Watch Out For The Ripple Effects of Bankruptcy

No man, and the rare bankruptcy debtor, is an island.  He or she comes with financial connections to family, former spouses, and partners of various sorts.

The challenge for bankruptcy counsel is to identify those interconnected others and to  advise the debtor of the consequences of the filing on those he cares about.

Real estate

The trustee’s power to sell co owned property found in §363(h) can produce the most dramatic event.  The trustee can sell, not just the debtor’s interest, but the entire asset.  The co owner shares the sales expenses and gets his share of the net proceeds.

A joint owner who is not a debtor may have to choose whether to be cashed out or to exercise the statutory right of first refusal. §363(i)  The sale may trigger tax consequences to the co owner which range from inconvenient to catastrophic.  When property values are down, and refinance money scarce, the bankruptcy filing can upset more lives than just the debtor’s.

Closely held business

When a debtor’s business interests have genuine value, the non debtor shareholder may find himself facing the liquidation of the corporation or meeting a new business associate in the form of the buyer of the debtor’s shares from the bankruptcy estate.  Even the well crafted buy sell agreements between the business partners outside of bankruptcy are generally held to be unenforceable in bankruptcy.

Former spouses

A Chapter 13 filing will discharge any non support obligations to an ex spouse.  That may leave the ex exposed to joint obligations left over from the marriage with the right to indemnification bargained for in the marital property division eliminated.

Insider preferences

While the client seldom cares about commercial creditors who received recoverable preferences, it’s far different when the trustee’s recovery target is the debtor’s parents who made the debtor a loan.  The one year look back, and the $600 threshhold for recovery, give the trustee’s avoiding powers real scope to wreak havoc in the client’s family.

Role of debtor’s counsel

The first imperative for counsel is to identify these ripple effects of a bankruptcy filing.  Let the client know who may be affected and in what ways.  The available palliatives include

  1. Notify the party exposed by the filing.
  2. Wait out timelines before filing.
  3. Unwind troublesome transactions.
  4. Sell the jointly owned interest before filing.
  5. File Chapter 13 if possible.

While your duty of loyalty lies with the client, if your focus is so narrow that you don’t alert the client to the unexpected impacts, you risk a dissatisfied client whose connections with others have been damaged.

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  • Peter Bricks

    Great Article Cathy. I would add “inheritances” to the ripple effects. The debtor needs to make the attorney aware of any possible inheritances before filing, or else the testator or any co-beneficiary of the decedent’s estate might wind up with some harmful unintended consequences when the debtor receives an inheritance during a bk case.

  • Garth

    debtors in 7s with non-corporate form businesses should be prepared with proof of insurance and a quickly filed motion to compel abandonment or the trustee could shut their business down pending abandonment of the business.

  • Anonymous

    Both very true.   I’m particularly sensitive to the sole proprietor problem, but that is a situation where the effects don’t go beyond the debtor.  My rule for a business of any significance is that the debtor either incorporate pre filing or file 13.  Otherwise the expense and the uncertainty of the trustee’s reaction to an operating business is a headache I want to avoid.