Goldilocks Bankruptcy and Divorce Are the Adversarial Relationships Too Much Not Enough or Just Right
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.
Is It Ethical to be a Referee for Your Clients? Representing a Divorcing Couple in Joint Chapter 7
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,1 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.2
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.
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, In the Matter of Zablocki, 635 N.W.2d 288 (Wis. 2001). 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"3 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.4
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.5
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").6 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 divorce7 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.
"Lost it in the Divorce:" Fraudulent Conveyance Issues in Bankruptcy Proceedings Following a Divorce
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 In re Fordu, 201 F.3d 693 (6th Cir. 1999),8 and the state cases, such as Mejia v. Reed, 118 Cal. Rptr. 2d 415 (Cal. App. 2002),9 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.10
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 Sholes v. Lehmann, 56 F.3d 750 (7th Cir. 1995), and In re Williams, 159 B.R. 648 (Bankr. D. R.I. 1993).11
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."12
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 decision13 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.
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.
1 See, generally, Note: "A Tug of War: State Divorce Courts vs. Federal Bankruptcy Courts Regarding Debts Resulting from Divorce," 18 Bankr. Dev. J. 169 (2001); Vance, "Till Debt Do Us Part: Irreconcilable Differences in the Unhappy Union of Bankruptcy and Divorce," 45 Buff. L. Rev. 369 (1997). Return to article
7 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. Return to article
9 See, generally, Dowell v. Dennis, 998 P.2d 206 (Okla. App. 2000); Greeninger v. Cromwell, 140 Ore. App. 241 (Ore. App. 1996); Atlantic Bank of NY v. Toscanini, 145 A.D.2d 590 (N.Y. App. 1988). Return to article
10 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); In re Falk, 98 B.R. 472 (D. Minn. 1989); In re Hoyt, 97 B.R. 730 (Bankr. D. Conn. 1989). Return to article
11 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. In re Williams, 190 B.R. 728, 732-735 (Bankr. D. R.I. 1996). Return to article