The Bankruptcy Estate
by Robert Berger and Paul Post
The Bankruptcy Estate
Subchapter III of the Bankruptcy Code ("the Code) concerns the bankruptcy estate, and includes a definition section which tells the practitioner what constitutes property of the estate (Section 541), how the Trustee can recover property of the estate (turnover under Sections 542 and 543), the Trustee's ability to "stand in the shoes" of certain lien creditors (Section 544), avoidance by the Trustee of certain statutory liens (Section 545), limitations on avoidance powers (Section 546), preferences and preference avoidance powers ( Section 547), fraudulent transfers and avoidance powers (Section 548), and postpetition transactions (Section 548). The remaining sections of this subchapter (549-560) would generally not apply to bankruptcy/divorce issues.
Almost All Property Interests of the Debtor are Property of The Bankruptcy Estate
Section 541, the section which defines property of the estate, is so broad that it includes virtually every imaginable kind of property in which the debtor would have an interest. The exceptions are very narrow, and would generally not apply in those consumers bankruptcy situations in which divorce issue usually arise (e.g., powers of appointment, leasehold interests in nonresidential property which have already expired, and interests in liquid or gaseous hydrocarbons До certainly not the usual lot of divorce matters!). Property which the debtor may exempt and which the debtor does exempt does not become property of the estate, unless a timely objection (usually by the Trustee) is filed, and the exemption is disallowed. A debtor generally will list property that he or she claims as exempt at the outset of the bankruptcy case, through Schedule C on the Official Forms.
When is the estate created?
Commencement of a case under Sections 301, 302, or 303 of the Code creates an estate. Since bankruptcy/divorce issues will usually arise in consumer bankruptcies, Section 303 До the involuntary bankruptcy procedure До generally will not come into play. However, practitioners should remember that while an estate is created upon the filing of the petition by a debtor in an individual case under Section 301 or joint debtors under Section 302, the filing of an involuntary petition creates no estate. Rather, it is the adjudication of bankruptcy by the bankruptcy court after trial and upon finding that the involuntary petition should be allowed, that the order for relief is granted.
1. Chapters 7 & 11: 11 U.S.C. Sec. 541(a)(1) provides that, with exceptions, all legal or equitable interests of the debtor in property as of the commencement of a case will flow into the bankruptcy estate created by the debtor's bankruptcy filing. Estate property will also include any interest in property that could have been property of the debtor's bankruptcy estate as of the date of filing, when the debtor acquires or becomes entitled to acquire such property within 180 days from the date of filing as a result of a property settlement agreement with the debtor's spouse, or of any interlocutory or a final divorce decree. This can be of particular importance if transfers are made to the debtor of property that my lose its exempt status in the possession of the transferee. This so-called "lookback" rule also applies to the right to receive an inheritance and life insurance. Aside from these limited exceptions, a Chapter 7 or Chapter 11 estate does not include property interests or income acquired by the debtor after the commencement of the bankruptcy case. All of these interests described in Section 541 will remain in the bankruptcy estate until the debtor's exemptions are allowed under F.R.B.P. 4003(b) or until the property is abandoned by the Chapter 7 trustee under F.R.B.P. 6007. If the Debtor's property is subject to liens, the estate takes the property subject to these liens, except to the extent they may be avoid by the bankruptcy Trustee or the Debtor. Remember that generally in Chapter 11, the debtor assumes the powers and duties of the Trustee, since the concept under Chapter 11 is that of "debtor-in-possession." However, the U.S. Trustee will exercise some supervisory duties in Chapter 11 cases, and will act as "watchdog" to insure that the debtor carries out his or her trustee duties До failure to do so may result in the appointment of a trustee in the case, or possible conversion or dismissal. Furthermore, Chapter 11 cases usually involve business entities, rather than individual consumers, although the latter may avail themselves to Chapter 11 relief. More likely, if reorganization is needed or desired, relief will be sought under Chapter 13.
