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FOR THE FORMER SPOUSE – LEGALLY AND EQUITABLY YOURS : Legal And Equitable Title as a Defense Against the Bankruptcy Estate
It’s no secret that bankruptcy often gets a bad reputation, from the perspective of debtors and creditors alike. Whereas a clear understanding of the bankruptcy objectives would show that it is a valuable tool for those facing serious financial hardships, with immense protections for the struggling debtor and “innocent” creditors. Nonetheless, as with any system, the interaction between different court systems and laws, at times, generates outcomes that may seem unfair, particularly to certain creditors. One such “creditor” is the former spouse of a debtor entitled to marital assets stemming from a divorce. However, between federal and state laws, the former spouse has many defenses in her arsenal to successfully overcome the misapplication of bankruptcy protections against what rightfully, legally and equitably, belongs to her.
Here we explore the concept of legal and equitable title and interest, which generally shields a non-debtor spouse’s assets acquired upon the entry of a divorce judgment, marital settlement agreement, or equitable distribution order prior to the commencement of the debtor-spouse’s bankruptcy.
More often than not, divorce proceedings (and the subsequent allocation of marital assets and debts) are emotionally and mentally draining for the parties involved. An obviously grim situation, further mitigated by each party fighting tooth and nail for what they essentially built together. Throw bankruptcy into the mix, and the situation seems to become far more grim. When a bankruptcy immediately follows the division of assets, the applicability of the bankruptcy protections against those transferred marital assets comes into question. Particularly, under chapter 7, where a bankruptcy trustee is placed in control of the estate, with the objective of maximizing the debtor’s bankruptcy estate, in order to provide a meaningful distribution to creditors. The impact is felt by the former spouse when the trustee demands, as “property of the debtor’s bankruptcy estate,” a return of transfers made by the debtor to the former spouse (in accordance with a divorce judgment or marital settlement agreement). It is here that the interplay between divorce and bankruptcy becomes quite apparent. Generally, the question becomes “what IS property of the debtor-spouse’s bankruptcy estate?”
WHAT IS THE BANKRUPTCY ESTATE?
The Bankruptcy Code provides that a bankruptcy case is commenced with the filing of a bankruptcy petition. Under Section 541(a) of the Bankruptcy Code, when the bankruptcy petition is filed, a bankruptcy estate is created, which encompasses “all legal or equitable interests of the debtor in property as of the commencement of the case.” Property becomes property of the estate regardless of location or by whom it is held. Meaning, the bankruptcy estate includes only those assets to which the debtor has rights or title at the moment the bankruptcy petition is filed.
Section 541 also defines property included in and excluded from a debtor’s bankruptcy estate. Section 541(d) provides that “[p]roperty in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest . . . becomes property of the estate only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest in such property that the debtor does not hold.” Under Section 541(a)(5), the bankruptcy estate includes any interest in property that would have been property of the estate if such interest had been an interest of the debtor on the petition date.
While federal bankruptcy law determines what types of property are included in a bankruptcy estate, state law determines what interest, if any, debtor has in property. Property interests generally are defined and created by state law. As such, whether a debtor has a legal or equitable interest in property such that it becomes “property of the estate” under the Bankruptcy Code is determined by applicable state law. The Supreme Court has previously noted that “unless some federal interest requires a different result, there is no reason why such interests should be analyzed differently simply because an interested party is involved in a bankruptcy proceeding.”
