Interests Held by the Bankruptcy Estate: Can Contingent Interests Go Poof?

Reinbold v. Thorpe (In re Thorpe), 881 F.3d 536 (7th Cir. 2018) –

A chapter 7 trustee sought to avoid the interest of a debtor’s wife in property that was awarded to her in a state court divorce proceeding. This decision turned on the nature of the interest that became part of the bankruptcy estate.

After they were married, the debtor and his wife purchased a home. They took title as joint tenants – meaning that they each had a one half interest in the house, and either could convey their interest without the consent of the other.

The wife filed for divorce. About nine months later the debtor filed a chapter 7 bankruptcy, causing the automatic stay to issue. As a result, the divorce court continued to adjudicate the issues but was stayed from entering a judgment. The state court found that there were grounds for divorce. Because the debtor dissipated $98,000 in marital assets, the divorce court also awarded the home to the wife free and clear of the debtor’s claims. Eventually the bankruptcy court modified the automatic stay to permit the divorce court to enter a judgment.

In the meantime, the chapter 7 trustee commenced litigation seeking to (1) undo the state court’s award of the home to the wife, and then (2) sell the debtor’s one half interest in the house. The bankruptcy court ruled in favor of the wife. The district court disagreed with the bankruptcy court’s reasoning, but affirmed the bankruptcy court’s decision. The trustee appealed to the Seventh Circuit.

As a preliminary matter, the Seventh Circuit noted that property rights are created and defined by state law, not federal law. So, the key question was what interest was owned by the bankruptcy estate given application of the state Dissolution of Marriage Act.

Under section 503(a) of the state act, marital property includes all property acquired by either spouse after the marriage. Section 503(e) of the state act provides that “[e]ach spouse has a species of common ownership in the marital property which vests at the time dissolution proceedings are commenced.”

Some states provide for independent ownership interests in property when it is acquired, while other states wait until the final divorce decree issues. This state (Illinois) took the middle ground of giving spouses independent contingent interests in all marital property when the divorce petition is filed. Later when the divorce court divides up the property, the contingent interest of one spouse becomes a full ownership interest while the contingent interest of the other spouse is extinguished.

In this case the home was clearly part of the marital property since it was acquired after marriage. So upon the filing of the divorce petition the debtor and his wife each had a contingent interest in the home. That was the state of affairs at the time the debtor filed bankruptcy. In the Seventh Circuit’s view this meant that the debtor had a half interest subject to the wife’s contingent interest. So, when the divorce court later awarded the home to the wife, the bankruptcy estate’s contingent interest disappeared, leaving the estate without any claim to the home.

The trustee argued for a different result based on the second sentence of section 503(e), which provides that a contingent interest in marital property “shall not encumber that property so as to restrict its transfer, assignment or conveyance.” The trustee argued that the spouse’s contingent interest was an impermissible restriction. According to the trustee once the debtor’s one half interest was transferred to the bankruptcy estate, it was “freed from the shackles” of the wife’s contingent interest.

The court disagreed. The referenced statute did not prohibit encumbrances per se, but rather restrictions on transfer. The court concluded this must mean something more than just affecting the value of the marital property. It also concluded that the trustee’s position would produce an absurd result. All contingent marital interests affect value, so under the approach advocated by the trustee “§ 503(e)’s second sentence evaporates the contingent interest produced by its first sentence.”

The Seventh Circuit also rejected the trustee’s arguments that the court’s interpretation renders certain sections superfluous and that case law holds the divorce act violates the contracts clause of the state and federal constitutions.

Thus, the court rejected the trustee’s appeal and held that under the state statute the bankruptcy estate acquired a contingent interest in the home that was subject to the wife’s contingent interest, and when the home was awarded to the wife, the bankruptcy estate had no remaining interest.

In an interesting sidelight, the court opened the door to further litigation by commenting that the trustee may be able to use its strong arm powers under section 544 the Bankruptcy Code to avoid the wife’s interest. In other words, rather than focusing on the debtor’s rights in the context of a divorce, consider whether a third-party bona fide purchaser might be able to avoid the sale. (This avenue of attack was a not addressed in the appeal since it was waived by the trustee.)

This case is also a reminder that state law is not uniform, and there could have been a different result in a state that defined marital interests differently.

Vicki R Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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