Bad News for the Non-Filing Spouse

Frequently it makes sense for only one spouse to file bankruptcy. Where the husband has wracked up large business debts in his name only and the wife has significant separate property or sole management property, the husband can file bankruptcy without bringing the wife's non-joint assets into the estate. This allows a certain amount of double-dipping. The husband can claim his assets and the joint assets as exempt and the wife can keep her non-estate assets as well. While this will benefit the couple 99% of the time, two recent cases show a downside for the non-filing spouse.

In Kim v. Kim, No. 3:09-CV-1082-N (N.D. Tex. 8/11/10), which can be found here(PACER registration required), creditors filed an involuntary bankruptcy petition against Mr. Kim and then sought to limit his homestead exemption under 11 U.S.C. Sec. 522(p) for the reason that the property had been acquired within 1,215 days before bankruptcy. As a result, the debtor's homestead exemption was limited to $136,875. Had the spouse joined in the bankruptcy, the couple would have been entitled to double this amount. Instead, Mr. Kim filed a declaratory judgment action against Mrs. Kim to determine whether her homestead interest in the property (1) precluded sale of the property by the estate and (2) whether she was entitled to compensation for her interest. The Petitioning Creditor intervened and opposed the relief.

The Bankruptcy Court granted summary judgment in favor of the Petitioning Creditor and the District Court affirmed. The District Court found that bankruptcy law preempted Texas state homestead law. Because the homestead was joint community property, it became property of the estate. Because it became property of the estate, bankruptcy law determined the extent to which it could be exempted. The result for Mrs. Kim was that the involuntary bankruptcy petition, to which she was not a party, diminished her homestead rights. Not only that, but because she remained outside of the bankruptcy proceeding, the couple received only half of the homestead protection they would have otherwise had under Sec. 522(p).

One of the cases relied upon by the Kim court was In re Douglass, 2008 WL 2944568 (Bankr. W.D. Tex. 2008)(a case that I am intimately familiar with because I was on the losing side). In that case, the husband filed chapter 13. He made a tactical decision not to claim the homestead as exempt. Instead, he argued that the house was contaminated and was worth no more than the value of the land. Because the house was not being occupied as a residence, he was successfully able to cram down the value on the house. Had the case proceeded to discharge, the couple would have been able to retain the house. However, mid-way through the case, the wife moved back into the house and the husband sought to sell the home and pay off his chapter 13 plan early. The parties agreed to allow the sale of the home and to fight over the proceeds. The Bankruptcy Court ruled that (1) the wife was not entitled to any compensation for her homestead rights under Texas law and (2) the wife had failed to establish a separate property interest in the home. (She had provided the down payment for the home from her separate property).

Had the husband not filed bankruptcy, he could not have sold the property without the wife's consent. Therefore, the husband's filing divested the wife of a valuable right without her consent. Of course, if the husband had not filed bankruptcy, the property would have been foreclosed upon and the wife would have lost her interest.

These two cases are a powerful cautionary that sometimes the decision to remain outside of the bankruptcy can have negative consequences for the non-filing spouse. While it may seem unfair, it is a simple matter of reading Sec. 541(a)(2) which includes all joint management community property in the estate.

Hat Tip to Howard Mac Spector for sending me the Kim case.

Whom do you trust when interpreting a trust?

Update: On June 15, 2011, the Fifth Circuit entered a ruling finding that the Trustee was entitled to 50% of the corpus of the trust. Roberts v. McConnell, No. 10-50462 (5th Cir. 6/15/11). You can read the Fifth Circuit opinion here.

Trusts are interesting things. They are a way to transfer property without completely letting go. One reason to transfer property in trust is to see that the beneficiary receives the benefit of the trust property instead of his creditors. Of course, the bankruptcy trustee has just the opposite incentive. The trustee would like to bust the trust and distribute the proceeds to creditors. When trust provisions are unclear, it can make for an interesting exercise as Judge Craig Gargotta discovered in Roberts v. McConnell, Adv. No. 09-1011 (Bankr. W.D. Tex. 11/3/09).

