The Limited Legacy of Lerbakken: Consumer Debtors Can Exempt Unencumbered, Qualified Retirement Funds Awarded in a Divorce

It has been two years since the Eighth Circuit Court of Appeals affirmed the BAP’s ruling [1] in In re Lerbakken [2] disallowing a debtor’s claimed exemption in retirement funds awarded by divorce dissolution under 11 U.S.C. § 522(b)(3)(C). The 2018 BAP opinion sent shockwaves throughout the bankruptcy community, drawing a clear distinction between an allowed exemption for funds placed in a retirement account created and contributed to by the debtor [3] versus funds placed in a retirement account created and contributed to by the debtor’s ex-spouse, but awarded to the debtor in a pre-bankruptcy divorce decree. The Eighth Circuit’s 2018 ruling employed the Supreme Court’s line of reasoning in Clark v. Rameker, [4] a decision that lives in infamy for its exclusion of inherited IRAs from the definition of exempt “retirement funds” under § 522(b)(3)(C). It was expected that chapter 7 trustees would emerge as beneficiaries of the BAP’s bright-line rule excluding divorce-transferred IRAs from the meaning of “retirement funds” under § 522(b)(3)(C). It appears, however, that the Eighth Circuit Court of Appeal’s decision tempered the BAP’s ruling — so much so that a debtor’s fear of losing their award in an ex’s divorce-related retirement account has all but dissipated.

Despite the BAP’s expansion of Clark to include divorcees’ awards as a new class of retirement funds excluded from the federal exemption, Lerbakken has not been relied upon, or even cited to, in any subsequent cases for purposes of limiting the exemption. The consumer industry gave a small collective sigh of relief following the Eighth Circuit Court of Appeal’s interpretation of Lerbakken previously rendered by the BAP. This second coming of Lerbakken did not reaffirm the BAP’s exclusionary language that allowed a valid exemption for funds in an IRA only to the extent that they were contributions made by the debtor, in an account established by the debtor. This is perhaps the most significant difference between the two Lerbakken decisions.

Nonetheless, the Eighth Circuit opined that to qualify as an exempt IRA, a divorce-related award of retirement funds must bear the traditional characteristics of “retirement funds” as of the petition date. In the context of Lerbakken, this equates to a vested property interest in funds on deposit in a qualified retirement account, set aside for the purpose of retirement. Unlike its predecessor by the BAP, the Eighth Circuit’s opinion opened the door for further interpretation of the circumstances in which an award of retirement funds may be claimed as exempt, regardless of whether they were the debtor’s own pre-tax funds to begin with. Two years later, consumers should take comfort knowing that Lerbakken has not been expanded by precedent. An individual can claim the federal exemption to protect an otherwise unencumbered award of qualified retirement funds received by divorce decree. Lerbakken’s legacy has therefore proven itself to be self-limiting, based on its unique set of facts.

A Narrow Ruling Based on Atypical Facts

Both fans and critics of the pair of rulings in Lerbakken are quick to overlook the numerous oddities that contributed to the appellate courts’ finding in the chapter 7 trustee’s favor in this case. Creditors and trustees would argue that Lerbakken “explicitly prohibits a “case-by-case, fact-intensive examination of subjective purpose” [5] as to the state court’s intent in granting an award of retirement funds. Conversely, debtors would argue that Lerbakken is a conjectural anomaly; the pair of rulings failed to contemplate the inherent conflicts of law that arise when a federal court is left to interpret a state court order.

Consider a “divorce court’s clearly expressed intent to create a maintenance award” in favor of a would-be debtor. Once that award becomes property of the recipient-debtor’s bankruptcy estate and the subject of an objection to exemptions, a federal court’s denial of the claimed exemption could easily turn into a Full Faith and Credit Clause violation. In this sense, the Eighth Circuit Court of Appeals opinion in Lerbakken can be viewed as an imperfect opinion rendered in light of the various circumstantial failures that caused Mr. Lerbakken to lose his claimed exemption in his ex-wife’s retirement proceeds.

The Facts

Lerbakken engaged Sieloff & Associates, P.A. to represent him in his pre-petition divorce. As part of the dissolution decree, Lerbakken was awarded all the proceeds in his ex-wife’s IRA, and half of the proceeds in her 401(k). The decree ordered Lerbakken to submit QDROs for a transfer of the funds, which was never completed. The divorce proceeding concluded with a separate order granting Sieloff an attorneys’ lien against Lerbakken for fees. That post-judgment order expressly permitted Sieloff to recover fees from Lerbakken’s interest in the retirement funds previously awarded.

