Goldilocks Bankruptcy and Divorce Are the Adversarial Relationships Too Much Not Enough or Just Right

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Jun 2002

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Ethical issues arise in the entire spectrum of bankruptcy legal practice, from the
largest chapter 11 proceeding to the smallest consumer chapter 7 case. One of the
areas where ethical problems frequently crop up in consumer bankruptcy practice involves
cases where the debtors are not only facing overwhelming financial problems, but are
also having to deal with the breakup of their family. Between the economic hardships
and the emotional strain of bankruptcy and divorce, cases that involve both of these
issues are some of the most challenging that will face a bankruptcy practitioner, as
well as his or her family law counterpart.

This article will discuss two important ethical issues that will confront bankruptcy
attorneys in cases involving family law issues in bankruptcy cases: (1) whether it
is possible for a bankruptcy practitioner to represent a husband and wife in a joint
chapter 7 when they are planning to get a divorce, and (2) whether a bankruptcy
attorney can have a husband and wife use a divorce as a financial planning tool.

<h3>Is It Ethical to be a Referee for Your Clients? Representing a Divorcing Couple in Joint
Chapter 7</h3>

While most of the case law and scholarly literature addressing the intersection of
bankruptcy law and family law deals with the dischargeability of obligations arising from
a divorce,<a href="#1" name="1a">1</a> bankruptcy is not solely an obstacle that must be faced by family law
practitioners. Indeed, properly filed bankruptcies can assist a couple in managing
their divorce and reordering their financial affairs. Indeed, in appropriate cases,
bankruptcies can be used to protect the finances of either one or both of the spouses
so that their resources can be used to benefit the family rather than unsecured
creditors.<a href="#2" name="2a">2</a>

One common way that bankruptcy can be used to assist parties facing a divorce who
have insurmountable debt is to file a chapter 7 bankruptcy prior to the filing of
their divorce and discharge the bulk of their debt. A pre-divorce chapter 7
bankruptcy can eliminate the need for domestic relations courts to "allocate" the debt
of the parties between the parties, and instead can concentrate on allocating income
and the parties' remaining assets between the parties to permit them a chance at a
fresh start with their lives. However, an ethical trap awaits for an unwary
bankruptcy practitioner in this situation if he or she represents both of the divorcing
parties in a joint chapter 7 bankruptcy prior to their divorce.

[I]f an attorney finds it is ethically permissible to
undertake the joint chapter 7 representation, the
attorney must take all reasonable safeguards to ensure
that all client confidences and secrets will be preserved
during the joint representation from the other spouse.
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The ethical problems of a single attorney representing both a husband and wife in
a pre-divorce chapter 7 are illustrated in the recent case from the Supreme Court
of Wisconsin, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… the Matter of Zablocki, 635 N.W.2d 288 (Wis. 2001)</a>.
In Zablocki, an attorney was retained in May 1997 by an unnamed woman to
represent her in a divorce proceeding. In early 1998, shortly after Zablocki had
been informed by the Wisconsin Supreme Court that his law license would be suspended
and while the divorce was still pending, the unnamed woman and her soon-to-be
ex-husband discussed with Zablocki the possibility of them filing bankruptcy to resolve
some of their outstanding financial problems. Zablocki advised the couple it would be
"cheaper and easier"<a href="#3" name="3a">3</a> if he were to represent both of them in a joint chapter 7
filing. Zablocki was paid $800 by the wife and husband, and he filed a joint
chapter 7 bankruptcy on their behalf just before his suspension went into effect.<a href="#4" name="4a">4</a>

In filing the bankruptcy for the husband and wife, Zablocki did not disclose to
them the possibility of a potential conflict of interest arising from his joint
representation of them in their chapter 7, nor did he cease representing the wife
in the divorce proceedings. Zablocki also never sought a waiver from either the husband
or wife concerning his joint representation. Finally, Zablocki failed to inform the
husband and wife of the pending suspension of his law license.

The Wisconsin Supreme Court found that representing the wife in the bankruptcy case
and in the divorce proceeding placed Zablocki at direct adversity to another client of
his, the husband, and also materially limited his ability to represent both the wife
and the husband in their chapter 7 due to his conflicting roles. For this and
several other ethical violations, the Wisconsin Supreme Court indefinitely suspended
Zablocki's license to practice law and publicly reprimanded Zablocki for his conduct in
this case.<a href="#5" name="5a">5</a>

Although most bankruptcy practitioners will not have the same "ethical challenges"
as the attorney in the Zablocki case, Zablocki does illustrate that there are serious
ethical issues that a bankruptcy attorney must consider before agreeing to represent in
a joint chapter 7 proceeding both a husband and a wife who are planning to get
divorced.

