Straight Outta Marriage
-By Nedda Ghandi, Esq.
Property rights are the cornerstone of any bankruptcy proceeding and are a critical issue fought over in any divorce proceeding. In either proceeding, the determination and classification of the property involved will have significant impact on the party’s rights. Many practitioners may not realize that one spouse, whether married or separated, can file bankruptcy alone and without the consent of the other non-filing spouse. Sometimes this is a good thing, because in Nevada, the non-filing spouse can often obtain the benefit of the automatic stay as to themselves or their property and can benefit from a community discharge of certain debts. This means that it is possible that one spouse filing bankruptcy can discharge liability as to both spouses while they remain married.
However, when mixing community property laws with the bankruptcy code, the non-filing spouse can find himself or herself in great jeopardy by design or accident. This is especially true when one spouse files bankruptcy during a pending divorce proceeding and prior to any family court determinations regarding the division of the separate and community property rights of the couple. If one spouse files bankruptcy during a pending divorce proceeding, it is critical that divorce counsel for the non-filing spouse immediately refer the non-filing spouse to competent bankruptcy counsel. Both the divorce lawyer and retained bankruptcy counsel should communicate directly with each other to ensure that the impact of the filing spouse’s bankruptcy on the non-filing spouse is properly handled in the both pending proceedings and clearly communicated to the client.
The Automatic Stay
Some spouses file bankruptcy during the pendency of a divorce to delay the divorce for some reason. When a bankruptcy petition is filed, the automatic stay is triggered instantly. With few exceptions, the stay prohibits numerous types of creditor activities, including but not limited to wage garnishment, foreclosures, repossessions and most lawsuits. Say that your client is going through a divorce and in order to divide property he/she needs to sell a home as part of an agreement, and escrow is in one week. Well, the bankruptcy likely just killed the deal because, in part, of the automatic stay. Or perhaps, your client is in a bitterly contested divorce and that long awaited (but dreaded) trial is finally going to happen. The automatic stay is going to mess with that. While child support, alimony and visitation rights are not technically affected by the stay, and the family court may proceed, many family law judges will not proceed for fear of violating the automatic stay.
Community Property Becomes Part of the Estate
In a Chapter 7, the debtor’s property, with some exceptions, becomes the bankruptcy estate. Section 541(a)(1) of the Bankruptcy Code provides that property of the estate includes all legal or equitable interests of the debtor in property as of the commencement of the case. This can include cars, real property, lawsuits, bank accounts, tax refunds, stocks, collectibles, and the list goes on. Property is a very broad concept in bankruptcy.
The presence of community property can complicate a bankruptcy proceeding, particularly when one spouse files bankruptcy during a pending divorce proceeding. Community Property is not defined in the Bankruptcy Code because, for the most part, state law will apply and control the creation and definition of community property interests. Under section 541(a)(2), the estate includes “[a]ll 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.” (Emphasis added). Section 541(a)(2) applies regardless of whether one or both of the spouses file. Thus, when one spouse files bankruptcy, the following community property becomes property of the bankruptcy estate: (i) all interests of both the debtor and the debtor’s spouse in any community property that is under the sole, equal, or joint management of the debtor, (ii) all property that is liable for any allowed creditor claim against the debtor, and (iii) all property that is liable for any allowed claims against both the debtor and the debtor’s spouse.
This is one of the most damaging aspects of when divorce intersects with bankruptcy proceedings. Unless there is a nuptial agreement or other means of maintaining property separately, in Nevada, all property acquired during marriage is likely community property and property of the bankruptcy estate. If the community asset contains equity that the filing spouse does not claim exempt, a Chapter 7 trustee may cars, sell homes and otherwise attempt to liquidate assets that are community in character. So, for instance, if a couple is separated and the non-filing spouse is living in the former marital residence while the filing spouse has moved into a new home, the filing spouse can claim the new home as the exempt personal residence thereby leaving the former marital residence exposed to a potential sale by the Chapter 7 trustee.
Additionally, the Chapter 7 trustee can attack certain financial transactions. For example, the Chapter 7 trustee could sue family members of the non-filing spouse to seek a return to the bankruptcy estate of any transfer of property or monies that were paid to those family members. This is just a small sampling, as Chapter 7 trustees are granted fairly extraordinary powers in bankruptcy for marshaling assets. Through the filing of a bankruptcy petition, the filing spouse has potentially exercised a vicious but effective form of revenge through filing bankruptcy, claiming exemptions that solely benefit the filing spouse, and dragging the non-filing spouse into bankruptcy court.
Disbursements to Creditors and the Community Discharge
For estates that include community property, the Bankruptcy Code provides a mechanism for dealing with community property. In essence, section 726(c) creates a “sub-estate” that calls for the segregation of community property from other property of the estate and sets forth the order of distribution of the sub-estates for payment of claims: first, administrative expenses are paid equitably from both kinds of property; second, community claims against the debtor or the debtor’s spouse are paid from community property, except such as is liable solely for the debts of the debtor; third, community claims against the debtor, to the extent not paid under the above provision, are paid from community property that is solely liable for the debts of the debtor; fourth, to the extent that all claims against the debtor including community claims against the debtor are not paid under the above provisions, such claims shall be paid from property of the estate other than community property of the estate; fifth, if any community claims against the debtor or the debtor’s spouse remain unpaid, they are paid from whatever property remains in the estate. See 11 U.S.C. § 726(c).
Bankruptcy Code section 524 includes community debts as obligations subject to discharge. Thus, even though only one spouse may have filed bankruptcy, the entire community may receive a discharge which means that the discharged obligation is no longer enforceable against any community property or against the separate property of the filing spouse. Section 524 also grants protection to after-acquired community property so long as both spouses are innocent of any wrongdoing. In other words, community creditors are barred from asserting their claims against the couple’s after-acquired community property. Therefore, the filing spouse’s discharge prevents all collection efforts except as against the separate property of the non-filing spouse. So long as the parties remain married, the non-filing spouse will obtain the benefit of the community discharge.
However, the key word in the phrase “community discharge” is the word “community.” When the couple divorces, there is no community anymore. Therefore, the non-filing spouse no longer retains the benefit of the filing spouse’s discharge and is potentially on the hook for all of the community debts. In all practicality, creditors are not always diligent enough to check to see if the spouse of the individual who filed bankruptcy later divorced. However, when the bankruptcy is filed during the pendency of the divorce, creditors participating in the bankruptcy may be more aware of the fact that the community discharge will be short lived. Often times, the filing spouse may try to discharge debts as to himself or herself and leave the non-filing spouse on the hook. However, if the non-filing spouse’s attorneys communicate effectively, this spiteful use of bankruptcy may backfire. The spouse filing bankruptcy may take some joy at sticking the non-filing spouse with all the debt, only to have the non-filing spouse, through competent counsel, successfully petition the family court for more support to pay for the increased debt load.
Tread cautiously if your client is considering a bankruptcy as a tool for revenge during a divorce. Your client may find he or she bit off way more than they can chew.
Nedda Ghandi, Esq., is the founding partner of Ghandi Deeter Blackham Law Offices. A Nevada native, Ghandi is a graduate of the University of Nevada, Las Vegas William S. Boyd School of Law and has practiced law in Las Vegas for 9 years. Ghandi has written numerous articles for publications concerning interesting developments in the law, and has been selected as a member of Nevada’s Legal Elite and as a Super Lawyer every year since 2013. Ghandi Deeter Blackham specializes in family law, bankruptcy, guardianship, and probate. Consultations may be scheduled by calling 702.878.1115 or visiting www.ghandilaw.com