The DEVIL is in the DETAILS and in the DISCHARGE – creditors beware!

Category: Bankruptcy

New Mexico is one of only a handful of states and territories in the United States that follow community property law.1 The most basic tenet of community property is a presumption of fifty-fifty split in ownership of property and debt in marriage. Under Section 40-3-12(A), all property “acquired during marriage by either husband or wife, or both, is presumed to be community property.” Exceptions include property one spouse acquired prior to the marriage, by gift, or by inheritance. This distinction, between community property and so-called separate property, is an important consideration when practitioners are consulting with potential bankruptcy clients.

When a petition is filed in a joint bankruptcy case, all community property of both spouses is disclosed to the court and subject to the liquidation powers of the trustee. If only one spouse files, that spouse’s property interests must be disclosed, including community and separate property. The non-filing spouse’s separate property, however, is neither property of the estate nor subject to the disclosure requirements of the filing spouse. Therefore, if one spouse has already inherited or is expected to inherit separate property, then it may be strategic to leave that spouse out of the filing.

The presumption of community acquisition of property applies equally to the allocation of debt. Debts incurred during the marriage are presumptively community debts.2 A separate debt is, among other things, one incurred by a spouse before the marriage or after entry of a divorce decree, one “contracted by a spouse during marriage which is identified by a spouse to the creditor in writing at the time of its creation as … separate debt,” or a debt determined to be separate debt by a court having jurisdiction.3 A bankruptcy discharge of debt is a release of the personal liability for a pre-petition debt. More accurately, a discharge is a bankruptcy court-ordered injunction against the collection of a prepetition debt. The discharge injunction also protects property “acquired after the commencement of the case, on account of any allowable community claim.”4

The potential pitfall for creditors occurs when the non-filing spouse receives the benefit of a practical discharge from the debtor’s discharge. “Community discharge” protects community property from claims even against the non-filing spouse.5 This includes post-petition wages of the nonfiling spouse, although it does not prevent creditors from attempting to collect separate property of the non-filing spouse. This means the community property injunction forever protects the entire community from pre-petition claims not excepted from discharge. If the non-filing spouse’s debt is from fraud or other nondischargeable wrongs, then the non-filing spouse can be protected by the “practical discharge” because the community property protections afforded under the discharge injunction protect the non-filing spouse’s interest in community property.

Not so long ago, many New Mexicans fell victim to a notorious Ponzi scheme associated with the Doug Vaughn and Vaughn Company Realtors bankruptcies. The Bankruptcy court denied Doug Vaughn’s petition for a discharge. Mr. Vaughn was single when he filed his case. The end result could have been drastically different had Mr. Vaughn been married at the time of his filing and his spouse filed an individual bankruptcy case instead. Enter the hypothetical Mrs. Vaughn. What if the hypothetical Mrs. Vaughn filed a bankruptcy without Doug joining the case? She would naturally give the necessary disclosures to the court, relating to property belonging to the debtor and outstanding debt. The hypothetical Mrs. Vaughn would disclose all creditors, including those victims in the Ponzi scheme since presumptively those creditors would count as community debt. She would also disclose all property interest including community property owned by herself and Mr. Vaughn. If she had no knowledge of the Ponzi scheme, then she would likely receive her own discharge.

All of the Ponzi scheme creditors would be put on notice of the Mrs. Vaughn’s petition for a bankruptcy discharge. The creditors would have to know the law in order to protect their claims from the injunction favoring the community property following discharge. Time is critical. If creditors failed to timely file an adversary action against Mr. Vaughn in Mrs. Vaughn’s case, then Mr. Vaughn’s interest in their community property would forever receive protections under the practical discharge discussed above. Mr. Vaughn’s wages, for example, could not be garnished by the victims of the Ponzi scheme following Mrs. Vaughn’s discharge.

Mr. Vaughn would not receive his own discharge, so his creditors would not be left without any remedy at all, but their remedy would be severely limited. The creditors would be restricted to seek redress only against his sole and separate property (i.e. not community property). A victim creditor must pay particular attention to the bankruptcy filings of the wrongdoer’s spouse so as to not fall victim a second time to the non-filing spouse’s wrongdoing.

A famous quote regarding the community discharge goes like this: “the Devil himself could effectively receive a discharge in bankruptcy if he were married to Snow White.”6 Retired New Mexico Bankruptcy Judge Stewart Rose clarified that position when he added “if [the Devil] does not treat [Snow White] better than his creditors, she will, by divorcing him, deny his discharge.”7

1 Other community property states include Arizona, California, Idaho, Louisiana, Nevada, Puerto Rico, Texas, Washington and Wisconsin.
2 See NMSA 1978, Section 40-3-9(B)
3 See NMSA 1978, Section 40-3-9(A)
4 See 11 U.S.C. §524(a)(3)
5 11 U.S.C. 524(a)(3)
6 Alan Pedlar, Community Property and the Bankruptcy Act of 1978, 11 S. Mary’s L.J 349, 382 (1979).
7 Gonzales v. Costanza (In re Constanza), 151 B.R. 588, 590 (Bankr.D.N.M. 1993)

Originally published in
New Mexico Lawyer, February 2019, Volume 14, number 1.