2. Chapters 12 & 13: Property of the estate is expanded under Chapter 12 (Farmer Reorganization) and Chapter 13 (sometimes called "Wage Earner Bankruptcy"). Since Chapter 13 is the more common reorganization, this discussion will be restricted to Chapter 13, although the Chapter 12 provisions essentially parallel those set out in Chapter 13. In Chapter 13, property of the estate includes not only the property set out in Sec. 541 but also includes income earned by the debtor after the date the petition is filed. See Sec. 1306(a). Section 1327(b) revests property of the estate in the debtor upon confirmation of the Plan, unless the Plan or Confirmation Order states otherwise. See In the Matter of Bernstein, 20 B.R. 595 (Bankr. Ct. M.D.Fl. 1982). Generally, confirmation orders used in Kansas cases will specify that future income earned by the Debtor will remain property of the estate, and will require the debtor to report to the Trustee concerning significant income increases during the life of the plan.
Determining and Recovering Property of the Estate
1. Property interests determined under state law: Although state law will determine the property rights and interests of the debtor, it is federal law that determines when property and interests become property of the bankruptcy estate. The bankruptcy estate's rights in property can be no greater than those enjoyed by a debtor who files bankruptcy and, since property rights and interests are determined under state law, reference must be made to state law to determine the bankruptcy estate's rights to property. See Collier Family Law and the Bankruptcy Code, Sec. 2.01[3]. The bankruptcy estate includes rights of the Debtor against her ex-spouse and, unless such right to payment is exempt, such as maintenance under Sec. 522(d)(1)(D), these interests would remain property of the bankruptcy estate unless abandoned.
Spouses are entitled to their separate property while married and "under normal circumstances a spouse has no interest in the separate property of the other." See In re: Octinger, 49 B.R. 41 (Bankr.D.Kan. 1985), citing as authority Wachholz v. Wachholz, 4 Kan.App.2d 161, 603 P.2d 647 (1979). Apparently, to avoid adverse tax consequences relating to the division of property attendant to a divorce (a concern which no longer exists under the Internal Revenue Code), Kansas law provides at K.S.A. 60-1610, that the District Court has jurisdiction to "[D]ivide the real and personal property of the parties whether owned" by either spouse before the marriage or acquired after time of marriage. See, Title Standards Handbook, Sec. 4.5, Kansas Bar Association.
Even though certain property may be held separately during the marriage, this distinction evaporates upon the filing of a divorce petition. Query whether this creates a common law exemption if only one of the spouse files bankruptcy, although this is probably a losing argument. See In re: Garrity, 144 B.R. 895 (Bankr. D. Kan. 1992) in which the court disallowed a claimed exemption of a personal injury action based on a statute that afforded similar protections to such recoveries.
The determination of whether a debtor's property is part of the bankruptcy estate is significant. Property of the estate is within the exclusive jurisdiction of the Court. Until the property is removed from the estate or until relief is granted, property of the estate receives the protections afforded by Sec. 362(a) (automatic stay). Property of the estate is subject to turnover and recovery by the bankruptcy estate under Sec. 542 and 543. See U.S. v. Whiting Pools, Inc., 462 U.S. 198, 103 Sup. Ct. 2309 (1983), in which the IRS was forced to turnover to the bankruptcy estate property upon which it had levied and property in which the debtor only enjoyed a limited right of redemption under the Internal Revenue Code. If a Debtor's ex-spouse has property of the estate, she can be forced to turn it over, even if she is not a creditor. See Matter of Levine, 84 B.R. 22 (Bankr. S.D. N.Y. 1988). In Matter of Geise, 132 B.R. 908 (Bankr. E.D. Wis. 1991) the ex-spouse was ordered to turnover shares of stock acquired by the ex-spouse as the debtor's share of marital property under state law. Even attorneys and accountants can be ordered to turnover papers and documents relevant to the Debtor's financial condition. See In re: Beef N' Burgandy, Inc., 21 B.R. 69 (Bankr. N.D. Ga. 1982).
2. Effect on divorce proceedings: The filing of a bankruptcy by one or both spouses has an important and immediate effect on the division of property in the dissolution proceedings, since the Bankruptcy Court acquires exclusive jurisdiction over all property of the bankruptcy estate. See, e.g., In re: Raboin, 135 B.R. 682, 684 *Bankr. Kan. 1991) and 28 U.S.C. Sec. 1304(d). Bankruptcy judges should grant modification of the automatic stay to allow entry of an equitable division by the State Court judge pursuant to marriage dissolution proceedings. See, e.g., In re: Robbins, 60 U.S.L.W. 2749 (4th Cir. 1992). Domestic law matters, which include equitable distributions of property, should be left primarily for state courts to decide since a debtor's property interests are determined by state law. Only those property interests the debtor has as determined in the dissolution proceedings constitute property of the debtor's bankruptcy estate, and hence, subject to the jurisdiction of the Bankruptcy Court. See Bankruptcy and Divorce in Kansas, 29 W.L.J. 551,597 (1990).
