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What should happen when bankruptcy and divorce proceedings coincide?

There has long been tension between the family and insolvency regimes – the former seeking certainty in providing for the spouse and children of a marriage, the latter seeking to ensure that assets of a bankrupt are made available to the unconnected creditors.

In particular, the tension arises when the Family Court makes an order transferring assets to one spouse and the transferring spouse is subsequently declared bankrupt. The divorce and subsequent bankruptcy of David Haines, with judgment passed down by the Court of Appeal on 5 December 2005, perfectly illustrates this tension.

The insolvency legislation has for some time included provisions enabling a trustee in bankruptcy to review transactions that take place prior to bankruptcy where there is evidence to suggest that value has not been obtained for the benefit of the estate.

Under the previous enactment, Section 42 of the Bankruptcy Act 1914, the test was whether “valuable consideration” had been given by the parties. The courts were willing to accept that the release of a right in matrimonial proceedings was valuable consideration.

Section 339 of the act introduced a different test. A transaction was at an undervalue if the bankrupt “entered into a transaction… for a consideration the value of which, in money or monies worth, is significantly less than the value, in money or monies worth, of the consideration provided by the individual”.

It has become received wisdom since the act came into force that a transfer made pursuant to a contested court order would not be vulnerable to being set aside as a transaction at an undervalue.

This is anomalous in light of clear guidance elsewhere in the act that interests of unconnected creditors are to be preferred to the spouse. For example, Section 329 of the act postpones the debts owed to a spouse to those owed to unconnected creditors, and Rule 12.3 of the Insolvency Rules 1986 provides that claims arising under an order made in family proceedings – other than an obligation to pay a lump sum or to pay costs – are not provable debts in a bankruptcy.

The Haines bankruptcy presents a stark example of the potential injustice to creditors that arises as a consequence of a property adjustment order made in ancillary relief proceedings. The district judge ordered that the matrimonial home be transferred to Wendy Haines, together with a car. He acknowledged that these two assets appeared to constitute all of David Haines’ wealth, although he voiced his dissatisfaction with David Haines’ financial disclosure.

The district judge made his decision in the knowledge that David Haines claimed to have substantial liabilities and would be insolvent if such an order was made. He made allowance for this in adjourning Wendy Haines’ claims for a lump sum payment, taking into account the possibility that the property adjustment order would be challenged by a trustee in bankruptcy if David Haines was subsequently declared bankrupt.

The district judge dealing with the claim brought by the trustees in bankruptcy to claw back David Haines’ former interest in the matrimonial home, dismissed it. The trustees successfully appealed. His Honour Judge Pelling QC held that Re Abbot (1983) was not binding because that judgment concerned the effect of Section 42(1) of the Bankruptcy Act 1914.

In a judgment handed down on 5 December 2007, the Court of Appeal unanimously reversed the decision, reaffirming the previous position that, although not constituting a cause of action that was transmissible, a spouse’s right to apply for ancillary relief was a valuable one and that the value of the wife’s right to apply for ancillary relief is commensurate with what the wife is actually awarded by the Family Court, such that its satisfaction is likely always to be for full value.

In reaching his decision, Lord Justice Thorpe referred to the fact that Section 25 of the Matrimonial Causes Act 1973 required the district judge to give first consideration to any children of the marriage and therefore “the district judge made the almost inevitable order, namely that the home should be sold and that the entire proceeds should go to rehouse the wife and child”.

However, in Re Citro (1991), a case dealing with Section 336 of the act, Lord Justice Nourse considered a sale of the family home to pay the creditors to be one of the “melancholy consequences of debt and improvidence”. The attitudes of Thorpe LJ and Nourse LJ, in balancing the interests of creditors, are inconsistent.

The trustees have filed a petition seeking leave to appeal the decision of the Court of Appeal.

The judgment of Judge Pelling also raised significant concerns in the family law community. The case was reported as establishing the principle that a property transfer made as part of a divorce settlement, whether by consent or after a contested final hearing, could be set aside for up to five years after the order was made by the trustee in bankruptcy if one party to the divorce subsequently became bankrupt.

That summary was too simplistic, but was widely reported as meaning that thousands of such settlements were at risk of being set aside where, following the end of the marriage, one party bankrupted themself.

Assuming the decision is not overturned in the House of Lords, it provides comfort for divorce lawyers, but much less comfort for insolvency practitioners and the creditors they seek to protect, who may well be prejudiced by the transfer of the one asset of any value away from the potential bankrupt.

However, while the Family Court will normally take into account the debts and liabilities of both parties in any order made, it does not then have to provide that those debts are repaid. The unsecured creditor, therefore, without bankruptcy proceedings in place, has little protection from the Family Court.

The conclusions for the family practitioner are that:#a property transfer made at the end of a contested hearing is unlikely to be set aside if one party subsequently becomes bankrupt; and#if an order is reached by consent, then provided there is no issue as to ‘collusion’, which remains undefined in statute, the order is likely to stand.

Gareth Schofield and Martin Askew are partners at Clarke Willmott