Divorce and the New Bankruptcy Law

Let us suppose that you have represented the wife, and her share of the value of the husband's business is $300,000. Because the husband cannot make a lump sum payment, he has agreed to make six annual payments of $50,000 each and has even agreed to pay interest on the unpaid indebtedness at the rate of 6% per year. A promissory note may be given and, possibly, even security. Payments commence, and the wife receives her annual installment after the first year; and then again, after the second year. However, at the time the third installment is due, the wife does not receive a check, but instead she receives a notice from the Bankruptcy Court that the husband has filed for bankruptcy and has scheduled for discharge his remaining obligation to the wife.

You can be sure that the wife's first step after receiving that notice is to call you, the attorney who prepared the agreement or who recommended it. What do you say? What assurances can you give to the client?

A Brief Explanation

Prior to 1994, only support and maintenance obligations of a debtor were non-dischargeable; property distribution obligations were dischargeable. If the obligations of a debtor were, in essence, in the nature of support, then they would not be dischargeable. Maintenance (or alimony as it is known in some jurisdictions and under the Internal Revenue Code) was and still is non-dischargeable. Child support, similarly, is not a dischargeable obligation of the debtor. That law has continued to the present time. It does not matter how the obligations are labeled, it is the nature of the obligation that determines its character as support or property distribution. Simply calling a property distribution “a support payment” does not make it one that is recognizable as such under the Bankruptcy Code. It is, rather, the essence of the obligation that controls, regardless of the label that it bears.

In 1994, the Bankruptcy Code changed. It permitted the Bankruptcy Court the discretion to allow or not to allow the discharge of an obligation for the distribution of property under a marital agreement or court order. Under USCA, Title 11, Bankruptcy (the “Bankruptcy Code”), section 523 was amended in 1994 to give discretion to the Bankruptcy Court to discharge a property distribution, if in the judgment of that court, discharging the debt would create a benefit to the debtor that outweighed the detrimental consequences to the debtor's spouse, former spouse, or child. This was a discretionary matter, which really became a “crap shoot” in the Bankruptcy Court as to whether or not the obligation will be discharged. The cases decided under the amended ' 523 were strictly fact-specific. A part of the examination of the facts included an examination of the parties' divorce settlement agreement.

The New Act

The Bankruptcy Act has now been further amended by the Bankruptcy Abuse Prevention and Consumer Act of 2005. The new provisions become effective on Oct. 17, 2005. Some of the changes impact directly upon matrimonial cases, even though a primary purpose of the newly revised Bankruptcy Act is designed to limit dischargeability of credit card debt. Among the notable changes that affect matrimonial cases are:

Property settlement obligations arising out of a matrimonial case are not dischargeable for any reason. There is no longer any discretion on the part of the Bankruptcy Court. Property settlement obligations have the same nondischargeability as support obligations. Both support and property obligations in a matrimonial agreement or order are included in a definition of “Domestic Support Obligations.” (Bankruptcy Code ' 1328 (a));

• Domestic Support Obligations are elevated to the highest priority of payment, higher even than taxes, and are subordinate only to administration expenses. (Bankruptcy Code ' 507 (a) (i));
• A Chapter 13 arrangement with creditors cannot be confirmed unless the debtor is current with all Domestic Support Obligations, and the Chapter 13 petition will be dismissed if the debtor is in arrears of post-petition Domestic Support Obligations. (Bankruptcy Code ' 1307 (c) (ii)); and
• A “means test” can be a barrier to a Chapter 7 proceeding (a complete discharge of debts) and relegate the debtor to Chapter 13 (an arrangement over a period of time for payment of debts in full or in part). If the debtor has incurred a downswing in income and/or ability to pay bills but may recover, a Chapter 7 discharge may not be possible, and the debtor may be relegated to a Chapter 13 plan of payment (Bankruptcy Act ' 707).

These are a few, sketchy highlights of the new Bankruptcy Act. However, the new provisions do not obviate the need to give clients as much protection as possible. Nondischargeability of an obligation does not assure its payment.

