The crossover between bankruptcy and family law is one of the more complex territories that one might encounter. Not only can the Bankruptcy Code magically stop a dissolution proceeding on the eve of trial, undo the carefully considered or crafted division of a community estate, or discharge counsel’s right to collect fees, but it also occasionally offers a benefit unexpected by the parties to the marriage. The “community discharge” of §524(a)(3) is one example of such an unexpected and often unknown benefit.
The Community Discharge
As the Byzantine provisions of the Bankruptcy Code often border on incomprehensible, even to those who drafted them, a simple reading of §524(a)(3) casts little light on the operation of that section in terms of its day-to-day application. Thus, to better understand how the community discharge works, it should first be understood that a bankruptcy discharge does not extinguish a debt, but rather enjoins the collection of the debt and voids any judgment determining the liability of the debt debtor. 11 U.S.C. §524(a)(1)-(2).
Thus, where there exists a co-debtor, such as a spouse, the debt remains enforceable as against that co-debtor. However, an exception exists under Chapter 13, where §1301 operates as a stay protecting an individual co-debtor from proceedings to collect a consumer debt. In those states that have adopted the community property system of marital property law, the Bankruptcy Code extends the discharge injunction to protect the community estate in order to preserve the debtor the full benefit of the discharge and unsure a “fresh start.”
Conceptually, the discharge under §524 wipes out the debtor’s personal liability, and all proceedings to enforce claims which existed as of the date of the bankruptcy filing are permanently enjoined. In addition, upon the closing of the bankruptcy case, all property of the estate that was claimed and allowed as exempt or abandoned by the trustee in the case revests in the debtor – free of any further claims with respect to the discharged claims. This encompasses all of the debtor’s interest in the community as of the date of the order for relief – usually the date the petition was filed except in involuntary cases. 11 U.S.C. §541(a)(2).
However, because of the interplay between the Bankruptcy Code and the California Family Code, certain claims against the debtor’s non-filing spouse that remain enforceable against the non-filer, but for the operation of §524(a)(3), would be enforceable against the community property acquired after the bankruptcy discharge. As the goal of granting the debtor’s “fresh start” would be abrogated if the claim bidders discharged in the bankruptcy could come in the “back door” by enforcing their claims against the non-filing spouse and the community estate, including the debtor’s interest in the estate, the drafters of the Bankruptcy Code added subsection §524(a)(3) to avoid such a result.
The Requirements of a Joint Filing
Typically, where a married couple is jointly liable for the majority of their debts, both will join in the bankruptcy petition. However, in order to do so, both must be eligible for the relief sought. Not all persons are eligible for Chapter 7 relief. For example, a person who has obtained a discharge in a Chapter 7 case within the last eight years or a discharge in a Chapter 13 case paying less than 70% of the allowed unsecured claims within the prior six years is ineligible. Also, even if eligible, a debtor may be unable to discharge certain debts, such as claims based on fraud, willful and malicious injuries, embezzlement, and the like. Where such a situation exists, the ineligible spouse or the spouse unable to benefit from the discharge will not join in the bankruptcy petition. Nevertheless, the filing spouse will still obtain a discharge of their personal liability, thus barring enforcement of the discharged claims against all property of the estate not administered by the trustee.
The Dilemma
The dilemma existed where the creditors, whose claims against the non-filing spouse remained, sought to enforce their claims against community assets acquired subsequent to the bankruptcy petition. California community property law makes the community estate liable for all debts incurred by either spouse before or during the marriage. See California Family Code §910. In addition, except with regard to pre-marital debts, since post-marital debts earnings are community property, the creditors of either spouse can reach post-bankruptcy the earnings of either spouse. See California Family Code §§760 and 911(a). As a result, the newly discharged spouse, promised a “fresh start” in furtherance of the purposes of the Bankruptcy Code, could find their property and earnings subject to execution or garnishment in order to satisfy the debts of the non-filing spouse. How does §524(a)(3) resolve this dilemma?
First, it needs to be understood that the so-called “community discharge” is not an actual discharge – it is actually only an injunction against the enforcement of debts. Section 524(a)(3) does not grant the “community” a discharge (In re Costanza, 151 B.R. 588 (Bankr. D.N.M. 1993)), nor does it prevent a creditor of the estate from seeking to enforce its claim as a personal liability of the non-filing spouse or from executing upon the non-filing spouse’s separate property. Matter of Kastner, 197 B.R. 620 (Bankr. E.D. La. 1996). Instead, its injunctive protection extends solely to the community assets acquired following the filing of the bankruptcy. To do this, §524(a)(3) enjoins the enforcement of a “community claim” against community property which is acquired post-bankruptcy. In re Karber, 25 B.R. 9 (Bankr. N.D. Tex. 1982); In re Smith, 140 B.R. 904 (Bankr. D.N.M. 1992); In re Strickland, 153 B.R. 909 (Bankr. D.N.M. 1993).