The amount due and owing to Sieloff exceeded the value of Lerbakken’s interest in the retirement funds awarded. Six months later, Lerbakken filed a chapter 7 bankruptcy in which he sought to exempt his interest in the ex-wife’s IRA and 401(k) under 11 U.S.C. § 523(b)(3)(C). By claiming the funds as exempt, Lerbakken attempted to protect and preserve the funds from his attorney’s claim of right. Lerbakken’s method of utilizing the chapter 7 bankruptcy as an “off-road vehicle” to secure retention of the retirement award was not lost on either the BAP or the Eighth Circuit.

On appeal from the BAP, the Eighth Circuit defined “retirement funds” as “sums of money set aside for the day an individual stops working.” [6] Using the framework employed in Clark, the court of appeals considered whether Lerbakken’s interest in his ex-wife’s IRA and 401(k) met the following three criteria: (1) the debtor claiming the exemption has the ability to make contributions to the funds; (2) the debtor is not obligated to withdraw the funds; and (3) the debtor must be required to pay a penalty for an early withdraw of the funds in question. Under this framework, failure to meet any of these three prongs would result in a disallowed claim of exemption. In addition to these characteristics, the Eighth Circuit Court of Appeals considered the language of § 522(b)(3)(C) quite literally, further “requir[ing] that the funds satisfy not one but two provisions to be exempt: the funds must be ‘retirement funds,’ and they must be held in a covered account.” [7]

The Eighth Circuit Court of Appeals ruled that the interests Lerbakken claimed in his ex-wife’s 401(k) and IRA failed to meet the outlined characteristics. With regard to the IRA, Lerbakken’s interest was controlled by the state court’s mandate that transfer of funds take place by QDRO. Without a QDRO in place as of the petition date, the funds in question were not subject to a claim under § 522(b)(3)(C), as they were not the debtor’s own retirement proceeds. And although Lerbakken did have the ability to make contributions to the IRA held in his ex-wife’s name, he was under a state court order to withdraw all of the funds, as they were subject to a lien for attorney’s fees. Thus, Lerbakken’s bankruptcy estate had a future contingent interest in the IRA by way of a state court order, but that interest failed to qualify as retirement funds for purposes of the statute, because Lerbakken did not have the ability to make a voluntary withdrawal on account of his divorce attorney’s lien ordered by that court. Seeing as the IRA lacked most of the legal characteristics of ordinary “retirement funds,” the Eighth Circuit found that it could not be claimed as exempt “retirement funds” under § 522(b)(3)(C). [8]

Along the same lines as the IRA, the court determined that Lerbakken did not cause a QDRO to be entered with respect to the 401(k). Without a QDRO, Lerbakken could not make a withdrawal of the funds. Accordingly, where the funds were not rolled over into a retirement account in his name, preventing him from making contributions to the retirement account, the 401(k) did not qualify as exempt retirement funds. The court similarly ruled that absent a QDRO, state law defined Lerbakken’s contingent interest in the 401(k) proceeds as subject to the lien in favor of his divorce counsel. State law required that he satisfy the lien, which again prohibited him from making a voluntary withdrawal. As with the IRA, the court ruled that Lerbakken’s conditional interest in the 401(k) lacked the legal characteristics of ordinary “retirement funds,” ultimately preventing him from claiming the exemption under § 523(b)(3)(C) as to both portions of the award.

Initial Impressions

At first glance, consumer practitioners viewed Lerbakken as a precedential hand permitted to reach deep into the pockets of divorcee debtors. With broad strokes and in bold terms, Lerbakken appears to upend traditional protections of the federal exemption for funds in an otherwise qualified retirement account exempt from taxation by the Internal Revenue Code. The Eighth Circuit’s exclusion of funds received by divorce decree from the definition of “retirement funds” under the federal exemption scheme has all the makings of a harsh and dangerous precedent; it hands the administrator of a bankruptcy estate an unabridged pass to recover money from post-divorce debtors, money that quite possibly was intended by the deciding state court for the recipient’s maintenance and support. The potential far-reaching effects of this decision sent divorce attorneys, consumer debtor attorneys and wealth managers alike scrambling in its wake to protect similarly situated clients.

Consequently, it is not surprising that the initial response to Lerbakken by consumer debtor practitioners was one of fear and loathing. From the consumer debtor attorney’s perspective, the interest in an ex-spouse’s retirement account is a rather common asset; consider the entire Qualified Domestic Relations Order (QDRO) industry that has arisen in response to the problem of separating retirement funds following a divorce action. Despite its rhetoric against “permitting debtors to enjoy cash windfalls through exemption” by converting the Bankruptcy Code’s purpose from a ‘fresh start’ into a ‘free pass,’ [9] Lerbakken has remained entirely limited in scope. This is due to the untimely and uncommon circumstances borne by Lerbakken in his failed attempt to exempt the award of his ex’s retirement accounts.