3. Trustee's right to intervene: At least one court has urged a Chapter 7 bankruptcy trustee in the debtor's pending bankruptcy to intervene in the debtor's divorce case to insure an equitable and proper division of property to prevent collusion that would diminish the assets of the debtor. See In re: White, 851 F.2d 170 (6th Cir. 1988). This makes it important that one obtain leave of the Bankruptcy Court for the state court to enter orders pertaining to the debtor's property. In an abundance of caution, the order should also indicate that the Bankruptcy Court abstains from the divorce proceedings.
4. Trustee avoidance powers: Bankruptcy Trustees, whether in a Chapter 7, 11, 12 or 13, enjoy what are commonly referred to as avoidance powers. These give the power to the Trustee to avoid (set aside or nullify) transfers of property or interests in property under Sec. 544, 547, 548, and 549 of the Bankruptcy Code. The term "transfer" is broadly defined under Sec. 101(54). While these avoidance powers have limitations, they can have surprisingly vital relevance in divorce proceedings. In addition, while it is not an avoidance power per se, the Sec. 361(a) automatic stay renders any actions undertaken in violation of the automatic stay void.
a. Post-petition transfers: With limited exceptions, Sec. 549 authorizes the Trustee to avoid post-petition transfers of property of the estate which are not authorized. See In re: Kelly, 169 B.R. 721 (Bankr. D. Kan. 1994) wherein the Court found that Sec. 362(a) applies to transfers arising out of the family or in the divorce court arena, and In re: Briglevich, 147 B.R. 1015 (Bankr. N.D. Ga. 1992) wherein post-petition transfers effected without Court authorization and in contravention of the stay were avoidable. If a debtor files bankruptcy and the non-debtor does not obtain relief from stay then property transfers incidental to a divorce proceeding may be avoidable.
b. Strong arm powers: The Trustee possess the "strong arm" powers under Sec. 544(a), which gives the Trustee the same status as a hypothetical judicial lien creditor, hypothetical creditor with an execution return unsatisfied, or a bonafide purchase of real estate. If these creditors could cut off an ex-spouse's interest in property of the estate, then the Trustee's power to avoid these interests would also prevail over the claimed interest of the ex-spouse. Most commonly, these powers are asserted against a creditor whose interest or lien in property of the estate is not properly perfected. For instance, the Trustee's strong arm powers under Sec. 544 have prevailed over the asserted oral agreement as to the division of personal property, see In re: Vann, 113 B.R. 704 (Bankr. D. Col.); or a divorce decree which was not properly filed in the real estate records, see In re: Hurst, 27 B.R. 740 (Bankr. E.D. Tenn. 1983); and an ex-wife's divorce judgment wherein she was attempting to execute against her ex-husband's (debtor's) franchise restaurants, see In re: Halverson, 151 B.R. 358 (Dist M.D.N.C. 1993). Additionally, Sec. 544(b) empowers the Bankruptcy Trustee to use the Kansas fraudulent conveyance provisions set out in the Statute of Frauds to avoid transfers. See K.S.A. 33-102. This is especially useful to a Trustee who may have failed to bring his action under the one year fraudulent transfer provisions of Section 548 of the Code До since under Kansas law an action to set aside a fraudulent conveyance may be brought within two years of the transfer.
c. Preferential transfers: A Trustee may also avoid preferences under Sec. 547(b). Casting aside the statutory limitations for a moment, a preference is generally a payment by the debtor of an old debt. The more detailed statutory definition is that it is:
a transfer of an interest of the debtor in property to or for the benefit of a creditor, for or on account of an antecedent debt, made while the debtor was insolvent, on or within 90 days before the date of the filing of the bankruptcy petition (or within on year if the creditor is an insider), that enables a creditor to receive more than it would receive if the case were a case under Chapter 7, had the transfer not been made, and the creditor received payment as part of the regular distribution of the estate's assets.
