Vesting of Marital Property Determines the Scope of the Bankruptcy Estate

Creditors seeking to foreclose in state court on their real property liens frequently find their efforts frustrated by serial bankruptcy filers attempting to use the protections of the automatic stay to delay the foreclosure. To address this problem, § 362(c)(4)(A) of the Bankruptcy Code provides that when a debtor has had two or more cases pending and dismissed within a one-year period, the automatic stay will not take effect. Debtors seeking the protections of the automatic stay must file a separate motion seeking such relief. The standards of what a debtor must demonstrate in order for the bankruptcy court to impose the automatic stay, despite the prior filings, are beyond the scope of this article.

In cases this author has recently encountered, some debtors are attempting to find a loophole in the ‘Serial Filer Rule’ by having their non-fee owning spouse file a petition and claim an equitable interest in the property merely on the basis of their status as a spouse of the actual fee owner.[1] The debtors advance a theory that if there were a hypothetical divorce between the spouses, the non-fee owning spouse would be entitled to equitable distribution of all property acquired during the marriage.[2] As a result, that future interest creates a current equitable interest in the real property and is thus an asset of the non-fee owning spouse. Effectively, due to this equitable interest, the property would be part of the non-fee owning spouse’s bankruptcy estate and generate the automatic stay.

However, in Musso v. Ostashko,[3] the seminal case in the Second Circuit addressing this unique intersection between federal bankruptcy law and New York domestic-relations law, the circuit court expressly refuted this theory. Ostashko dealt with a debtor-wife who had been awarded 100 percent of the marital assets in a New York State matrimonial action, including a marital home in which the husband was the sole deeded owner. Subsequent to the decision granting the divorce and awarding the debtor-wife the marital assets but prior to the actual entry of such judgement, an involuntary chapter 7 petition was filed against the husband. Thereafter, the chapter 7 trustee commenced an adversary proceeding seeking a judgment declaring that the debtor-wife did not have any legal interest in the marital home and that the martial home was property of the bankruptcy estate. The wife opposed, moving for summary judgment and arguing that on the basis of the matrimonial court decision, the marital home belonged solely to her and was thus not part of the husband’s bankruptcy estate.

The bankruptcy court delved into a substantial discussion regarding the issue of when the wife’s rights to the property actually vested within the context of equitable distribution. The court reasoned that if the wife’s “rights vested before the Petition Date, then the Marital Assets did not become part of the Debtor’s bankruptcy estate ... if her rights vested after the Petition Date, then the Marital Assets [are] property of the Debtor’s bankruptcy estate.”[4]

The bankruptcy court ultimately ruled that under New York’s domestic-relations law, the rights to marital property vests only upon the final entry of judgment. It is important to note that within this holding, the court implicitly rejected the notion that a potential future right to equitable distribution could create an equitable interest sufficient to bring the asset into the bankruptcy estate. In other words, it is the actual vesting of the legal rights to the property that determines whether the asset can properly be classified as part of the bankruptcy estate. A mere potential right to equitable distribution before a divorce action is even filed certainly will not place the asset into the bankruptcy estate. Consequently, the automatic stay will not attach to the property of a non-fee owning spouse; as such, the asset does not fall into the scope of the estate.

While the bankruptcy court ruling stood for the basic proposition that it is the vesting of the rights that determines whether an asset falls into the bankruptcy estate, the appellate courts addressed the narrower issue of when vesting occurs. The district court sided with the debtor’s wife in ruling that “the right to equitable distribution vests upon the determination of a court that a judgment of divorce is to be granted, and that actual entry vel non of a written judgment pursuant to such a determination, which is a purely ministerial act, is not essential to the vesting of that right.”[5]

On appeal, the Second Circuit reversed, holding that equitable distribution rights do not vest in the spouse until after the entry of the judgment in matrimonial court. The Second Circuit distinguished between legal rights as between spouses and legal rights and remedies as between a spouse and a third party. The Second Circuit conceded that “as between spouses the actual entry of judgement [may well be] immaterial … because the spouses have already had an opportunity to participate in the proceedings by which their respective rights in the property at issue have been determined.” However, as between a spouse and a third party (such as a judgment lien creditor), entry of the judgment is what effectively serves to put creditors on notice.

Despite the express ruling of Ostashko¸ practitioners should be aware that the Southern District of New York has followed a different approach. In In re Levenstein, the bankruptcy court voided a foreclosure sale conducted after a bankruptcy filing of a non-fee owning spouse.[6] While the Levenstein bankruptcy court pointed to Ostashko for the proposition that applicable state law determines whether a property interest of the debtor’s is a legal or equitable interest, Levenstein did not follow the Ostashko holding that vesting does not occur until after entry of the judgment. Instead, Levenstein followed the arguable-property approach of the Fifth Circuit: “When property is only arguably property of the estate, the automatic stay applies.[7] The Levenstein court found that the debtor’s financial contributions toward the monthly mortgage payments, property taxes and maintenance of the property sufficiently qualified to consider the property “arguably” property of the debtor and thus was able to bring the property into the bankruptcy estate and invoke the protections of the automatic stay.[8]

Practitioners should be mindful of this split between Ostashko and Levenstein. Under Ostashko, the key to determining whether an asset is part of the bankruptcy estate in the context of a non-fee owning spouse is to look at when the asset actually vests. Under Levenstein, the key is the ‘arguable property’ approach: a fact-driven analysis examining the debtor’s monetary contributions to the property. In sum, while a line of Eastern District cases have followed the Second Circuit approach that vesting does not occur until entry of judgement,[9] the Southern District has declined to follow this approach, instead adopting the Fifth Circuit’s arguable-property approach. Even though the Second Circuit is controlling, the Second Circuit has yet to address any Southern District cases challenging Levenstein’s application of the Fifth Circuit’s approach over the Second Circuit’s approach. While this issue is ripe for Second Circuit clarification, creditors’ attorneys confronted with this fact pattern would nonetheless be wise to seek a comfort order from the bankruptcy court before proceeding with a foreclosure sale.