Protective Clauses

Despite the new changes in the Bankruptcy Code, there is still a need for protective clauses in an agreement. Those clauses help to fortify the position of the recipient spouse in obtaining adjustments of support payments in the event of a failure to receive property distributions. If support payments are adjusted because of nonpayment of property obligations, there are myriad enforcement remedies for support that are not available for property obligations.

In order to help protect the obligee spouse — usually a former wife — language may be inserted in the settlement agreement to indicate the intent of the parties and provide recognition of the importance of the distribution of property in the scheme of providing support to the former spouse. In the section of the settlement agreement that provides for maintenance and/or child support, it is suggested that the following language may be added to help buttress the position of the former wife in obtaining an upward modification of support in the event of a bankruptcy or any other disruption of payments:

Sample Wording

“The parties acknowledge that the provisions in this Article and other Articles in this agreement relating to maintenance and child support are dependent upon the actual distributions and payments for the division of marital property as hereinafter provided and that the Wife will necessarily depend upon receipt of said assets and payments in order to maintain a proper standard of living, that failure to receive said assets and payments will seriously impair that standard and that the provisions for maintenance and child support would have been significantly higher but for the reliance of the Wife upon receipt of the said assets and payments. Accordingly, the Husband acknowledges that any bankruptcy or insolvency proceedings or other delay in making the said distribution and payments to the Wife will adversely impact upon the Wife's ability to maintain a proper standard of living and may warrant a modification of the support payments herein in order to carry out the intention and agreement of the parties.”

To buttress the position of the wife in our illustration, there can be a further provision in the section of the agreement relating to the distribution of marital property, which may read as follows:

“The parties acknowledge that the provisions herein relating to maintenance and child support are dependent upon the actual distributions and payments for the division of marital property as herein provided and that the Wife will necessarily depend upon receipt of the said assets and payments in order to maintain a proper standard of living, that failure to receive said assets and payments will seriously impair the said standard and that the provisions for maintenance and child support would have been significantly higher but for the reliance of the Wife upon actual receipt of the said assets and payments. Accordingly, the Husband acknowledges that any bankruptcy or insolvency proceedings or other failure or delay in making prompt payments herein, will affect adversely the Wife's ability to maintain a proper standard of living. Notwithstanding the foregoing, the parties acknowledge that all of the payments and distributions under this Article constitute an equitable division and distribution of marital property and are not intended to be treated as taxable income to the Wife or deductible by the Husband and are being made hereunder as a nontaxable event.”

Debts and Obligations

Also, it is common for a spouse (the husband in our illustration) to assume payment of certain named debts and obligations incurred by the wife or by the wife jointly with the husband. If, in a bankruptcy proceeding, the husband can receive a discharge for those debts payable to the named creditors, that discharge will not prevent the creditors from seeking payment of those debts and obligations from the wife. The husband's indemnity to the wife for those debts and obligations could likewise be discharged and leave the wife solely liable to the creditors.

Although in our illustration the Bankruptcy Court cannot discharge the husband's obligations, it is important to lock the husband into a position favorable to the wife by having his assumption of debts be a support obligation. Suggested language in the agreement is as follows:

“The Husband acknowledges that the foregoing named debts and obligations for which he has solely assumed payment represent expenses for support and maintenance of the family in accordance with the parties' standard of living and are not dischargeable in any bankruptcy or insolvency proceeding. Any failure to pay as herein provided will adversely affect the ability of the Wife to maintain a proper standard of living.”

The foregoing language in an agreement helps posture the wife in maintaining that the assumption of debts is, in essence, a function of support and maintenance and necessary for her to maintain a proper living standard as contemplated. In case of a default, the language then becomes a basis for reopening the issue of maintenance and support, facilitating an application to a court to adjust maintenance and support, especially if the settlement agreement so provides.

