At least in Illinois, a divorce court can strip property from a spouse’s bankrupt estate after filing, according to the Seventh Circuit. The January 31 opinion is another example showing how state law can automatically remove property from an estate after bankruptcy.
A husband and wife owned a home. A few months after the wife filed for divorce, the husband filed a chapter 7 petition. A month after bankruptcy, the divorce court decided that the wife had established grounds for divorce and awarded the home to the wife, free and clear of any claims by the husband because he had dissipated marital property. The divorce court did not enter a judgment regarding the home until the bankruptcy court modified the automatic stay.
The bankruptcy trustee initiated an adversary proceeding to set aside the state court’s award of the home to the wife. The trustee intended to sell the home and retain the husband’s half interest in the proceeds under Section 363(h).
Employing different rationales, the bankruptcy court and the district court, on the first appeal, ruled that the wife emerged as owner of the home free of the husband’s interest. In an opinion by Circuit Judge Diane S. Sykes, the Seventh Circuit reached the same result, after a more extensive analysis.
According to Judge Sykes, the result turned on Section 503(e) of the Illinois Marriage and Dissolution of Marriage Act, which granted both the husband and wife contingent rights in the entire house at the moment the wife filed the divorce action.
Judge Sykes said that the appeal tasked the court with deciding what the husband’s bankrupt estate “currently owns,” because the estate only includes the debtor’s title and rights in property at the time of bankruptcy.
Contrary to community property states, Illinois “does not establish independent ownership interest in marital property at the moment it is acquired,” Judge Sykes said. Instead, she said that divorcing “spouses are vested with independent contingent interests in all marital property at the moment a divorce petition is filed.”
When the divorce court ultimately divides marital property, Judge Sykes said that the “contingent interest in that property ripens into a full ownership interest.”
Since the wife filed for divorce in advance of the husband’s bankruptcy, Judge Sykes said that the husband “no longer owned a simple half-interest in the house.” Instead, she said, the husband had “a half-interest subject to [the wife’s] contingent interest.”
When the divorce court awarded the home to the wife, “the estate’s contingent interest in the house disappeared,” thus leaving “the estate without a claim,” Judge Sykes said.
The result might not always be the same, in view of an argument the husband’s trustee did not make on appeal. Judge Sykes said that a trustee in a similar circumstance could exercise strong-arm powers under Section 544 to “protect federal interests.” She did not intimate what the outcome might be.
The opinion also does not discuss the power of a trustee to sell a non-filing spouse’s interest under Section 363(h). Under that section, the first question is whether the husband and wife were “co-owners.” Assuming they were co-owners, the trustee would also need to show that the benefit to the estate would outweigh the “detriment” to the wife.
Whether Section 363(h) even applies might depend on when the respective interests of the husband and wife were measured. If determined as of the date of bankruptcy, the bankrupt estate might have interest subject to the trustee’s power of sale.
If measured when the divorce court awarded the home to the wife, the estate would no longer have an interest the trustee could sell. Would the result in the Seventh Circuit case have been different were there no modification of the automatic stay allowing the divorce court to extinguish the husband’s interest in the home?
The opinion is another example of the messy collision between bankruptcy and divorce law.
The opinion is akin to an unresolved question about the automatic loss or diminution of an estate’s interest in property under state law. For ABI’s discussion of a case on direct appeal to the Tenth Circuit, Davis v. Tyson Prepared Foods Inc. (In re Garcia), 17-3247 (10th Cir.), click here.