It is probably unwise to embark on a divorce when bankruptcy is in the air. Legal experts from Stevens & Bolton take a look at the issues.

Family lawyers are uniquely placed to get under the skin of a family’s finances. Often this reveals how easy it is for debt to be masqueraded as wealth, with 100 per cent-plus mortgages, debts and cars on hire purchase creating the impression of high living. The recession has brought families’ financial management into sharper focus, with the stress of debt bringing already unhappy marriages to the brink.

It is unsurprising that the number of bankruptcies has increased during the recession as jobs are lost and the over-extended fall behind with payments. But is it wise to embark on a divorce when the threat of bankruptcy is in the air?

When a bankruptcy order is made, all of the bankrupt’s assets automatically pass to a trustee in bankruptcy. If there is an ongoing divorce, the trustee has to “join in” the financial aspect, and the non-bankrupt spouse has to deal with the trustee as well as their spouse. Thus getting divorced whilst bankrupt is a three-way affair, and all the more expensive for it. 

Trustees have wide-ranging, retrospective powers. To claw back assets to the bankrupt estate for the benefit of creditors, they can reverse transfers of property that have occurred up to five years before the bankruptcy order, in some cases even where such transfers have been made within divorce proceedings. They have three years from the bankruptcy to start that exercise.

Once a bankruptcy order is made, the family court finds its powers fettered. It can only deal with a spouse’s claims in relation to income, and not capital. Consequently the court cannot order a payment of a lump sum or re-distribute the interests in a property. To a mother, whose main concern is to save the family home, those restrictions are key. The non-bankrupt spouse will find themselves haggling with the trustee to assert and retain their claim to the family home and other capital assets. 

The trustee’s approach will be clinical, putting the interests of the bankrupt’s creditors ahead of the family, particularly the children, who are the focus for the family court in such situations.

If there is a threat of bankruptcy, timing is critical. If the family court can deal with the finances and conclude the proceedings with a final order before a bankruptcy petition is presented, the non-bankrupt spouse should be safe in retaining what they have been awarded if the other spouse is later made bankrupt. In most family cases, such final orders embody the agreements of the parties (consent orders). 

This accepted position was recently threatened by a surprise decision where the bankruptcy court ruled that final orders did not prevent a trustee reversing transfers of property to a wife, because that wife had not given consideration for that transfer, i.e. she had not paid anything in return. That decision was later overturned when the Court of Appeal ruled that by compromising and giving up her potential financial claims against the husband was consideration, because she was giving up something of potential value.

Divorce and financial proceedings should therefore not be delayed in such circumstances so as to ensure that a final order is made before a bankruptcy petition can be presented. Separating married couples (or civil partners) should also bear in mind that it is only a court order that will afford some measure of protection. A Separation Agreement will not afford any protection in the event of a bankruptcy that occurs within the following five years. 

Having a common “enemy” can be a uniting factor for a warring couple, bringing them together to act in their combined self-interest. Therefore, where an order is made by consent, a trustee will scrutinise the terms of the order, and the circumstances in which it was made, for signs of collusion or fraud between the parties to keep assets out of the hands of creditors. If they find those signs, they can still challenge a final order, but only in those limited circumstances. 

There is a flip side to that situation. Some spouses who feel that they won’t achieve their desired outcome, threaten to make themselves bankrupt to pressurise their spouses to settle on more favourable terms.  

Such threats should be made and carried out with extreme caution. The non-bankrupt spouse can apply for the bankruptcy order to be annulled if it is simply a device to thwart claims on divorce. Such an application will result in the bankruptcy proceedings being transferred to the court dealing with the divorce so that same Judge can hear both matters together.

If the bankrupt spouse is found to have been substantially dishonest about their affairs and in fact holds assets exceeding their liabilities, the court is more than likely to annul the bankruptcy petition. The family court is also very likely to penalise such action by making that spouse contribute towards the legal costs of their spouse.