Family Law and Bankruptcy: When One Spouse Files a Bankruptcy Petition

By M. Jonathan Hayes[1]

Bankruptcy pundits like to point out that bankruptcy has been around since the time of the Bible. Deuteronomy 15:1 says:

At the end of every seven years you shall grant a release of debts. And this is the form of the release: Every creditor who has lent anything to his neighbor shall release it; he shall not require it of his neighbor or his brother, because it is called the Lord’s release."

That is a fun sort of thought but bankruptcy, until fairly recently, has never been about the discharge of debts. The purpose of bankruptcy has always been, and indeed bankruptcy law was invented, to facilitate the orderly liquidation of the debtor’s assets. By requiring creditors to act as a group, through a third-party trustee, the debtor’s assets can be efficiently sold for the highest value and distributed fairly to all creditors pro-rata. The discharge provided in early American bankruptcy law and state insolvency laws permitted the cooperative debtor to be discharged from jail when his assets were sold and distributed to creditors; there was no general discharge of debts. In modern times, the discharge of debts in a chapter 7 bankruptcy case has become an automatic process. 

This article examines the treatment of assets in a chapter 7 case, the resulting discharge of the debtor’s debts, and how these processes interact with California family law - particularly when only one spouse files the bankruptcy petition.

Assets in Bankruptcy

The Bankruptcy Code provides that the filing of a bankruptcy petition creates a bankruptcy estate which consists of all “legal and equitable interests of the debtor in property as of the commencement of the [case].”[2]  The concept of “property of the estate” then is very broad. It includes your home, your clothes, books and personal effects, your car, your bicycle and the like. But it also includes rights to things, like royalties to be received down the road, the right to sue someone, collect from insurance for some loss, an unearned bonus, tax refund, rights under your partnership or joint venture agreement, commission from a real estate sale which will close next week, auto leases, your season tickets to the
Lakers, fractional interests in things.[3]

The existence and scope of these rights are determined by looking at state law rather than federal bankruptcy principles. In Butner v. United States, 440 U.S. 48 (1979), the issue was who had the right to rent collected during the bankruptcy case and now sitting in the bank. The Supreme Court said (something like) “we don’t know who gets it either, but the answer comes from state law, not some equitable bankruptcy rule.”

Community Property in Bankruptcy

The Bankruptcy Code also mandates that property of the estate includes “[a]ll interests of the debtor and the debtor’s spouse in community property as of the commencement of the case . . . “[4] This is not a big deal when a husband and wife file a joint petition; all of their property is property of the estate irrespective of whether it is community or separate property under California law. But when only one spouse files a chapter 7 petition, all community property that the filing spouse owns with his non-filing spouse is property of the estate. The non-filing spouse’s separate property is not property of the estate.

Yes, if my wife decides one day to file a chapter 7 petition, the trustee will sell our home.[5] I will not get my share out of the sale; the proceeds go to creditors first. Further, the trustee will seize my bank account, my truck, my interest in my law firm, the books I have written, and my bike, as long as those assets are community property on the petition date.[6]

Defining Community Property

So, what is community property? In Brace v. Speier (In re Brace), 979 F.3d 1228 (9th Cir. 2020), an enterprising husband filed a petition by himself and argued that real property he and his wife acquired and held as joint tenants was not community property based on the title set forth in the deed. The debtor argued to the bankruptcy court that the record title presumption in Cal. Evid. Code § 662[7] was binding on the court, rather than the community property presumption of Cal. Fam. Code § 760.[8]  The bankruptcy judge and the Ninth Circuit Bankruptcy Appellate Panel (BAP)[9] disagreed with the debtor ruling that the property was community property. On further appeal, the Ninth Circuit Court of Appeals asked the California Supreme Court to clarify the competing presumptions. The Supreme Court ruled that:

when a married couple uses community funds to acquire property with joint tenancy title[,] . . . the property is presumptively community property under Family Code section 760 in a dispute between the couple and a bankruptcy trustee.

It added that:

Nothing in our decision precludes spouses from holding separate property as joint tenants or from transmuting community property into separate property held in joint tenancy as long as the applicable transmutation requirements are met.

