay on a state court dissolution action, very few are familiar with the effect of the discharge injunction on the issues raised in that proceeding. Therefore, the best way to describe the discharge injunction is to compare it to the automatic stay. Upon the filing of a bankruptcy, Section 362 of the code imposes an automatic stay which operates as an injunction against certain actions taken against either the debtor or property of the estate without Bankruptcy Court permission, including an action seeking to collect a debt. Any such action violates the automatic stay, and any act in violation of the automatic stay is void. In re Schwartz (9^th Cir. 1992) 954 F.2d 569.

Once a debtor receives a discharge in a bankruptcy case, the automatic stay terminates (if not terminated sooner by court order), and a discharge injunction created by certain provisions of 11 U.S.C. §524 takes its place. Section 524(a)(2) enjoins any actions to collect or recover from or offset any pre-petition debt as a personal liability of the debtor. This section provides a debtor with personal protection from a spouse, the debtor’s family law attorney and third-party creditors. Section 524(a)(3) enjoins any actions to collect or recover from or offset any pre-petition debt against any after acquired community property by either the debtor or his/her spouse on account of any allowable community claim, with certain exceptions. This section protects the community property of both a debtor and hi/her spouse from third/party creditors.

THE EFFECT OF SECTION 524(A)(2) ON THE RIGHTS OF THE SPOUSE AGAINST THE DEBTOR

The discharge injunction affects the rights of a spouse against a debtor—not only if the parties are involved in a dissolution of their marriage—but also long after a judgment of dissolution has been entered in which the property was divided.

A judgment of dissolution generally provides for the assignment of debts to one party or the other with a provision that the person to whom the debt has been assigned will hold the other harmless from collection from third-party creditors. In addition, in order to comply with “Family Code §2550 requiring the state court to “divide the community estate of the parties equally,” judgments often provide for equalizing payments to be paid from one party to the other. Both the equalizing payment and the hold harmless provision are debts which will be discharged. Unless a spouse files a complaint seeking to except these debts from discharge under Section 523—most likely under Section 523(a)(15)—a spouse is enjoined from seeking collection of the equalizing payment, and is further enjoined from enforcing the hold harmless provisions of the judgment by the discharge injunction created by §524(a)(2). If no such action is filed, or if the spouse does not prevail in the complaint, the only remedy to the spouse will be to request a modification of spousal support if the state court has reserved jurisdiction. Family Code §3592 permits the spouse to modify support obligations if debts have been discharged in bankruptcy. The ninth circuit has held that a state court’s modification of alimony based on a bankruptcy discharge of a property settlement did not violate the discharge injunction. In re Siragusa (9^th Cir. 1994) 27 F.3d 406.

When a couple is involved in a proceeding to dissolve their marriage, and only one of the parties files bankruptcy, the injunction created by Section 524(a)(2) shields the debtor from the spouse and the state court’s desire to divide the community estate equally.. The state court is enjoined from making such orders as (1) assigning a discharged debt to the debtor, (2) ordering reimbursement to be paid by the debtor to a spouse, (3) ordering the debtor to make an equalizing payment, (4) ordering the debtor to hold the spouse harmless from payment of a debt, and/or (5) offsetting any amount which would have other wise been due from the debtor if it had not been for the bankruptcy. In essence, the state court is precluded from dividing the debts and assets equally – only the assets may be divide. The only time a state court retains jurisdiction to make some of the orders set forth above is if the spouse has sought a Bankruptcy Court adjudication that, for example, a claim for reimbursement (even in an unknown amount) and/or indemnification in nondischargeable under 11 U.S.C. § 523 (a)(15). If no such action has been taken by the spouse, the only remedy a state court has is to take the bankruptcy and the discharge into effect in awarding spousal support and attorneys’ fees.

THE EFFECTS OF SECTION 524(A)(3) ON THE RIGHTS OF CREDITORS

When only one spouse files for protection under the Bankruptcy Code, understanding the effects of the discharge injunction can be a useful tool which can be used to protect the community property assets from the claims of third-party creditors.

In a situation where no divorce or separation is anticipated, it is very often strategically beneficial for only one party to file for bankruptcy protection. Since all of the community property receives the benefit of the discharge injunction. Third-party creditors are enjoined from seeking collection of their debts not only from the community property included in the bankruptcy estate, but from all community property acquired after the bankruptcy. However, the community property discharge does not operate as an injunction against a creditor’s efforts to collect a community property debt from a spouse’s separate property. In re Strickland(D.N.M. Bankr. 1993)153 B.R. 909. Therefore, whether or not it is necessary for one or both spouses to file for protection under the code may very well depend on whether or not either of the spouses has separate property which can be reached by a creditor.

When a couple is terminating their marriage it may or may not be in the best interest of both parties for a bankruptcy to be filed. Furthermore, whether a spouse will obtain the benefit of the community property discharge may depend upon whether or not the marital status has been terminated and/or whether or not the property has been divided. With certain limitations, §524(a)(3) enjoins any action to collect a pre-petition debt for which the community property would otherwise be liable from community property acquired by either the debtor or his/her spouse subsequent to the debtor receiving a discharge. In general, whether a spouse receives the benefit of the discharge injunction will depend on whether the community property has been subjected to the jurisdiction of the bankruptcy court. If community property has not yet been divided, it is generally includable in the bankruptcy estate.

If bankruptcy is being considered by either spouse, the parties should work together with their family law and bankruptcy attorneys, if at all possible, to obtain the maximum benefit from the bankruptcy filing for both parties, Family Code §910 generally provides that all community property is liable for debts incurred before or during marriage by either spouse. However, once it is divided, Family Code §916(a)(2) provides that,”… after division of community and quasi-community property…(2) The separate property received by the person in the division is not liable for a debt incurred by the person’s spouse before or during marriage, and the person is not personally liable for the debt, unless the debt was assigned for payment by the person in the division of the property.” These two Family Code sections and others, as well as the effects of the discharge injunction and other bankruptcy issues should be taken into consideration in preparing a marital settlement agreement that benefits both parties.

Settlement negotiations should include discussions regarding such things as whether to file before or after the marriage is terminated and/or the property is divided, the characterization of property as community or separate, the characterization of debts as separate or community, whether both parties have personal liability for specific debts and the assignment of such debts to one party or the other and/or the retention of security interests in property transferred. The foregoing considerations can be sued to reach mutually beneficial settlement or they can be used as bargaining chips. Unfortunately, a non-filing spouse is at times at the mercy of a vindictive spouse who files bankruptcy with the intention of injuring his/her spouse. It is this writer’s hope that family law and bankruptcy attorneys can impress upon their clients the benefit of a situation where both parties receive the maximum benefits from a bankruptcy filing.

CONCLUSION

The issues raised in cases in which bankruptcy law and family law overlap are complex and confusing to attorneys and the courts. Unfortunately, money problems very often create marital problems and vice versa. Hopefully, a better understanding of how the two areas intersect can be used to benefit couples who are facing some of the most difficult times of their lives.