Of course, a preferable way of assuring payments to the wife would be for the husband to provide security for his obligations, such as a mortgage on real property owned by himself — or anyone else, for that matter. Another device that may be utilized, where possible, is the guarantee by a third party of the obligations assumed by the husband. The guarantor or guarantors can be business associates, parents, relatives or friends. Obviously, the guarantee is only as good as the guarantors, but at least the guarantee will be a better protection than none at all.

Conclusion

In summary, every settlement agreement should recognize that an insolvency or bankruptcy proceeding could frustrate the intent of the parties and affect the prompt payment of obligations of the payor. Even with the added protections of the newly revised Bankruptcy Act, the agreement should contain protective language to help recover payment of obligations under the agreement despite a bankruptcy proceeding. The clauses are usually relatively simple to have included in the agreement, and experience shows that there is normally little or no opposition to that protective language. The language is not a guarantee of protecting the deferred payments. However, it certainly will be of inestimable value in the event that the obligations of the payor are examined by a court in any proceeding to increase support obligations because of nonpayment of property obligations, regardless of their nondischargeability.

Although the newly revised Bankruptcy Act is a giant step forward in protecting economically dependent spouses, specific language in the agreement can help keep the door open for the matrimonial court to revisit the child support and maintenance provisions of the parties' judgment of divorce.

Willard H. DaSilva, the Chairman of the Editorial Board of this newsletter, is a member of Da Silva, Hilowitz & McEvily LLP, in Garden City, NY. He is a Diplomate of the American College of Family Trial Lawyers, past President of the American Academy of Matrimonial Lawyers, New York Chapter, and is listed in The Best Lawyers in America and Who's Who in America.

Among the more arduous tasks for an attorney handling a matrimonial case is the negotiation of the financial aspects, primarily support and maintenance and the division and distribution of marital property. In many cases, exhaustive financial disclosure is necessary; evaluations of property are obtained and challenged, and months of negotiations and legal services result, finally, in a resolution of the financial issues.

Once the major issues of the case are settled, an agreement is prepared so that the acrimony and bitterness of the parties can hopefully become history. The deal is set, and the parties proceed to restructure their lives for a better future in reliance upon the agreement. It is usual that the settlement agreement is executory; that is, there is required of the parties future performance of the obligations that they assumed under the provisions of the agreement. Commonly, the obligations include future payments or distributions of marital property. Although the agreement may determine the respective shares and entitlement of each party, the actual distribution frequently does not take place until a later date.

For example, if a husband owns a business, or an interest in a business, the wife may be entitled to a portion of the value of the husband's interest in that business. After it has been evaluated, it is not uncommon that there is insufficient cash flow to fund the buyout of the wife's interest in one lump sum at the time of the settlement. Consequently, there are often payout arrangements extending sometimes over a period of years.

Let us suppose that you have represented the wife, and her share of the value of the husband's business is $300,000. Because the husband cannot make a lump sum payment, he has agreed to make six annual payments of $50,000 each and has even agreed to pay interest on the unpaid indebtedness at the rate of 6% per year. A promissory note may be given and, possibly, even security. Payments commence, and the wife receives her annual installment after the first year; and then again, after the second year. However, at the time the third installment is due, the wife does not receive a check, but instead she receives a notice from the Bankruptcy Court that the husband has filed for bankruptcy and has scheduled for discharge his remaining obligation to the wife.

You can be sure that the wife's first step after receiving that notice is to call you, the attorney who prepared the agreement or who recommended it. What do you say? What assurances can you give to the client?

A Brief Explanation

Prior to 1994, only support and maintenance obligations of a debtor were non-dischargeable; property distribution obligations were dischargeable. If the obligations of a debtor were, in essence, in the nature of support, then they would not be dischargeable. Maintenance (or alimony as it is known in some jurisdictions and under the Internal Revenue Code) was and still is non-dischargeable. Child support, similarly, is not a dischargeable obligation of the debtor. That law has continued to the present time. It does not matter how the obligations are labeled, it is the nature of the obligation that determines its character as support or property distribution. Simply calling a property distribution “a support payment” does not make it one that is recognizable as such under the Bankruptcy Code. It is, rather, the essence of the obligation that controls, regardless of the label that it bears.