There are eight listed exceptions set out in Sec. 547(c). One of these exceptions was enacted in the Bankruptcy Reform Act of 1994 which specifically excepted the avoidance as a preference the payment for alimony, maintenance or support. However, payments for other liabilities owed to an ex-spouse (such as property division) are still avoidable under Sec. 547. An ex-wife should not be considered an insider under Sec. 547 (transfers to insiders are avoidable for up to one year as opposed to the 90 day limit for non-insiders). See In re: Busconi, 177 B.R. 153 (Bankr. D. Mass. 1995), in which the Court did not allow the Trustee to avoid transfers of the family home and its contents and over $250,000.00 to the debtor's ex-spouse, when the transfers occurred more than 90 days prior to the filing of the petition.
d. Fraudulent Transfers: The Trustee is empowered to avoid fraudulent transfers under Sec. 548. Transfers made with an intent to hinder, delay or defraud any creditor are subject to avoidance under the statute, as are transfers made for less than a reasonably equivalent value and when the debtor is insolvent or became insolvent as a result of the transfer. There is a one-year lookback period under Sec. 548. Section 548 can be used by a Trustee to set aside divorce settlements which are little more than shams to remove property from the debtor's estate and to place it in the hands of an ex-spouse. See In re: Williams, 159 B.R. 648 (Bankr. D.R.I, 1993).
e. Liability for avoided transfers: To the extent that a transfer is avoided under any of the above sections, the Trustee may recover, for the benefit of the estate, the property transferred or the value of the property from the initial transferee or any immediate transferee. Of course, such a transferee could include the debtor's ex-spouse when the transfer is avoided under Trustee's avoidance powers.
What is Excluded from the Bankruptcy Estate
1. Legal title only: Certain property is excluded from the bankruptcy estate. The Sec. 541(d) exclusion applies to the property in which the debtor only possesses legal title and not an equitable interest. However, this exclusion is limited in scope and has not been used with great efficacy by ex-spouses seeking to exclude property from the bankruptcy estate. See In re: Halverson, supra, in which the Court found that the debtor's ex-spouse did not hold equitable title in the debtor's personal property to qualify for Sec. 541(d) and that the lien could be avoided under Sec. 544.
2. Spendthrift interests: Section 541(c)(2) provides that property of the estate does not include:
A restriction on the transfer of a beneficial interest of the debtor in a trust under applicable non-bankruptcy law that is enforceable in a case under this title.
The legislative history intimates that this exception applies generally to spendthrift trusts, although it has been expanded to include discretionary trusts as well. See In re: Pechanec, 59 B.R. 899 (Bankr. D. Kan. 1986).
3. Exemptions: While not specifically excluded as property of the estate, exemptions also allow the removal of property from the bankruptcy estate. Exemptions are classifications of property that are protected from most creditors (tax liabilities are a common exception to such exclusion) and which can not be taken from the Debtor by a creditor who does not have a lien in the exempt property. Common examples are the homestead, a vehicle, clothes and household goods and furnishings. F.R.B.P. provides that if a creditor does not object to a debtor's claimed exemptions within 30 days from the date that the debtor's 341 meeting is concluded, that the exemptions are deemed allowed, even if the claimed exemptions are not legally allowable or are invalid as a matter of law. See Taylor v. Freeland & Kronz, 503 U.S. 638, 112 Sup. Ct. 1644 (1992). Upon allowance, the exempt property is removed the estate and revests in the Debtor.
4. ERISA retirement plans. Section 541(c)(2) is the exclusion which prevents inclusion of ERISA qualified plans in the bankruptcy estate. The exclusion occurs because ERISA qualified plans must contain anti-alienation language in order to be qualify under the ERISA statues. This anti-alienation language is considered a sufficient restriction on the transfer of the beneficial interest of the debtor in the retirement plan so as to exclude that interest from the bankruptcy estate. See In re: Ralston, 61 B.R. 502 (Bankr. D. Kan. 1986), in which the debtor's interest in a plan was excluded from the bankruptcy estate; and In re: Threewitt, 24 B.R. 927 (Bankr. D. Kan. 1982), in which the debtor's pension plan provided by a large corporation was excluded from the bankruptcy estate. The Court in Patterson v. Shumate, 504 U.S. 753, 112 Sup. Ct. 2242 (1992) resolved a split of among the circuits by holding that ERISA plans are excluded from the bankruptcy estate under Sec. 541(c)(2). While the Debtor's interest in an ERISA plan still needs to be listed as an interest of the debtor on the debtor's schedules, qualified plans should nevertheless be excluded from the estate. In addition, Kansas amended K.S.A. 60-2308(b) to provide that any ERISA qualified plan shall be conclusively presumed to be a spendthrift trust under exemption statutes. This amendment supplements the Sec. 541(c)(2) exclusion.