THE FORMER SPOUSE’S LEGAL AND EQUITABLE TITLE AND INTEREST IN PROEPRTY – IS NOT PROPERTY OF THE DEBTOR’S BANKRUPTCY ESTATE
In order for a former spouse to overcome a trustee’s demand for the transferred property, the former spouse may demonstrate that the property in question is not property of the debtor’s bankruptcy estate because the former spouses has legal and equitable title and interest to the property as a matter of law pursuant to the divorce judgment and settlement. In fact, the former spouse may motion the bankruptcy court for a determination that the property in question is not property of the debtor’s bankruptcy estate. The Bankruptcy Court is empowered to enter such orders pursuant to Section 105(a) of the Bankruptcy Code. To do so requires a showing that the property in question is not property of the debtor’s bankruptcy estate under Section 541 of the Bankruptcy Code, as former spouse has equitable and legal title and rights, as well as legal and equitable interest by way of the divorce judgment and settlement in accordance New Jersey law. For starters, the former spouse may argue the following:
Transfer Occurred Pre-Petition Prior To The Creation Of The Estate
The most obvious defense is that the transfer occurred prior to the bankruptcy filing, thus no bankruptcy estate was in existence at the time. This requires a showing of evidence that clearly demonstrates that the property was transferred at a time before the bankruptcy petition was filed. Notably, the filing of a petition with the bankruptcy court results in a timestamped header, which states the exact date and time the petition was filed. Additional evidence clearly showing the date and time the transfer occurred, should be sufficient to determine a chronology of the events. Ultimately showing that the bankruptcy estate did not exist at the time the transfer took place, so the property cannot be property of the bankruptcy estate pursuant to Section 541(a).
Debtor Lacked Equitable Title At The Time Of Filing
The marital settlement agreement (or similar instrument), a consensually entered into agreement, provides for the distribution of the property to the former spouse as the sole owner of that property, such that it serves as a transfer of equitable interest in the property from the debtor to the former spouse. As long as the divorce judgment and settlement were entered into prior to the filing of the bankruptcy, the equitable title of the debtor in the property was severed before the estate was created, and transferred to the former spouse. The debtor’s legal title to the property was severed at the time the transfer took place. In fact, the pre-petition transfer extinguished even bare legal title in the property.
As such, the pre-petition transfer and pre-petition execution of the divorce settlement dictates that the debtor lacked both equitable and legal title at the time of filing. Therefore, as a matter of law, Section 541(a) provides that the property was not, and is not, property of the debtor’s bankruptcy estate.
Debtor Lacked Legal And Equitable Interest At The Time Of Filing
Essentially, all that is required is a showing that irrespective of the fact that the property was not in the debtor’s possession at the time of filing, any interest the debtor may have held in the property was extinguished by the pre-petition entry of the divorce judgment, and/or the provisions of the marital settlement agreement. Note that the agreement or the divorce judgment must clearly provide that the property in question belongs solely to the former spouse and not the debtor. The consensual nature of the agreement further shows that the debtor agreed to the transfer of rights and interest in the property to the former spouse at the time of execution.
Debtor Lacks Equitable Interest Pursuant To New Jersey Law
As previously mentioned, state law dictates what interest a debtor has in property. A former spouse may look to New Jersey divorce laws to determine property interest in greater detail. Generally, a spouse’s right to share in marital property by virtue of equitable distribution arises when a judgment of divorce is entered.” Under New Jersey law, N.J.S.A. 2A:34-23, the entry of the Judgment of Divorce ripens and perfects the right to equitable distribution. As such, interest in marital assets transfers upon the entry of the divorce judgment.
Therefore, prior to entry of the divorce judgment, the interest and rights in the property were presumed by law to be a marital asset and, upon entry of the judgment, the property was, as a matter of law, vested in the former spouse. Leaving the Debtor with no equitable interest at the time of filing.
There are several other defenses available to a former spouse in this situation, such as the creation of a construction trust and res judicata. However, where property of the estate is concerned, coupled with divorce-related issues of equitable and legal interest, the inquiry is fact-specific and should be handled on a case-by-case basis. Unfortunately, there is rarely a one size fits all defense available to the former spouse. It is comforting nonetheless, that while bankruptcy protects the financially drained, it strives to strike a balance in protecting creditors and claimants alike.
The complexity and the interplay between federal and state laws, divorce and bankruptcy require the guidance of experienced legal counsel that can provide clear options in this unique situation. The Scura Law Firm is experienced in creditor representation and can help you navigate your options, while avoiding potential pitfalls. Call one of our experienced attorneys for a free consultation today!
 11 U.S.C. § 301.
 In re Whittick, 547 B.R. 628, 634 (Bankr. D.N.J. 2016).
 See 11 U.S.C. § 541(a)-(f).
 11 U.S.C. § 541(a).
 Butner v. U.S., 440 U.S. 48, 55, 99 S.Ct. 914, 918, 59 L.Ed.2d 136 (1979).
 Carr v. Carr, 120 N.J. 336, 576 A.2d 872, 875 (1990).
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