Protecting Divorce Clients from Post-Divorce Bankruptcy

Divorce settlements can be undone by the filing of a petition in bankruptcy by the payor spouse – sometimes even before the ink has dried on the property settlement agreement. As a direct consequence, what should have been a comfortable existence for the non-monied spouse will no longer be what had been anticipated. Depending on how finances were structured, this might even negatively impact the collection of a hard-earned fee. 

It is reasonable to ask, “Were there warning signals I should have seen?” or “Could I have taken precautions to protect me/my client from this potentiality?” Whether the bankruptcy be the handiwork of a vindictive former spouse or simply the unfortunate consequence of uncontrollable or unpredictable happenstance, sometimes it is possible to avoid going through such a wrenching catastrophe.

Margin of Safety – in many middle-class and upper middle-class divorces, there is little margin of safety – the ability of the monied spouse to make payments is inexorably tied to the financial vagaries of a closely-held family business, leveraged real estate or an executive position which is subject to the mercies of corporate downsizing. It is important when fine-tuning a settlement to take a step back and view the financial package (perhaps with the assistance of a CPA) – can it pass the cash flow “smell test”?

If the marital estate has little or no liquidity, if the ability of the payor to make the structured payments is totally reliant upon the continued good fortune of a business or employment at current income levels, there may be a financial problem in the making. Particularly if the marital estate is leveraged, the danger of potential default is magnified by the slightest of financial reverses. Much like analyzing the financial statement of a business and coming to the conclusion that its working capital ratio is inadequate to meet a business downturn, so too is it possible to look at a divorcing party’s ability to make payments and conclude that any financial reverses, genuine or concocted, may cause bankruptcy – real or pretend/apparent.

Warning Signals – does the settlement agreement call for one or more large (or balloon) payments, particularly several months or a year after the settlement? This could be just enough time to let the dust settle and perhaps lend an aura of legitimacy to a filing of bankruptcy. Whether planned or not, the burden of a substantial property settlement payment, particularly if occurring at a time when finances are strained, may be sufficient to propel a spouse into bankruptcy court.

A payout that, in the context of what you know of the payor’s financial wherewithal, seems out of line, is another warning sign. Consider restating the balance sheet for the payor spouse, factoring in as an obligation the property settlement. If that exercise results in a negative balance sheet – liabilities exceeding assets – you may have a bankruptcy (perhaps even a planned bankruptcy) in the making.

Does the ability of the payor to make the payments rely heavily or solely on his/her continued income stream from a closely held business, in which he/she has only a partial interest (particularly a minority interest), and the remainder of the interests are held by family or close friends? This may present an opportunity for a planned bankruptcy. With a little cooperation from family and friends, it would not be too difficult to give at least a surface impression of things being worse than they are and propel one into a respectable illusion of a bankruptcy.

Another possible flag is where the monied spouse is too willing to consider a handsome property settlement (to be paid over a period of time) in lieu of a combination of ongoing support payments coupled with a smaller property settlement. Unless structured carefully, a property settlement is relieved in bankruptcy, whereas a support obligation is not.

Protecting Your Client or Yourself – assume you are faced with a situation exhibiting one or more of the elements described above. What steps can be taken for protection? One question to ask is whether any collateral is available. Unfortunately, in divorce, there is often no collateral that is truly adequate. You may have to accept (assuming you can get the payor to go along) a business as collateral. 

Another approach is to get as many assets up front as possible, leaving little on the table for a term payout. The more received initially, the less are the risks arising from a reliance on a former spouse. Unfortunately, in many middle-class divorces, there isn’t enough liquidity to get much upfront, and the business often represents a disproportionate share of the estate.

Where there are assets, but not sufficient liquid assets, refinancing should be considered. For instance, assume one is to receive $500,000 as a property settlement. Funds in this amount are not available, but there is a piece of real estate, either unencumbered or slightly encumbered.   A refinancing of that real estate might generate the dollars for an upfront payment. 

Finally, if there simply isn’t sufficient liquidity available, consider structuring the agreement in the form of spousal support.  Have the agreement explicitly call it spousal support. Payments in the nature of support have a better chance of withstanding a bankruptcy discharge. Subject to negotiation skills and the relative positions of the parties, it is possible to have what would otherwise be a property settlement categorized as support payments.

Conclusion – the threat of a potential bankruptcy is, at times, a real one that should not be ignored, and therefore one which demands attention. Get your CPA involved in analyzing the possibilities. Even if there is nothing you can do to prevent it, you need to be aware of this possibility.  By doing so, you may avoid some of the shock and finger pointing should bankruptcy occur.