In 1994, the Bankruptcy Code changed. It permitted the Bankruptcy Court the discretion to allow or not to allow the discharge of an obligation for the distribution of property under a marital agreement or court order. Under USCA, Title 11, Bankruptcy (the “Bankruptcy Code”), section 523 was amended in 1994 to give discretion to the Bankruptcy Court to discharge a property distribution, if in the judgment of that court, discharging the debt would create a benefit to the debtor that outweighed the detrimental consequences to the debtor's spouse, former spouse, or child. This was a discretionary matter, which really became a “crap shoot” in the Bankruptcy Court as to whether or not the obligation will be discharged. The cases decided under the amended ' 523 were strictly fact-specific. A part of the examination of the facts included an examination of the parties' divorce settlement agreement.

The New Act

The Bankruptcy Act has now been further amended by the Bankruptcy Abuse Prevention and Consumer Act of 2005. The new provisions become effective on Oct. 17, 2005. Some of the changes impact directly upon matrimonial cases, even though a primary purpose of the newly revised Bankruptcy Act is designed to limit dischargeability of credit card debt. Among the notable changes that affect matrimonial cases are:

Property settlement obligations arising out of a matrimonial case are not dischargeable for any reason. There is no longer any discretion on the part of the Bankruptcy Court. Property settlement obligations have the same nondischargeability as support obligations. Both support and property obligations in a matrimonial agreement or order are included in a definition of “Domestic Support Obligations.” (Bankruptcy Code ' 1328 (a));

• Domestic Support Obligations are elevated to the highest priority of payment, higher even than taxes, and are subordinate only to administration expenses. (Bankruptcy Code ' 507 (a) (i));
• A Chapter 13 arrangement with creditors cannot be confirmed unless the debtor is current with all Domestic Support Obligations, and the Chapter 13 petition will be dismissed if the debtor is in arrears of post-petition Domestic Support Obligations. (Bankruptcy Code ' 1307 (c) (ii)); and
• A “means test” can be a barrier to a Chapter 7 proceeding (a complete discharge of debts) and relegate the debtor to Chapter 13 (an arrangement over a period of time for payment of debts in full or in part). If the debtor has incurred a downswing in income and/or ability to pay bills but may recover, a Chapter 7 discharge may not be possible, and the debtor may be relegated to a Chapter 13 plan of payment (Bankruptcy Act ' 707).

These are a few, sketchy highlights of the new Bankruptcy Act. However, the new provisions do not obviate the need to give clients as much protection as possible. Nondischargeability of an obligation does not assure its payment.

Protective Clauses

Despite the new changes in the Bankruptcy Code, there is still a need for protective clauses in an agreement. Those clauses help to fortify the position of the recipient spouse in obtaining adjustments of support payments in the event of a failure to receive property distributions. If support payments are adjusted because of nonpayment of property obligations, there are myriad enforcement remedies for support that are not available for property obligations.

In order to help protect the obligee spouse — usually a former wife — language may be inserted in the settlement agreement to indicate the intent of the parties and provide recognition of the importance of the distribution of property in the scheme of providing support to the former spouse. In the section of the settlement agreement that provides for maintenance and/or child support, it is suggested that the following language may be added to help buttress the position of the former wife in obtaining an upward modification of support in the event of a bankruptcy or any other disruption of payments:

Sample Wording

“The parties acknowledge that the provisions in this Article and other Articles in this agreement relating to maintenance and child support are dependent upon the actual distributions and payments for the division of marital property as hereinafter provided and that the Wife will necessarily depend upon receipt of said assets and payments in order to maintain a proper standard of living, that failure to receive said assets and payments will seriously impair that standard and that the provisions for maintenance and child support would have been significantly higher but for the reliance of the Wife upon receipt of the said assets and payments. Accordingly, the Husband acknowledges that any bankruptcy or insolvency proceedings or other delay in making the said distribution and payments to the Wife will adversely impact upon the Wife's ability to maintain a proper standard of living and may warrant a modification of the support payments herein in order to carry out the intention and agreement of the parties.”