Speier v. Brace (In re Brace), 9 Cal. 5th 903, 912 (2020)

This is the rule law students learn the first day of Community Property class. Property acquired during the marriage is community property unless acquired by gift, bequest, devise or decent.[10] Pre- and post-marital agreements[11] in which the couple redefines the ownership of their property[12] are enforceable against the bankruptcy trustee as long as the requirements under California law are satisfied.

What about the age-old question which comes up when community property is used to improve separate property or pay the mortgage on the separate property during the marriage? There may be a right of reimbursement to the community,[13] or the separate property may actually become community property to some extent.[14] A right to reimbursement in a bankruptcy setting is simply a debt. On the other hand, if, under California law, some portion of the separate property became community property, the trustee will sell that portion. 

Suffice it to say, the trustee has little to no interest in why or how it became community property or how the family court might treat it in a dissolution proceeding. If the property is community property on the petition date, the chapter 7 trustee will sell it (unless it is exempt or has no equity).

The Bankruptcy Process and Family Law

Bankruptcy courts are frequently asked to determine the extent of the debtor’s ownership rights in specific property, including whether something is community property.[15] If the couple has been engaged in a family law proceeding, the bankruptcy court is bound by rulings of the state court as long as claim or issue preclusion applies.[16]  And bankruptcy courts are generally not hesitant to permit the issue to be resolved in state court even after the bankruptcy case has begun. When the state court is in the process of resolving the issue, bankruptcy courts will often grant relief from stay to allow the state court to finish its task.

The Discharge of Debts in Bankruptcy

It is helpful at the outset to think of the discharge as an injunction. It is essentially a court order instructing creditors to leave the debtor alone forever; that is, do not commence or continue any act to collect a prepetition debt from the debtor forever.[17] The discharge doesn’t make the debt disappear or otherwise affect the creditor’s rights to collect the same debt from other parties, should it have such rights.

It is also helpful to understand that the concept of debt in bankruptcy is just as expansive as the concept of property. The Bankruptcy Code defines debt very broadly as a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured . . .”[18]  The debtor receives a discharge of every debt unless one of 19 exceptions set forth in the Bankruptcy Code applies.[19] Two exceptions are relevant to this discussion: first, domestic support obligations are automatically not discharged,[20] and, second, debts owed “to a spouse [and] incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement [or] divorce decree . . .” are automatically not discharged.[21]

But how do we know what a debt is, and, more importantly for our discussion, which spouse is liable for the debt? This is important because, as stated, only the filing spouse gets a discharge of his/her debts. Again, Butner instructs us to look to state law, or to be more specific, non-bankruptcy law, to find the “right to payment.”

Debts arise from contract, a tort, or some government statute or rule. There seems to be a common belief that sometimes a spouse is liable for the debt of the other spouse just because they are married.  I hear it mistakenly said that it depends on why the debt was incurred, or the intention of the parties, or the benefit to the community, or something else which supposedly tells us whether it is a “community debt” and somehow that makes the other spouse liable for the debt.

Remember the Hayes Rule: My wife is not personally liable for my debts. My creditors cannot sue my wife if I don’t pay one of my creditors. My wife is not liable for the office lease I signed or my AMEX card unless she promised the landlord or AMEX that she would pay it. She is not liable for the car accident I had or my failure to pay my business license.  My creditors have no general “right to payment” from my wife.

The one exception under California law making a spouse personally liable for a debt he did not personally incur is when the debt is for “necessaries.”[22] I’ll leave it to you to figure out what is a “necessary.”

This non-liability probably sounds good but, under California law, the spouses’ community property is liable for the debts of either spouse incurred before or during the marriage.[23] So if I default on my office lease, the landlord can seize and sell my community property home, and apply the proceeds to pay my debt, even though my wife is not liable for the debt. My creditor must get a judgment against me for breach of contract and then execute the judgment by seizing my property, whether separate or community.

In summary, spouses are not liable for each other’s debts, but their community property is liable.[24]

Of course, the family court will, as part of a dissolution proceeding, assign, or “confirm,” the debts to each spouse according to the Family Code.[25] That has nothing to do, in my opinion, with who the creditor can sue, i.e., who is liable for the debt.