Clearly Distinguished Takeaways

Lerbakken is easily distinguishable from a typical post-divorce debtor entitled to receive an interest in retirement funds. Lerbakken’s own failure to submit QDROs played a large role in prohibiting his ability to exempt his interest in the funds. A QDRO is a domestic-relations order that (1) creates or recognizes the existence of an alternate payee’s right to, or assigns to an alternate payee the right to, receive all or a portion of the benefits payable with respect to a participant under a plan; (2) clearly specifies certain facts; and (3) does not alter the amount or form of the benefits under the plan. [10] A domestic-relations order is defined as “any judgment, decree, or order (including approval of a property settlement agreement) which — (i) relates to the provision of child support, alimony payments, or marital property rights to a spouse, former spouse and (ii) is made pursuant to a State domestic relations law (including a community property law).” [11]

The funds in question awarded to Lerbakken were never properly transferred as ordered by the dissolution decree. They remained an asset titled in his ex-wife’s name. Lerbakken’s failure to meet this threshold requirement by giving effect to QDROs ends the legal inquiry as to whether the 401(k) portion of the divorce award qualified under the statute. Without an ability to contribute directly to the funds in question, Lerbakken failed satisfy at least one of the required criteria.

Furthermore, Lerbakken’s failure to submit QDROs left him with interests granted by a dissolution decree, specifically governed by state law. The law of the case in his divorce proceeding contained an attorney’s lien ordered by the judge during the dissolution proceeding. Even if Lerbakken had attempted to timely submit QDROs in advance of filing his bankruptcy, the QDROs themselves would have been ineffective. Lerbakken did not have the ability to seek transfer or rollover, or make a withdrawal as an alternate payee, due to the attorney’s lien secured against the full value of his contingent interest therein.

Thus, the judgment lien for attorney’s fees secured by the full amount of Lerbakken’s award precluded him from even effectuating QDROs to protect these funds. In a case where there is no attorney’s lien securing the value of the retirement funds in question, an executed QDRO entered prior to a bankruptcy petition would preserve a debtor’s right to exempt a qualified award of retirement funds.

Formidable Future Turned Limited Legacy

Although the duo of opinions concerning Lerbakken is certainly open to further interpretation, the net result of the Eighth Circuit Court of Appeal’s ruling poses very little threat to post-divorce debtors with timely entered QDROs. The prospect of losing a debtor’s right to claim as exempt their property interest in qualified retirement proceeds seemed rather formidable two years ago. But hindsight is 20/20, as far as the legacy of Lerbakken is concerned. Since the BAP and the Eighth Circuit opinions were published, Lerbakken has been relied upon only once by a trustee: In In re Glass, [12] the chapter 7 trustee’s objection to a debtor’s claimed exemption over his right to receive an “IRA-to-IRA” transfer by stipulated settlement agreement pre-dating the bankruptcy petition was overruled. [13] The bankruptcy court in Glass found that the funds in question qualified as retirement funds under the Supreme Court’s reasoning in Clark, even though the transfer had yet to be effectuated. The chapter 7 trustee’s reliance on the BAP’s interpretation of In re Lerbakken was rejected, and the Eighth Circuit’s view upheld for the benefit of the debtor. Per the bankruptcy court’s ruling in Glass, New York state law governed the divorce settlement. Under New York state law, the transfer was considered “effective” as of the date of the stipulated settlement. In this instance, the funds were not on deposit in a qualified account in the debtor’s name. Therefore, the Eighth Circuit Court of Appeal’s ruling that state law governs the property interest created by the separation agreement spared the debtor his claimed exemption. Thus, the logic of Lerbakken can even be used to protect a debtor’s right to their claimed exemption in a post-divorce retirement award.

In conclusion, Lerbakken does not provide chapter 7 trustees with the ideal platform for seeking revocation of post-divorce retirement awards, as consumers may have feared. Lerbakken’s divorce attorney’s lien against his interest is a factor of distinction, limiting the future application of this ruling in the negative context for consumers. As the past two years have proven, neither the BAP’s broad exclusion, nor the Eighth Circuit’s more narrow application of qualified “retirement funds,” have seen any expansion by way of legal precedent. Therefore, unencumbered retirement accounts transferred in connection with a divorce decree are exempt in a debtor-transferee’s bankruptcy under 11 U.S.C. § 522(b)(3)(C).