Commercial Fraud Task Force Committee

ABI Committee News

Is Divorce Deceitful in Bankruptcy?

The best way to get a bad law repealed is to enforce it strictly.
-Abraham Lincoln

Prior to and since its enactment, bankruptcy judges and legal commentators have criticized the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). Some judges criticize BAPCPA through articles and lectures, while others heed Lincoln’s advice and strictly construe BAPCPA’s language to harsh conclusions.

One of BAPCPA’s popular provisions was Bankruptcy Code §522(p), which closed the "millionaires’ loophole." This new homestead cap limits the debtor’s homestead exemption when the debtor chooses to use exemptions governed by state law, or if his or her state has opted out of the federal bankruptcy exemption scheme. Specifically, BAPCPA added language that put a $125,000 cap on the debtor’s allowed homestead exemption with respect to a home the debtor bought within 1,215 days prior to filing for bankruptcy protection. This provision does not apply if the debtor’s new home was purchased with funds from the sale of the debtor’s previous home in the same state.

The relevant language of §522(p) reads:

a debtor may not exempt any amount of interest that was acquired by the debtor during the 1,215-day period preceding the date of the filing of the petition that exceeding the aggregate $125,000 in value in-- (A) real or personal property that the debtor or a dependent of the debtor uses as a residence . . . or (D) real or personal property that the debtor or dependent of the debtor claims as a homestead . . . For purposes of paragraph (1), any amount of such interest does not include any interest transferred from a debtor's pervious principal residence (which was acquired prior to the beginning of such 1,215-day period) into the debtor's current principal residence, if the debtor's previous and current residences are located in the same state.

The House report to BAPCPA reads that the homestead cap is another provision that limits the "mansion loophole" or "millionaires' loophole." The millionaires' loophole was the scenario of a person moving to a state (such as Florida), buying a million-dollar home, filing for bankruptcy protection and taking advantage of the new state's large or unlimited homestead exemption. Despite the clear reasoning behind this provision, there are two recent cases that construe the above language in a manner that makes the homestead cap applicable to purely intrastate transactions.

The first case is In re Presto, 2007 WL 2913316 (Bankr. S.D. Tex., Oct. 7, 2007). This case involved the chapter 7 bankruptcy case of a former vice-president of Enron, Kevin Presto (the debtor). The debtor filed for bankruptcy during the aftermath of getting a judgment entered against him in Enron's chapter 11 bankruptcy case. In Enron's bankruptcy case, the Official Employment-Related Issues Committee of Enron Corp. (the committee) obtained a judgment against the debtor for his receipt of a fraudulent transfer. In an attempt to realize on its judgment, the committee made several objections in the debtor's individual bankruptcy case to the allowance of the debtor's homestead exemption.

In one such objection, the committee objected to the debtor's homestead exemption based on §522(p)(1). The committee's objection relied on the following facts: On Aug. 24, 2001, the debtor and his wife purchased land in Texas (at all relevant times, the debtor lived in Texas and all of the facts take place in Texas, so there is no issue of changing jurisdiction) to build a home (the first residence). The first residence was built sometime in 2002, and the debtor and his wife moved into the first residence in January of 2003. Pursuant to Texas law, the debtor and his wife held the first residence jointly as community property.

On May 13, 2005, the debtor and his wife entered into an Agreed Final Decree of Divorce, pursuant to which the debtor retained the first residence. On May 18, 2006, the debtor sold the first residence and used some of the proceeds to purchase a less expensive home (the second residence).

The debtor filed his chapter 7 bankruptcy petition on July 31, 2006. For ease of reference, below is a timeline of critical dates.

August 24, 2001 The debtor and his wife purchase land for first residence.
December 2, 2001 Enron bankruptcy.
2002 The first residence is built.
January 2003 The debtor and his wife move into the first residence.
April 2, 2003 1,215 days before the petition date.
May 13, 2005 Entry of the divorce decree.
December 9, 2005    Judgment entered against the debtor for $2 million in the Enron bankruptcy case.
May 18, 2006 The debtor sells the first residence and purchases the second residence.
July 31, 2006  The debtor files for bankruptcy protection.

Based on these facts, the court stated that the debtor “acquired” his wife’s community property interest in the first residence through the divorce decree within the critical 1,215-day period. The court stated that the wife’s interest was an “interest” for purposes of §522(p)(1), because the debtor “went from owning a half interest in the undivided whole to owning the entire property in fee simple.” Id. at 12. The court also stated that the debtor “acquired” the wife’s interest, for purposes of §522(p)(1), because he was an active participant in formulating the divorce decree. The court held that the debtor could use the equity roll-over exception of §522(p)(2) for his own half interest, but he could not use the exception for the wife’s interest.

The second case is In re Leung, 356 B.R. 317 (Bankr. D. Mass. 2006). In re Leung is a Massachusetts case considering the parameters of §522(p)(1). In this case, the debtor was never involved in any divorce proceeding, but the court held that the homestead cap was applicable because of various transfers that the debtor and his wife made prior to the debtor’s bankruptcy petition.

Specifically, the debtor and his wife purchased a piece of real property in Quincy, Mass. (the residence) in May of 1988. In April 2001, the debtor and his wife transferred the residence solely to the wife, for consideration of $1. In February 2003, the debtor’s wife transferred the residence back to the debtor and herself as tenants by the entirety, for consideration of $1. On Sept. 6, 2005, the debtor filed for bankruptcy protection. The debtor tried to use the equity rollover exception to avoid the homestead cap.

The debtor initially argued that he had an equitable interest while his wife had the legal title to the residence. For this argument, the debtor relied on Mass. Gen. Laws ch. 208, §34. The court quickly dismissed this argument, stating that the statute only applied to equitable distribution of property between couples that were divorcing and was not applicable to the debtor and his wife, who were not divorcing.

The court went on to hold that the debtor acquired his current interest in the residence when the debtor’s wife transferred her sole interest to both the debtor and herself. The court noted that to the extent that the debtor needs an affirmative act to “acquire” an interest for purposes of the homestead cap, the debtor’s acceptance of delivery of the deed and then declaring a homestead were enough for any affirmative act requirement. The court then held that the debtor could not use the equity rollover exception because the clear language of the exception requires two principal residences, and “[i]n this case, there is no transfer from a previous principal residence to a current residence.” Id. 323.

These are just two recent examples of bankruptcy court judges strictly construing the provisions of BAPCPA. These judges point out that the language of the statue must be adhered to unless it would cause an absurd result. When a judge has knowledge of the deceitful pre-bankruptcy planning that the homestead cap was enacted to guard against, are these decisions that punish entirely intrastate activity absurd? Is it really against statutory construction to consider the bad behavior this provision is supposed to guard against? Does it really follow that Presto was deceitful in getting divorced?

To be continued in Part II.