Article of the Week

“The Devil Could Get a Discharge ... If He Were Married to Snow White!”

by Marlene G. Weinstein

In this day of Ponzi schemes and real estate fraud, creditors need to be aware of the "community property discharge" provided to debtors who file for protection under the Bankruptcy Code, as well as their spouses, regardless of whether or not the wrong-doing spouse files bankruptcy.

Consider the following scenario: Joe and Julie live high on the hog in a 3,000 square foot house in one of the nicest neighborhoods in the area. Their two children attend private school. Julie doesn't work and so she shops, lunches with her friends and works out at the country club. Joe is an investment advisor and got himself in a little bit of trouble. He started out honest enough when money was flowing and everyone was making money. Unfortunately, over time, his investments went sour (not uncommon). He needed money to support the life style he and Julie had become accustomed to. He started using the money that his clients were investing with him to pay his other clients their interest. At some point, it all crashed and fell down around him. His investors wanted their money back, and when they found out it no longer existed, they started suing Joe in state court for fraud, conversion, breach of his fiduciary duty and various other claims that could survive notwithstanding if Joe filed a bankruptcy to discharge his debts ... as long as the creditors took action against Joe in his bankruptcy case by filing a complaint either excepting their specific debt from discharge under 11 U.S.C. §5231 , or objecting to Joe receiving a discharge of any of his debts under §727. But instead of Joe filing bankruptcy, Julie does. Julie never did anything wrong, and so when she files her bankruptcy case, none of Joe's creditors file complaints against her or against Joe under either §523 or §727, and her bankruptcy case proceeds smoothly with Julie receiving a discharge of all of her debts.

Notwithstanding Julie's bankruptcy, Joe's creditors continue to litigate in state court and get judgments against Joe. However, when they seek to enforce their judgments by garnishing Joe's wages, (he now has a high-earning job), levying Joe and Julie's bank accounts, or filing an abstract of judgment against Joe and Julie's home to which title has always been held in community property, they are thwarted. Since Joe and Julie are still married, Julie files a motion to reopen her bankruptcy case in order to file motions against Joe's creditors for violating the discharge injunction

Enter §524(a)(3) and the community property discharge which, with certain limitations, permanently enjoins any action to collect a pre-petition debt for which the community property would otherwise be liable from the community property acquired by either the debtor or his/her spouse subsequent to the debtor receiving a discharge. "... According to Section 524(a)(3), after-acquired community property is protected by injunctions against collection efforts by those creditors who held allowable community claims at the time of filing. This is so even if the creditor claim is against only the nonbankruptcy spouse; ..." In re Kimmel, 378 B.R. 630, 636 (9th Cir.BAP 2007), citing Burman v. Homan (In re Homan), 112 B.R. 356, 360 (9th Cir. BAP 1989).

It all comes down to the fact that at the time of Julie's bankruptcy filing, Joe's creditors were "creditors" who held "community claims" under the Bankruptcy Code. A "creditor" as defined by §101(10) means, "(A) entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor; ... or (C) entity that has a community claim." A "community claim," for bankruptcy purposes, is a pre-petition claim for which the community property of the debtor and the debtor's spouse is liable, whether or not such claim has proceeded to judgment or is otherwise liquidated as of the filing of the bankruptcy case, and whether or not there is any such property at the time the bankruptcy case is filed. See §§ 101(7) and 541(a)(2).

Since virtually all property acquired by a married person during the marriage is community property (see California Family Code §7602), and since F.C. §ยง910 generally provides that all community property is liable for debts incurred before or during marriage by either spouse, all of the community property belonging to both Julie and Joe was included in Julie's bankruptcy estate and subject to the administration of the Bankruptcy Court. See Section 541(a)(2).

In order for Joe's creditors to be able to enforce their judgments against Joe against the community property acquired by either Joe and/or Julie following Julie's receipt of her Chapter 7 discharge, including but not limited to Joe's wages, they would have had to have filed a lawsuit against Joe in Julie's bankruptcy case.3

If a debt on a community claim would be excepted from discharge in a bankruptcy case filed by the nondebtor spouse, a nondischargeability action or an objection to discharge action directed at the nondebtor spouse can be initiated to establish an exception to the allowable community claims that are discharged. In addition, if the court would not grant the nondebtor spouse a discharge in a hypothetical case filed by the nondebtor spouse, or if the nondebtor spouse has been denied a discharge within the preceding six years of the date of filing of the debtor's bankruptcy case, the community property discharge does not apply. See §§ 523(a), 524(a)(3) and 524(b)."

