It has become increasingly common for spouses planning a divorce to be advised to commence a joint Chapter 7 liquidating bankruptcy case prior to obtaining a divorce decree to wipe out their unsecured, dischargeable debt before their remaining property and debt obligations are allocated in a final dissolution decree. While a bankruptcy filing might be in your client’s best interests, it might bring unwanted scrutiny to your own fees.
A pre-divorce bankruptcy case may have certain benefits for the client. First, under section 302 of Title 11 (the Bankruptcy Code), only spouses may commence a joint bankruptcy case, which allows both parties to file with the payment of a single $335 filing fee. Additionally, commencing the bankruptcy case before the entry of a final divorce decree reduces the risk that the property division itself could be unwound by a bankruptcy trustee on a fraudulent conveyance theory. See In re Fordu, 201 F.3d 693 (6th Cir. 1999) (concluding that property division settlement awarding ex-wife $380,000 in lottery winnings and the entirety of the marital residence was subject to collateral attack by ex-husband’s bankruptcy trustee as a fraudulent conveyance); In re O’Neill, 550 B.R. 482 (Bankr. D.N.D. 2016) (concluding that property division was actually fraudulent under § 548(a) of the Bankruptcy Code, and that, while ex- spouse acted in good faith and was entitled to a credit for the value of the property she transferred to the debtor under § 548(c), the ex-wife received $29,062 more than the value of the property she transferred and such sum was recoverable by the bankruptcy trustee).
Further, in states that retain the legal fiction of tenancy by the entireties, the bankruptcy trustee may liquidate marital property only to pay joint marital debts, such that the clients may be able to retain otherwise nonexempt equity in marital assets over and above the amount necessary to satisfy their joint creditors and still obtain the benefit of completely discharging their individual obligations. See 11 U.S.C. § 522(b)(3)(B). However, the division of entireties property following a divorce or court-supervised legal separation has been held to destroy the tenancy, leaving the equity in such property available to pay the individual obligations of the parties. See Bakewell v. Breitenstein, 396 S.W.3d 406, 413 (Mo. Ct. App. 2013). Accordingly, it may be in the best interests of the client to commence a joint case with the soon-to-be ex if he or she has significant equity in the marital property and individual obligations to discharge without the risk that the marital property may be liquidated by the trustee to pay those obligations.
However, the commencement of such a case may impact the legal fees of the prudent family law attorney, especially where the attorney has requested a retainer for the payment of fees prior to commencing the divorce case or where the lawyer advised the client concerning the possibility of filing for bankruptcy. Most states, including Missouri, hold that even where a flat fee may be charged, such retainer may not be designated as nonrefundable and may be retained only in proportion to the services rendered. See Advisory Committee of the Supreme Court of Missouri, Formal Op. 128 (May 18, 2010), https://boonecountybar.org/wp-content/uploads/2016/04/2011-03-09_Read06_Formal_Opinion_128-nonrefundable_fees.pdf. Thus, while a family law attorney may permissibly contract with a client to treat a higher percentage of a fee as earned up front due to the possible disqualification of the attorney from the matter, any fees that are "nonrefundable" or that have not yet been earned under the temrs of the contract or under the reasonableness standard of rule 1.5 of the Model Rules of Professional Conduct are still property of the client.
Commencement of a bankruptcy case may impact the legal fees of the prudent family law attorney, especially where the attorney has requested a retainer for payment of fees prior to commencing the divorce case.
When a bankruptcy case is commenced, the bankruptcy estate includes all equitable and legal interests in property that belong to the debtor. See 11 U.S.C. § 541 (a)(1). This would necessarily include all interests in any unearned portion of the retainer held by the debtor's divorce counsel. Under section 544 of the Bankruptcy Code, the bankruptcy trustee obtains a lien in all property of the eastate, even where the holder of such property may not be aware of the commencement of the case. Futher, under section 542(a) of the Bankruptcy Code, counsel in possession of such funds and with actual knowledge of the filing of the case may have an affirmative obligation to deliver the unused retainer to the trustee, even before a demand is received. Even where no arffirmative obligation exists, such funds may be subject to a turnover demand or motion for turnover commenced before the bankruptcy court having jurisdiction over the bankruptcy case.
Even counsel’s already earned fee may be subject to a reasonableness review by the bankruptcy court. Under section 329(a) of the Bankruptcy Code, counsel who rendered services “in contemplation of or in connection with the case” must disclose all fees earned by such counsel beginning on the date of the one-year period prior to the commencement of the bankruptcy case. These disclosure rules are implemented by rule 2016 of the Federal Rule of Bankruptcy Procedure. Further, under section 329(b) of the Bankruptcy Code, the bankruptcy court has jurisdiction to review the reasonableness of any fee required to be disclosed under section 329(a) and to order the return of any excessive fee to either the entity making such payment or the bankruptcy estate.
Most family law attorneys are under the mistaken impression that section 329(a) only applies to an attorney who commences the bankruptcy case as counsel to the debtor. However, several courts have extended the reach of section 329’s disclosure and review provisions to any attorney who advises the debtor about his or her financial affairs where a resulting bankruptcy is a possible outcome. In re Zepecki, 277 F.3d 1041 (8th Cir. 2002) (holding § 329 applied to real estate attorney who advised the debtor concerning the pre-petition sale of property and its tax consequences and reducing unreasonable fee by over $32,000). The Zepecki court specifically noted the term “in contemplation of” bankruptcy “generally denotes that the impelling cause of the transaction is influenced by the possibility or imminence of a bankruptcy proceeding.” Id. at 1045.
Even counsel's already-earned fee may be subject to a reasonableness review by the bankruptcy court.
Thus, a family law attorney who advises a client about the possibility of filing for bankruptcy is likely subject to the requirements of section 329. This is consistent with the conclusion recently reached by the U.S. Bankruptcy Court for the Southern District of New York when it applied section 329 to the debtor’s post-bankruptcy divorce counsel and reduced counsel’s fee by $500 as a sanction for failing to comply with section 329’s disclosure requirements. See In re Gorski, 519 B.R. 67 (Bankr. S.D.N.Y. 2014) (divorce counsel retained during Chapter 13 bankruptcy case was subject to § 329). Thus, it is important for family law attorneys to be aware of the disclosure requirements of section 329(a) when advising their clients to commence a bankruptcy case as part of their pre-divorce planning or when being retained by clients in an active bankruptcy case.
Additionally, any fees already earned but unpaid may become dischargeable in bankruptcy. With certain very limited exceptions, debt obligations incurred at any time prior to the commencement of the case are discharged. Accordingly, it is likely that any unpaid fees owed by your clients to you at the time they file for bankruptcy will be discharged. However, obligations incurred in the course of the divorce proceeding and imposed as part of a marital dissolution or separation are not dischargeable. Under section 523(a)(15) of the Bankruptcy Code, a debtor may not discharge any obligation in a marital dissolution to pay his ex-spouse’s attorney fees. To the extent that your fees are to be paid by the other party as a result of the dissolution settlement or order, they cannot be discharged.
The purpose of this article is not to scare family law attorneys who discuss or advise their clients concerning the possibility of filing for bankruptcy. Rather, the purpose is to inform practitioners about the practical and legal effects of a bankruptcy filing on their own fees, regardless of whether such funds have been recently earned or are still being held in trust. Disclosure of the receipt of such fees, even were the client has failed to do so, is often mandated by statute and can subject the attorney to significant sanctions, including disgorgement. fa