First and most important, an attorney has the duty not to represent one client
if that representation would be directly adverse to the interests of another client of
that attorney (adversity duty). Given the nature of a divorce, a bankruptcy attorney
must always carefully consider this duty when considering whether to represent a divorcing
husband and wife in a joint chapter 7 case.

A second ethical limitation to an attorney's ability to represent a couple planning
to divorce is the general prohibition that an attorney may not represent a client if
the representation of that client would be materially limited by an attorney's
responsibility to another client (material limitation duty").<a href="#6" name="6a">6</a> Even if an attorney
believes that the interests of a divorcing couple are not adverse when they file a
joint chapter 7, the attorney must consider whether he will be limited in his
representation of either the husband or the wife by his professional duties to the
other party.

The third core issue that an attorney must consider when representing a divorcing
couple in a joint chapter 7 bankruptcy is an attorney's duty not to reveal confidences
and secrets of clients to other parties, including other clients (confidential
information duty). Although most of the information given to a bankruptcy attorney
will ultimately become public record, there may be certain confidences of an individual
spouse that an attorney might have to take steps to protect, even in light of a
joint bankruptcy.

While the above three duties may be stated differently in any given state, they
are the three most important core issues that a bankruptcy attorney must consider prior
to representing a divorcing couple in a joint chapter 7 bankruptcy proceeding. A
bankruptcy practitioner must also be careful to consider whether other state ethical rules
would limit or restrict his or her ability to represent a divorcing couple in a joint
chapter 7.

The best way to address the problems arising from the above-discussed duties is to
first determine whether it is even possible, given the factual situation in the case,
for an attorney to represent both the husband and wife in a pre-divorce joint chapter
7 bankruptcy. In most states, an attorney can obtain a waiver to represent clients
that are adverse to another client of that attorney if the attorney reasonably believes
the representation will not adversely affect the relationship the attorney has with the
other client. If, under the facts of a given case, an attorney believes the amount
of adversity between the husband and wife is so severe that it will adversely affect
or materially limit the attorney's ability to represent one or both of the individuals
in a joint chapter 7, then the attorney is ethically prohibited from undertaking that
representation.

Assuming an attorney believes that his representation of both the husband and wife
in a joint chapter 7 petition will not adversely affect either party, nor materially
limit his ability to represent each party, the attorney, under most state rules, may
represent both parties in a joint chapter 7 bankruptcy after (1) giving them
information about the potential conflict issues involved in such a joint representation,
and (2) obtaining their informed consent to the representation and their waiver of
the possible conflicts. These waivers must be in writing and should be backed up with
detailed written and oral communication with the clients concerning their rights in this
matter.

Finally, if an attorney finds it is ethically permissible to undertake the joint
chapter 7 representation, the attorney must take all reasonable safeguards to ensure
that all client confidences and secrets will be preserved during the joint representation
from the other spouse. As an alternative, the attorney may suggest an agreement with
both spouses prior to the undertaking of the representation that any information provided
to him by either spouse will be shared with the other spouse for purposes of the
bankruptcy filing. Depending on the interpretation rules of a particular state bar,
the attorney, after giving proper disclosure to his clients, should be able, in a
joint chapter 7 relationship, to be permitted to obtain only such information as is
necessary to fill out chapter 7 bankruptcy schedules (which are public record) and
have the clients waive, as between themselves, any right to keep any confidence or
secret that they may impart to the attorney hidden from the other spouse during the
bankruptcy representation. Either the proper establishment of procedures to prevent any
confidences or secrets from "changing hands" during a joint chapter 7 or the "open
kimono" method of dealing with this problem should, with the written agreement by the
parties, be sufficient to allow an attorney to meet his or her confidential information
duty to the husband and wife in a pre-divorce joint chapter 7 proceeding.

In summary, an attorney must carefully consider representing any party that is
contemplating a divorce<a href="#7" name="7a">7</a> in a joint chapter 7 bankruptcy. The ethical issues are
many, and given the generally innate hostility of the parties, the possibility of
ethical action being taken against the attorney is great. However, on a practical
side, many parties who need both chapter 7 bankruptcy help as well as a termination
of their marriage have insufficient funds to obtain separate counsel for both their
divorces and bankruptcies, and therefore, a joint bankruptcy may be a viable option
under certain circumstances.

