Sometimes a spouse or a couple will file a bankruptcy case before filing a divorce. Others wait until after the divorce is final to take care of lingering financial issues (in which case they’d file separately). In some cases, it makes sense for the couple to file a bankruptcy case together before getting the divorce—especially if they don’t have much in the way of property.
However, a couple who files for divorce while a bankruptcy case is pending can expect the bankruptcy judge to review any property settlement to make sure that creditors are receiving the amount that they are entitled to receive.
Bankruptcy is a federal process governed by federal law. By contrast, spouses file for divorce in state court. Sometimes these two areas of law conflict. When they do, the supremacy clause of the U.S. Constitution resolves the problem (federal law is the supreme law of the land). In other words, state courts have to respect decisions made by federal courts, and the bankruptcy court the final say in matters within its jurisdiction, namely issues about property and debt.
State law governs most aspects of a divorce. For instance, to facilitate a dissolution, the state court makes determinations about:
Bankruptcy judges can hear many types issues, but the issue must be related to the debtor’s debt and property. Because dissolving a marriage and allocating child custody do not directly affect debt and property, the bankruptcy judge will not address those issues. However, the bankruptcy judge does have authority to address the division of property and debt.
If the bankruptcy case was filed before the divorce, the bankruptcy judge will allow the divorce action to continue in state court. This is true even though the automatic stay is in place (the order prohibiting creditors and others from taking any action to collect or transfer the debtor’s property). The bankruptcy court might allow the state court to decide property division issues but will retain jurisdiction (the authority) to approve the property settlement.
The bankruptcy judge has the final say because otherwise, the creditors could easily be left out in the cold. This can happen because when you file a bankruptcy case, you’re allowed to protect some of your property by claiming bankruptcy exemptions.
In a Chapter 7 bankruptcy, the trustee appointed to administer your case can take possession of the property that isn’t exempt, sell it, and use the proceeds to pay creditor claims. The court protects creditors rights by ensuring that a property division doesn’t transfer nonexempt assets out of the reach of the trustee.
Example. Harry and Wendy own a house worth $200,000 with a paid-off mortgage. Harry files a Chapter 7 bankruptcy. He can only exempt $50,000 of the house’s value so the trustee will have the right to sell the house to pay Harry’s creditors. But, Harry and Wendy negotiate a property settlement that awards her the house instead of alimony. Harry agrees to be responsible for all the marital debt (which he intends to discharge in the bankruptcy).
Although this could be an acceptable division of marital property in other circumstances, when a bankruptcy is pending, it is doubtful that the bankruptcy court would approve this settlement. It transfers away Harry’s interest in a large piece of nonexempt property that the trustee could use to pay his debts.
A property division during a Chapter 13 bankruptcy can present other challenges. A debtor who drafts a Chapter 13 plan must take into account the debtor’s income, expenses, debts, and any nonexempt property. A property division could throw off those figures to the detriment of creditors.
Example. Harry and Wendy file a Chapter 13 case and propose a five-year plan that pays off all of their debt without requiring that they sell their house. Wendy files for divorce half-way through. The parties negotiate the same settlement as in the previous example. Wendy no longer wants to be in Chapter 13 bankruptcy and leaves the case. Harry no longer has access to Wendy’s income to help pay the plan payments, but he remains responsible for all the debt. Again, it’s unlikely that the bankruptcy court would approve this property division because it would likely doom the Chapter 13 plan and force Harry to convert the case to Chapter 7 bankruptcy. As a result, creditors wouldn’t receive the payments that they were entitled to under the plan.
It is possible that the bankruptcy judge could come up with another plan that is fairer to the creditors. On the other hand, the bankruptcy judge could reject the settlement and allow the state court to reconsider and suggest a division that’s more equitable.