Have it in for Your Ex-Spouse? File Bankruptcy!

by Gary on November 12, 2012

New opinion from the Southern District of Texas may require ex-spouses to pay claims and fund plans. In re Porretto, Southern District of Texas, Houston Division, Case No. 09-35324, Adv. No. 11-03226 (10/18/2012).

Does a Chapter 7 trustee have the right to demand immediate turnover of funds from the debtor’s ex-husband under hold harmless and indemnification provisions in a property settlement?  Yes, so says Judge Jeff Bohm of the United States Bankruptcy Court for the Southern District of Texas, if the indemnification language in the property settlement agreement is broad enough.

As a part of their divorce decree, Darryl Nelson agreed to pay certain creditors and to hold Sonya Porretto harmless for any damages arising from his failure to pay.  After filing Chapter 11, Porretto and three of her creditors litigated and settled their claims in bankruptcy court.  (The three creditors held secured claims of $704,780.21 and unsecured claims of $226,856.10). Porretto filed an adversary proceeding under Section 542, the turnover statute, against Nelson seeking to enforce the indemnification agreement and force turnover of funds sufficient to pay the three claims plus reasonable attorneys’ fees.  After she converted her case to Chapter 7, the trustee substituted in as plaintiff.

The court concluded that Nelson was obligated to indemnify Porretto and turnover funds sufficient to pay the three claims settled in Porretto’s bankruptcy case even though the trustee had not yet made any distributions. Whether turnover is appropriate requires a determination that the debt is property of the estate and that it is mature and payable on demand or on order.  See Section 542(b).  The court had no trouble finding that the indemnification agreement is property of the estate.  Nelson, however, argued that turnover was not appropriate because the trustee had made no distributions for which to seek indemnification.

The court, relying on the wording of the property settlement, rejected that argument and held that the duty to indemnify is not conditioned on actual payments being made.  The court reasoned:

  • The Nelson/Porretto agreement is broad and indemnifies against liabilities, not just damages.
  • Under Texas law, the duty to indemnify arises upon a finding of liability that is fixed and certain, such as by the rendition of a judgment, even though the indemnitee (here Porretto or the estate) has suffered no damages by payment of a judgment.
  • In the Nelson/Porretto agreement, indemnification and reimbursement are separate and independent conditions.

Nelson argued that it inequitable to require that he turn over funds to pay the claims because the trustee would use those funds to pay all allowed claims on a pro rata basis — likely less than 100% of their allowed amounts — which would leave him exposed and obligated to the claimants on the unpaid portions even though he had turned over 100% of the claim amounts to the trustee.  The court was not swayed.  Equity requires clean hands.  Because he was in contempt of state court for failing to pay the claims under the divorce decree, Nelson’s hands were most assuredly not clean. The court granted the turnover relief subject to a determination of the total amount of the debt and reasonableness of the attorneys’ fees.

Points to Ponder

It may be needless to say, but our trustee friends are pleased.  We, however, are curious about the outcome of various scenarios we can imagine.

Indemnification as Asset or Debt

First off, this case takes for granted that an indemnification agreement of the type commonly found in Texas property settlements is an asset to the indemnitee and a financial obligation to the indemnitor.  It follows that the indemnification agreement must be listed on the debtor’s schedules as either a debt or an asset.  How would the indemnification be valued?  Is it exemptable?

Exes as Parties to the Bankruptcy

Porretto would appear to make every Chapter 7 filed by a divorced person a potential asset case, imposing on trustees a duty to question debtors on the terms of their divorce decrees and evaluate the ex’s financial standing.   A broad reading of this opinion would make every former spouse a party to his ex’s bankruptcy case subject to a turnover order.  Is it beyond the pale to imagine a bitter ex-husband filing a Chapter 7 case in order to vex his ex-wife into bankruptcy court, also?

Closed cases would not be immune from scrutiny.  Under Reed v. City of Arlington, 650 F.3d 571 (5th Cir. 2011 en banc), which confirmed the estate’s right to pursue an asset that the debtor failed to list on his schedules, a trustee could review her old cases for unlisted indemnifications and bring turnover actions against unsuspecting ex-spouses.

Taking Advantage of the Superdischarge

It may be necessary to counsel some clients, who are otherwise eligible for a Chapter 7 discharge, to file a Chapter 13 case to take advantage of what is left of the superdischarge, namely the discharge of obligations under a marital property settlement.  Consider the case of Madge and Ernie.  Ernie files a Chapter 7 bankruptcy to discharge all those debts he agreed to pay in the property settlement.  The indemnification agreement, however, is not a dischargeable debt.  Madge files a Chapter 7 bankruptcy, too, and lists the indemnification as an asset.  Madge’s trustee seeks a turnover order directing Ernie to make good on the indemnification obligation, despite the fact that Ernie received a personal discharge of the debts themselves.

Chapter 13 and Best Interest of Creditors

Speaking of Chapter 13, could a Chapter 13 trustee object to a debtor’s plan under the “best interest of creditors” test based on the existence of an indemnification agreement?  Let’s say Tina files a Chapter 13 case to save her home from foreclosure.  She lists an indemnification agreement from her ex-husband Henry as an asset.  The Chapter 13 trustee objects to Tina’s 0% plan under the “best interest of creditors test,” in effect requiring her to enforce the indemnification before her Chapter 13 plan can be confirmed.

In Chapter 13 cases, the “best interest of creditors test” does not require that the debtor liquidate the asset, but rather the value of the asset is paid to the trustee over the course of the plan.  Could the Chapter 13 trustee require that Henry provide his tax returns, paystubs or P&L statements or otherwise require that Tina prove how she’s going to contribute the value of the indemnification agreement to her plan?

Costs of Claims Litigation

What about the costs of litigating claims in the bankruptcy (or state) court?  Many, if not most, indemnification agreements require the indemnitor to defend the indemnitee in any action for collection of the debt.  For Nelson, the opinion is not clear with respect to any involvement he might have had in the negotiations that led to the settlement of the claims actions.  Now he’s stuck with the outcome regardless of any legitimate defenses he may have had.  But what of other, more routine cases?  Could Carl the electrician be required to pay his ex-wife’s bankruptcy estate the claim amounts and the cost of litigating those claims?

Who gets the Surplus?

Finally, nothing in this opinion would limit the non-debtor’s exposure only to allowed claims.  Claims owed by the debtor and claims owed to the debtor — like the indemnification amount — are independent of each other.  Conceivably, the trustee could demand turnover of the total amount subject to the indemnification, not just the amount for which claims had been allowed in the bankruptcy case, just as a trustee can liquidate non-exempt assets that total more than the claims in a case.  .

What if Mary has $100,000 in unsecured debt when she files Chapter 7, all of which is subject to indemnification by her ex-husband Patrick.  Pursuant to a turnover order, Patrick pays $100,000 into the estate.  Claims totaling $10,000 are filed.  After administrative expenses are paid and distributions made to claimants, there remains a surplus of $75,000.  Who gets it?  Pursuant to Section 726(a)(6), the surplus goes to Mary.

And to add insult to injury, Patrick remains obligated to the creditors who chose not to participate in Mary’s bankruptcy case.  Just a thought.

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