<h3>"Lost it in the Divorce:" Fraudulent Conveyance Issues in Bankruptcy Proceedings
Following a Divorce</h3>

As noted above, a bankruptcy attorney must carefully determine whether the adverse
relationship between a divorcing husband and wife is too great to allow an attorney
to represent both the husband and wife in a joint chapter 7 petition filed before
their divorce. However, over the past several years, bankruptcy courts and state
domestic-relations courts have been addressing the issue of whether a divorcing couple
may not be "adverse enough" when it comes to transferring assets, which may have had
the effect of hindering, delaying or defrauding one of the spouse's creditors.

In federal cases, such as <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Fordu, 201 F.3d 693 (6th Cir.
1999)</a>,<a href="#8" name="8a">8</a> and the state cases, such as <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Reed, 118 Cal. Rptr.
2d 415 (Cal. App. 2002)</a>,<a href="#9" name="9a">9</a> courts have been increasingly willing to find
that transfers of assets made pursuant to agreed divorce decrees or marital settlement
agreements are subject to being voided under the provisions of either state or federal
fraudulent conveyance law. These cases have determined that there is generally no
statutory exception to the operation of fraudulent conveyance laws for a transfer made
pursuant to the terms of a consensual divorce decree or a property settlement agreement
incorporated into such a decree.<a href="#10" name="10a">10</a>

While most of the recent case law involves fraudulent conveyances based on transfers
of property being made for inadequate consideration at a time when the debtor making
the transfer is insolvent, some of these cases present more troubling ethical issues
for counsel in that they involve allegations of direct fraud on the part of the
spouses obtaining the divorce. The two most important cases involving allegations of
actual fraud relating to transfers of property pursuant to a divorce decree are <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…
v. Lehmann, 56 F.3d 750 (7th Cir. 1995)</a>, and <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Williams,
159 B.R. 648 (Bankr. D. R.I. 1993)</a>.<a href="#11" name="11a">11</a>

In the Sholes case, an individual (debtor) and his corporation were placed into
a federal receivership action due to the fact that they were involved in a complex
ponzi scheme that defrauded investors of more than $20 million. Prior to the federal
receivership action, corporations owed by the debtor made payments of approximately
$300,000 to the debtor's former spouse as part of their divorce decree.

In the receivership action, the receiver brought suit under fraudulent conveyance
law against the debtor's former spouse and her current husband to recover payment made
by the debtor's corporations to her to satisfy his obligations under the divorce
decree. The U.S. District Court granted summary judgment in favor of the receiver
in the amount of approximately $300,000 against the individual's former spouse
and her current husband, who appealed this judgment.

On appeal, the Seventh Circuit held that the transfers to the debtor's former
spouse could be avoided as fraudulent conveyances if they were either made at the time
the debtor was insolvent for less-than-adequate consideration, or if they were made
in order to defraud the individuals in his corporations' creditors. The Seventh Circuit
reversed the entry of summary judgment on the grounds that the question of whether the
wife engaged in actual fraud had not been fully litigated and remanded the matter to
the district court for further consideration. The Seventh Circuit found no legal theory
that prevented a transfer made pursuant to a divorce decree from being avoided if the
spouse recovering the transfer had been involved in a scheme to defraud the debtor's
creditors.

The case of In re Williams presents a far more complex problem. In Williams,
based on the findings of the bankruptcy court, the debtor and his wife were happily
married until the debtor's investment business collapsed and the debtor was accused of
obtaining fraudulent loans from Citibank. At the time these financial calamities were
befalling the debtor, the debtor and his wife testified that she came in, announced
to the debtor her request for a divorce and, according to the record before the
bankruptcy court, the debtor then gave her all of his property, including property
he had previously listed as his sole property, as a part of his "settlement" with
her in their divorce proceedings. The bankruptcy court was particularly troubled and
stated:

"We further find, as argued by the bank, that various matrimonial and bankruptcy
attorneys and Diana's lawyers were coordinating their efforts to effectuate the
best possible deal for their respective clients at the expense of Citibank."<a href="#12" name="12a">12</a>

The bankruptcy court found this settlement suspicious in that, under the terms of
the parties' financial settlement, the debtor's former spouse would be receiving several
million dollars' worth of assets, while the debtor retained assets with a total value
of $59,900. Based on these factual determinations, the bankruptcy court denied
the debtor his discharge and set aside the transfers to the debtor's former spouse as
fraudulent conveyances.

On appeal, the federal district court reversed the bankruptcy findings on the
fraudulent-conveyance and denial-of-discharge issues due to its determination that the
bankruptcy court may have misapplied the "missing witness" doctrine in making its
decision on the fraudulent conveyance action and denial of discharge action. However,
the federal district court did note that, except for the possible misapplication of
the missing-witness doctrine, there were "solid grounds" for the bankruptcy court's
decision<a href="#13" name="13a">13</a> and that there was no legal impediment to a bankruptcy trustee setting
aside transfers made pursuant to a divorce decree if the transfers were made in an
effort to hinder, delay or defraud one of the spouse's creditors.