To buttress the position of the wife in our illustration, there can be a further provision in the section of the agreement relating to the distribution of marital property, which may read as follows:

“The parties acknowledge that the provisions herein relating to maintenance and child support are dependent upon the actual distributions and payments for the division of marital property as herein provided and that the Wife will necessarily depend upon receipt of the said assets and payments in order to maintain a proper standard of living, that failure to receive said assets and payments will seriously impair the said standard and that the provisions for maintenance and child support would have been significantly higher but for the reliance of the Wife upon actual receipt of the said assets and payments. Accordingly, the Husband acknowledges that any bankruptcy or insolvency proceedings or other failure or delay in making prompt payments herein, will affect adversely the Wife's ability to maintain a proper standard of living. Notwithstanding the foregoing, the parties acknowledge that all of the payments and distributions under this Article constitute an equitable division and distribution of marital property and are not intended to be treated as taxable income to the Wife or deductible by the Husband and are being made hereunder as a nontaxable event.”

Debts and Obligations

Also, it is common for a spouse (the husband in our illustration) to assume payment of certain named debts and obligations incurred by the wife or by the wife jointly with the husband. If, in a bankruptcy proceeding, the husband can receive a discharge for those debts payable to the named creditors, that discharge will not prevent the creditors from seeking payment of those debts and obligations from the wife. The husband's indemnity to the wife for those debts and obligations could likewise be discharged and leave the wife solely liable to the creditors.

Although in our illustration the Bankruptcy Court cannot discharge the husband's obligations, it is important to lock the husband into a position favorable to the wife by having his assumption of debts be a support obligation. Suggested language in the agreement is as follows:

“The Husband acknowledges that the foregoing named debts and obligations for which he has solely assumed payment represent expenses for support and maintenance of the family in accordance with the parties' standard of living and are not dischargeable in any bankruptcy or insolvency proceeding. Any failure to pay as herein provided will adversely affect the ability of the Wife to maintain a proper standard of living.”

The foregoing language in an agreement helps posture the wife in maintaining that the assumption of debts is, in essence, a function of support and maintenance and necessary for her to maintain a proper living standard as contemplated. In case of a default, the language then becomes a basis for reopening the issue of maintenance and support, facilitating an application to a court to adjust maintenance and support, especially if the settlement agreement so provides.

Of course, a preferable way of assuring payments to the wife would be for the husband to provide security for his obligations, such as a mortgage on real property owned by himself — or anyone else, for that matter. Another device that may be utilized, where possible, is the guarantee by a third party of the obligations assumed by the husband. The guarantor or guarantors can be business associates, parents, relatives or friends. Obviously, the guarantee is only as good as the guarantors, but at least the guarantee will be a better protection than none at all.

Conclusion

In summary, every settlement agreement should recognize that an insolvency or bankruptcy proceeding could frustrate the intent of the parties and affect the prompt payment of obligations of the payor. Even with the added protections of the newly revised Bankruptcy Act, the agreement should contain protective language to help recover payment of obligations under the agreement despite a bankruptcy proceeding. The clauses are usually relatively simple to have included in the agreement, and experience shows that there is normally little or no opposition to that protective language. The language is not a guarantee of protecting the deferred payments. However, it certainly will be of inestimable value in the event that the obligations of the payor are examined by a court in any proceeding to increase support obligations because of nonpayment of property obligations, regardless of their nondischargeability.

Although the newly revised Bankruptcy Act is a giant step forward in protecting economically dependent spouses, specific language in the agreement can help keep the door open for the matrimonial court to revisit the child support and maintenance provisions of the parties' judgment of divorce.

Willard H. DaSilva, the Chairman of the Editorial Board of this newsletter, is a member of Da Silva, Hilowitz & McEvily LLP, in Garden City, NY. He is a Diplomate of the American College of Family Trial Lawyers, past President of the American Academy of Matrimonial Lawyers, New York Chapter, and is listed in The Best Lawyers in America and Who's Who in America.