The Community Discharge

Back to the discharge. The chapter 7 debtor automatically gets the bankruptcy court injunction ordering his creditors to leave him alone (i.e., the discharge). The non-filing spouse does not get the discharge even though that spouse has lost his interest in the community property they owned. In the common scenario where the debtor and the non-filing spouse both owed the same debt, only the debtor will get the discharge. But that would leave the creditor of the non-filing spouse with the power to seize any community property the spouses acquire post-bankruptcy, as long as they remain married which kind of defeats the purpose.

Congress tried to fix this dilemma by creating what is known as the community discharge. This may be the most misunderstood concept in the Bankruptcy Code. I have heard very good bankruptcy attorneys say “the community gets a discharge.” Notwithstanding that I don’t know what that means, it is wrong. I have heard that the discharge is “in rem.” That is also wrong. Or the discharge applies to community debts. Wrong.

The community discharge simply provides (looking past the clumsy language Congress gave us) that the debtor’s creditors must leave the debtor alone forever (we knew that) and his community property acquired postpetition must also be left alone forever (my words).[26]  Creditors of the debtor’s non-filing spouse can continue to sue her on the debt – she did not get the discharge. But the community discharge prevents those creditors from seizing any community property the couple acquires postpetition – as long as they remain married. 

Bankruptcy Filed During the Dissolution Proceeding

The automatic stay does not stop everything; it is actually pretty specific. The stay provides that (again, my words) creditors may not commence or continue any act to collect a prepetition debt from the debtor or from property of the estate.[27]  That said, there are 29 “acts” specified in the Bankruptcy Code that are not stopped by the automatic stay.[28] For our discussion here, portions of postpetition activities in a family law case are specifically exempted from the stay; for example, proceedings dealing with domestic support obligations, child custody or visitation, domestic violence, and the ministerial act of dissolving the marriage.[29]

When the automatic stay applies and stays some upcoming event, the bankruptcy court is authorized to grant relief from stay to permit the non-bankruptcy action to proceed.[30] Generally speaking, the bankruptcy courts are content to permit the dissolution action to proceed as long as it does not interfere with the trustee’s efforts to do her primary job, i.e., liquidate the debtor’s assets.

A common scenario occurs when a bankruptcy petition is filed right before trial or some other evidentiary hearing is set to begin. As noted above, to the extent the trial or evidentiary hearing is going to focus on an issue not included in the automatic stay, trial may proceed. But if there are portions of the trial affected by the stay, or even any doubt, the non-filing spouse should file a motion with the bankruptcy court seeking permission to proceed with the trial or other stayed event. Our local bankruptcy courts are likely to grant relief, even on shortened notice, if the trial was really ready to go. The order granting relief will specifically provide that the stay is not lifted to permit the spouse to enforce any ruling by seizing any property of the estate or interfering with the trustee’s rights to liquidate the estate.

Conclusion

Why would only one spouse file a bankruptcy petition? Often it is psychological; the other spouse did not create “the problem” and does not want the scarlet letter created by the bankruptcy. But just as often the parties are engaged in a dissolution proceeding and one spouse believes that the bankruptcy will give him or her a litigation benefit. The latter reason is a big mistake; bankruptcy courts do not appreciate being brought into a scrum when one side is simply looking to change judges or gain some perceived advantage in the divorce by filing a petition in the middle of the proceeding.

The result in any event is that all community property will be sold if it has equity that is not exempt. And the debtor’s debts will be discharged and his postpetition community property will be protected.

M. Jonathan Hayes is Senior Counsel at RHM Law LLP in Encino, Calif. He has practiced bankruptcy and appellate law for 44 years in the San Fernando Valley. He recently completed a two-year sabbatical as a law clerk to two bankruptcy judges who sit on the Bankruptcy Appellate Panel.  He currently focuses on bankruptcy, both debtor and creditor, and appeals. He can be reached at jhayes@RHMFirm.com.

The purpose of bankruptcy has always been, and indeed bankruptcy law was invented, to facilitate the orderly liquidation of the debtor’s assets. By requiring creditors to act as a group, through a third-party trustee, the debtor’s assets can be efficiently sold for the highest value and distributed fairly to all creditors pro-rata.

Family law litigation and bankruptcy often intersect as both proceedings deal with dividing up the parties’ properties and paying the parties’ debts. This article attempts to explain how the different courts resolve the issues mandated to them and how and when they give deference to each other’s decisions.