From a review of both the Sholes and Williams cases, it is clear that some
attorneys have looked to divorce law as a method of either protecting a client's
assets or hindering creditors, depending on your point of view. These cases, along
with the emerging case law permitting parties to set aside as fraudulent conveyances
transfers made pursuant to divorce decrees, increasingly demonstrate that divorce
decrees will not provide an absolute haven from the reach of fraudulent conveyance
law.

<h3>Conclusion</h3>

Divorce is one of the messiest areas of civil law that an attorney can encounter.
The purpose of this article is not to terrorize bankruptcy attorneys into not
representing clients who have had substantial domestic relations issues, but rather to
caution them about the ethical pitfalls they may encounter in dealing with clients who
either (1) are undergoing a divorce or (2) may consider a "friendly" divorce to
be an additional financial planning tool.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> See, generally, Note: "A Tug of War: State Divorce Courts vs. Federal Bankruptcy Courts Regarding Debts Resulting from

<a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 18 Bankr. Dev. J. 169 (2001)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…, "Till Debt Do Us Part: Irreconcilable Differences in the Unhappy Union
of Bankruptcy and Divorce," 45 Buff. L. Rev. 369 (1997)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> Briger and Bowles, "Bankruptcy and Divorce: Can an Unholy Alliance Make the End of an Unhappy Marriage Less Painful?" 13
Amer. J. of Fam. L. 148 (1999). <a href="#2a">Return to article</a>

<a name="3">3</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… N.W.2d at 289</a>. <a href="#3a">Return to article</a>

<a name="4">4</a> Id. at 290. <a href="#4a">Return to article</a>

<a name="5">5</a> Id. at 291. <a href="#5a">Return to article</a>

6 See, generally, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Zablocki,</a><a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; 635 N.W. at 289</a>. Return to article

<a name="7">7</a> The author notes that sometimes it is impossible for an attorney to make the proper pre-representation disclosures concerning these
domestic relations issues when representing parties in a joint chapter 7. Several years ago, the author represented one of the "happiest" couples
he had ever met in a joint chapter 7 bankruptcy. The parties had informed the attorney that they lived in different cities because of their
managerial-level jobs' requirements, but that both of their cities were in the same jurisdiction for purposes of bankruptcy filing. The chapter
7 bankruptcy was filed without incident until at the first meeting of creditors, when the parties mentioned to the trustee, in responding
to his question about their two households, that they would be "finally" getting their divorce so the wife could marry her current fiancée.
After the first meeting, the parties explained to this dumbfounded author that they had separated several years before the bankruptcy, and
only decided to get divorced at this time because the wife had met someone she wished to marry. They confided to the attorney that they were
the best of friends and had already arranged for an uncontested divorce under state law as soon as their bankruptcy was completed. After
voluntarily signing the required waivers, the parties completed their bankruptcy and divorce without incident, and your author added a question
to his standard individual bankruptcy checklist for chapter 7 debtors. <a href="#7a">Return to article</a>

<a name="8">8</a> See, generally, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hope, 231 B.R. 403 (Bankr. D. D.C. 1999)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Sorlacco, 68 B.R. 748
(Bankr. D. N.H. 1986)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Lange, 35 B.R. 579 (Bankr. E.D. Mo. 1983)</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> See, generally, <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Dennis, 998 P.2d 206 (Okla. App. 2000)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… v. Cromwell, 140 Ore. App.
241 (Ore. App. 1996)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… Bank of NY v. Toscanini, 145 A.D.2d 590 (N.Y. App. 1988)</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> Some cases have concluded that fraudulent conveyance actions cannot avoid transfers made pursuant to divorce decrees or property separation
agreements arising from a divorce. See Gagen v. Gouyd, 86 Ca. Reptr. 2d 733 (Cal. App. 1999); <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Falk, 98
B.R. 472 (D. Minn. 1989)</a>; <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Hoyt, 97 B.R. 730 (Bankr. D. Conn. 1989)</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> The bankruptcy court's decision in Williams was remanded to the bankruptcy court due to an error in the bankruptcy court's application
of the missing witness doctrine. <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Williams, 190 B.R. 728, 732-735 (Bankr. D. R.I. 1996)</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 657</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 735</a>. <a href="#13a">Return to article</a>

Journal Authors

C. R. Bowles

Journal Date

Saturday, June 1, 2002 - 12:00

Bankruptcy Rule

2002