In this case, Mary McConnell set up a trust for her grandson. The trust allowed the beneficiary to withdraw funds from the trust according to a graduated schedule based on the beneficiary's age, but only if "the Settlor of this Trust (or each Settlor, if more than one) is then deceased." The grandmother passed away in September 1997. At that time, the grandson could have withdrawn 33% of the trust. However, several months later, his mother made a contribution to the trust which she repeated during six additional years.

The debtor filed for bankruptcy in 2004. At that time, he was 37 years old. At that time, he would have been entitled to one-half of the trust if the Settlor (or Settlors if more than one) were deceased. In 2009, the bankruptcy trustee brought suit against the trustee of the trust seeking to recover the entire corpus for the benefit of the bankruptcy estate. The trustee of the trust moved to dismiss.

The issues that the court faced were:

1) Was the term settlor limited to the person who initially created the trust or did it extend to the mother as well?
2) If the mother was deemed to be a settlor, could the trustee at least recover the funds which the debtor was entitled to withdraw for a brief period prior to his mother's initial contribution?

Under the Texas Property Code, the term settlor is defined as the person who creates the trust. However, the Trust defined settlor as anyone who contributed property to the trust. Under the Texas Property Code, the specific language of the trust controlled over the definition of settlor contained within the Property Code. The parenthetical language (or each Settlor if more than one) suggested that there could be additional settlors. Thus, the trustee could not recover the full amount of the trust, since there was still a settlor alive.

However, this gave rise to a second question: could the mother, by becoming a settlor, unvest the debtor's right to make a withdrawal? Recall that when the debtor's grandmother passed away, she was the sole settlor of the trust and he could withdraw one-third of the value of the trust at that time. Had bankruptcy not intervened, one could imagine the unpleasant conversation which might transpire when the son learned that his legacy was now out of reach due to this mother's decision to add to the trust. In this case, the bankruptcy trustee was just making the argument which the son would likely have made, namely, it's not fair.

In trying to determine the intent of the settlor, the court found it significant that the trust imposed two different requirements for withdrawing funds from the trust: reaching a specified age and the prior death of all settlors. The court found an intent for both benchmarks to be present at any time that a withdrawal was requested.

The court's result seems to be a natural reading of the language of the trust. However, it is not hard to imagine how these provisions could be used to reach a twisted result. Imagine that the grandmother had two grandsons, one of whom always wrote his thank you notes timely and never forgot his grandmother's birthday. The other grandson was an ungracious lout who stole spare change from his grandmother's purse and never had a kind word, let alone a thank you. The grandmother decides to create a trust for one of the grandsons but not the other. The grandmother passes on and the ungrateful grandchild learns that he has been passed over. Upon learning of the trust provision, he contributes $10 to his brother's trust so that he can never access the trust funds. In this scenario, could the ungrateful grandson keep his favored brother from ever accessing the trust? Would the likelihood that the sinister grandson would encounter an unfortunate accident go up? These would make for good law school exam questions. Fortunately Judge Gargotta didn't have to reach these questions. (Congratulations to new law clerk Sarah Darnell on her first opinion).

Update #1: Eric Taube advises that this opinion is being appealed.

Update #2: Alert grammarians Pat Autry and Fay Gillham pointed out that my headline should have read "Whom do you trust when interpreting a trust?" instead of the original "Who do you trust when interpreting a trust?" I did some research and found out that they were correct.

According to wikiHow, who is used as the subject of a sentence or phrase while whom is used as the object of a verb. This still left me scratching my head, so I read further on. If the answer to the question is he, then who is correct, while if the answer to the question is him, then it is whom. Thus, the answer to the question would be "I trust him to interpret a trust" indicating that whom was the correct way to begin the sentence.