"The net result is that §§ 524(a)(3) and 524(b)(2) combine to prevent a wrongdoer from hiding behind an innocent spouse's discharge, ... These provisions for nondischargeability and objection-to-discharge actions directed at the nondebtor spouse are, however, subject to a diligent creditor requirement. The failure by creditors to raise nondischargeability and discharge objection issues in a timely manner in the case of the debtor spouse will allow the community property discharge to be effected." In re Kimmel, supra, at p. 637.

The strict time deadlines generally provide that a complaint filed pursuant to §§ 523(c) and/or 727(a) must be filed no later than sixty (60) days following the first date set for the meeting of creditors. See Federal Rules of Bankruptcy Procedure 4007(c) and 4004(a)4. Of course this presumes that Joe's creditors were aware of Julie's bankruptcy filing.

In the event Joe's creditors had no knowledge of Julie's bankruptcy filing in time to file a complaint with 60 days following the meeting of creditors, they would have the right to file a motion to reopen Julie's bankruptcy case in order to file a lawsuit against Joe and/or Julie based upon §§ 523(a)(3) and/or 727(d)(1). However, §523(a)(3) would not be applicable if "such creditor had notice or actual knowledge of the case in time" to file a complaint pursuant to §523(a), and §727(d)(1) is available to a creditor only if the creditor "did not know of such fraud until after the granting of the discharge." But creditors beware. A creditor does not have to be listed by the debtor in the bankruptcy case, and it is not necessary for the creditor to receive written notice of the bankruptcy filing. Any notice that gives the creditor time to take action in the bankruptcy case within the time limits provided by the Bankruptcy Code is sufficient. As an example, the author of this article won an exception to discharge case filed on behalf of a creditor under §§ 523(a)(3) and 523(a)(2) when the Judge asked the debtor-defendant during trial, "When you ran into the plaintiff at the Safeway, did you tell him that "you had" filed bankruptcy, or that "you were going to" file bankruptcy?" When the debtor answered, "that I was going to file bankruptcy" I knew I had won. My client had never received actual notice of the bankruptcy filing.

But all is not lost. The community property discharge injunction does not eliminate (or discharge) Joe's personal liability for his debts to his creditors. His creditors are free to enforce their judgments against Joe against his separate property (if he should have any). Although it is likely that Joe will make sure that everything he acquires during his marriage is community property so that it is protected from his creditors, in the event Joe and Julie should ever divorce, any and all property acquired by Joe in the divorce, as well as all income and assets acquired subsequent to his separation from Julie, would be his separate property and therefore, subject to enforcement by his creditors. All property would also become Joe's separate property in the event of Julie's death.

As the court stated in In re Kimmel, supra, at p. 637, "If creditors are not diligent, as one commentator has explained, "the Devil himself could effectively receive a discharge in bankruptcy if her were married to Snow White." Alan Pedlar, Community Property and the Bankruptcy Act of 1978, 11 ST. MARY'S L.J 349, 382 (1979); cf. Gonzales v. Costanza (In re Costanza), 151 B.R. 588, 590 (Bankr.D.N.M. 1993) ("I would add: if [the Devil] does not treat her better than his creditors, [Snow White] will, by divorcing him, deny his discharge.").

Marlene Weinstein's practice in Walnut Creek is devoted to Bankruptcy Law representing debtors, creditors and Chapter 7 trustees. She has written articles and given lectures to professional groups. She believes pre-bankruptcy planning is important and that it can often be used as an effective tool in negotiations between parties involved in non-bankruptcy disputes. She often works with clients in conjunction with their family law attorneys, tax professionals and other non-bankruptcy lawyers.

1 Unless otherwise indicated, all references to section numbers refer to sections of Title 11 of the United States Code, commonly referred to as "the Bankruptcy Code.
2 Hereinafter all references to the California Family Code will be referred to as "F.C."
3 Although the remainder of this article discusses the issues as they relate to Chapter 7, similar rules apply in cases filed under Chapters, 11, 12 and 13 of the Bankruptcy Code.
4 Unless otherwise indicated, all references to rule numbers refer to the Federal Rules of Bankruptcy Procedure.

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