To deal with the status of the transferee's interest in a qualified plan, K.S.A. 60-2308(c) was enacted to afford to the transferee the same protection as that afforded to the original participant if the transfer is effected pursuant to a qualified domestic relations order. Arguably, under this statute, the transferee who receives her interest under a QDRO will enjoy the same protections as her ex-spouse. The statute says that any qualified plan is conclusively presumed to be a spendthrift trust under the exemption statutes and common law of the state. The section has been held applicable to 401(k) plans. See In re James, 126 B.R. 360 (Bankr. D. Kan. 1991). Some annuities may also be excluded as property of the estate if they are ERISA-qualified. In re Bennett, 185 B.R. 5 (Bankr. E.D. N.Y. 1995).
Practice Pointers
1. Examination of a Debtor: Examination of a debtor under the Bankruptcy Code may relate only to the acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor's estate, or the debtor's right to a discharge. If the debtor is in a reorganization case, she may also be examined regarding the operation of any business and regarding a Plan of Reorganization. See F.R.B.P. 2004 and Sec. 343. A "Rule 2004 Examination" is essentially a deposition conducted within these limitations by Bankruptcy Court order. Since the Federal Rules of Civil Procedure apply to adversary proceedings, it makes sense to use those discovery rules (including a deposition) in lieu of the Rule 2004 examination if there is pending litigation. The limitations of Rule 2004 would not apply in such situation, and the scope of examination considerably broader than that envisioned by Rule 2004. Of course, to utilize deposition procedure, there must exist an adversary proceeding under Bankruptcy Rules 7001 et. seq., such as a dischargeability complaint, a general objection to discharge, an action to revoke a discharge, and other similar types of proceedings. It does not appear that use of a deposition would be available in contested matters, such as objections to confirmation, objections to claims, and other similar proceedings. In those instances, the Rule 2004 procedures would apply, with their attendant limitations.
2. Joint vs. individual filing: On occasion, persons involved in a divorce proceeding will agree to resolve the financial aspects of their marriage through the filing of a joint bankruptcy. Often times, division of debt in divorce situations may be an impediment to settlement, the resolution of which can be facilitated through bankruptcy filing. However, practitioners would be wise to reject the notion of filing a joint Chapter 13 bankruptcy for divorcing spouses. Obviously, a Chapter 13 bankruptcy is going to continue on for at least three years and possibly as long as five years. What this means is that the divorcing parties will still be "married" to each other through the vehicle of a Chapter 13 bankruptcy. Divorcing parties will sometimes attempt to divide a Chapter 13 payment in some fashion through a Property Settlement Agreement in the divorce proceeding. The problem with this approach is that should one of the debtors cease making his or her portion of the Chapter 13 payment following dissolution of the marriage, this will result in dismissal of the entire Chapter 13 case. Enforcement action would be available to the non-defaulting spouse through the divorce proceedings, but most divorce practitioners are well aware of the fact that most motions to enforce filed by one ex-spouse against another for the payment of debt are not particularly efficacious. Should one spouse cease making his or her portion of the Chapter 13 payment and then convert to a Chapter 7, such enforcement action would cease to be the remedy, since the non-converting ex-spouse would be a creditor of the converting ex-spouse. Finally, it almost goes without saying that the bankruptcy practitioner who recommends a joint Chapter 13 to divorcing spouses may be placed in a conflict of interest situation should one ex-spouse default or convert, and could also run the risk of a potential malpractice claim. These problems can all generally be avoided if the bankruptcy vehicle utilized for divorcing spouses is the Chapter 7.
Other problems can occur where only one spouse seeks bankruptcy protection while the divorce is pending. While some state District Court judges understand the impact which bankruptcy filing by one spouse has on a pending divorce case, others do not. This may result in a decision by the divorce judge to attempt a debt assignment to the spouse filing bankruptcy through the guise of an award of spousal maintenance to the spouse not filing bankruptcy. Even if this is not the result, certainly a pre-emptive bankruptcy filing by one spouse prior to the conclusion of the divorce proceeding will scuttle any further settlement negotiations. It will also require the non-bankruptcy filing spouse, at least in the Chapter 13 scenario, to request and obtain stay relief from the Bankruptcy Court in order to finalize the divorce proceeding.