The Community Claim
What is a “community claim”? Bankruptcy Code §101(7) defines a community claim as a “claim that arose before the commencement of the case… for which [community] property is liable, whether or not… such property [exists] at the time of the commencement of the case.” What constitutes community property is to be determined in accordance with state law. Matter of Grimm, 82 B.R. 989 (Bankr. W.D. Wis. 1988). In other words, if a claim existed at the time the bankruptcy was commenced, and that claim is one which reached the community estate, it cannot reach community property interests after the bankruptcy, even where it is a claim solely against the spouse who did not seek or obtain a discharge and even where the community asset protected was not yet property of the community estate!
Limitations to the Non-Filing Spouse
Of course, there are limits to how effectively a non-filing spouse can shield themself and their interests in community property from creditors. As noted above, the injunction of §524(a)(3) only extends to community property. The non-filing spouse’s separate property enjoys no protection. In addition, the injunction survives only as long as the community. Upon termination of the marriage by annulment, dissolution, or death, the community estate ceases and with it the injunction of §524(a)(3). In re Costanza at 589.
Also, the “community discharge” will not apply where the non-filing spouse attempted to obtain a discharge within a discharge within six years before the filing spouse’s bankruptcy and was denied a discharge, or where the bankruptcy court would not grant the non-filing souse a discharge if the non-filing spouse filed a case on the date that their spouse filed a case and such a determination is sought within the time permitted. 11 U.S.C. §524(b). This is also true where the community claim has been determined to be non-dischargeable in the filing spouse’s case, or which would be found to be non-dischargeable by the non-filing spouse in a hypothetical case filed on the same date and such a determination is sought within the time permitted. In re Braziel, 127 B.R. 156 (Bankr. W.D. Tex. 1991); see also 11 U.S.C. §524(a)(3).
The Trap
Does §524(a)(3)-(b) create a trap for the unwary? Absolutely. If not vigilant, a person who has not even filed a bankruptcy case may obtain essentially all of the benefits of a discharge simply because their spouse filed for bankruptcy, even if the non-filer could not have obtained a discharge or discharged a particular debt. Furthermore, this may occur even where the affected creditor had no claim against the spouse who filed bankruptcy. This is because there is a relatively brief period during which the creditor may challenge the right of the non-filing spouse to obtain the benefits of a community discharge, and it must be raised in the non-filing spouse’s bankruptcy case. Federal Rules of Bankruptcy Procedure 4004 requires that such determinations be sought by filing a complaint within 60 days following the date set for the first §341(a) Meeting of Creditors, which typically occurs 30 to 45 days after the filing of the petition.
While discharge requires that the creditor be given notice, that notice will only reflect the filing spouse’s name and Social Security number. Thus, the creditor is faced with a dilemma; it has received a bankruptcy notification, but the person filing this bankruptcy may be completely unknown to the creditor who only knows of the non-filing spouse. Yet, if that creditor fails to timely raise the issue of dischargeability and the community discharge prior to the expiration of the 60-day deadline, they will forever lose their right to do so.
Preventative Measures
What can be done to protect your interests? If someone wants to maintain the benefit of the community discharge to block collection efforts, it is essential that, in addition to avoiding the termination of the community, the community property nature of assets acquired following a spouse’s bankruptcy be preserved. Post-marital agreements that have the effect of characterizing earnings of separate property should be carefully avoided, as should transmutation agreements that convert community property assets to the separate property of the non-filing spouse.
Conclusion
There is no doubt that the concept of the “community discharge” is troubling as it can be used to protect an undeserving spouse. As one widely cited commentator has suggested, “the Devil himself could effectively receive a discharge in bankruptcy if he were married to Snow White.” See Alan Pedlar, Community Property and the Bankruptcy Act of 1978, 11 St. Mary’s L.J. 349, 382 (1979). Nevertheless, that protection, deserved or not, does not come without a price. As the Court in Costanza further noted, “if the Devil does not treat Snow White better than his creditors, she will, by divorcing him, deny his discharge.”
