‘Cause Tonight / Is the Night / When 2 Become 1

-The Spice Girls

According to UrbanDictionary.com, the word “separated” is described as “[t]he purgatory between marriage and divorce.”  This also holds true in the bankruptcy process.  The Eighth Circuit recently held in Boellner v. Dowden that a separated couple must substantively consolidate their bankruptcy estates, based on the facts and circumstances surrounding their separation.  The court was ultimately concerned that the couple was trying to “double dip” their exemptions to the disadvantage of their creditors. 

Facts

The debtors, a married and separated couple, filed separate chapter 7 petitions in the Bankruptcy Court for the Eastern District of Arkansas.  At the time of filing, the debtors shared a checking account, several credit cards, a leased car, and were jointly and severally liable for a judgment in a civil case.  They did, however, maintain separate homes—the wife’s home was unencumbered, while the husband’s home was in the process of being surrendered to a mortgage holder. The couple also maintained separate insurance policies, annuities, and credit card debt.

In a chapter 7 case, a debtor is entitled to a certain amount of exemptions, which allow the debtor to withhold specific items from a bankruptcy estate as a matter of law.  A debtor must choose between the federal exemptions—embodied in section 522(d) of the Bankruptcy Code—and the state law exemptions where the debtor is domiciled, which can vary greatly.  A strategic debtor will generally try to choose the exemptions that will protect the debtor’s most prized assets.  A debtor cannot have two bites at the apple and must choose to insulate assets under either federal or state law.

Here, the schedules for each debtor revealed that the husband had claimed his annuities as exempt under section 522(d), while the wife exempted her unencumbered home under Arkansas state law.  The chapter 7 trustee argued that the two debtors’ assets, liabilities, and handling of financial affairs were substantially indistinguishable, and allowing them to maintain separate bankruptcy estates would prejudice their creditors as they would be able to “stack” both federal and state law exemptions and withhold a greater number of assets from their estates.  If the debtors’ estates were substantively consolidated, however, the debtors would be forced to choose one exemption scheme, and creditors would be able to collect from a shared pool of non-exempt assets.

The bankruptcy court ordered substantive consolidation of the debtors’ estates after considering the following factors: (1) whether the debtors were interrelated; (2) whether the benefit of consolidation outweighed the harm to creditors; and (3) whether any prejudice would result from allowing the debtors to maintain separate bankruptcy estates.  The district court affirmed the bankruptcy court’s order and denied the debtors’ motion for reconsideration.  On appeal, the Eighth Circuit analyzed whether the bankruptcy court abused its discretion in ordering substantive consolidation.

Analysis

In deciding whether to affirm the lower courts’ decisions, the circuit court relied on the case of In re Reider, in which the Eleventh Circuit, in assessing whether to order substantive consolidation between spouses, held that the court must analyze whether a “substantial identity” exists between debtor spouses and, ultimately, must be persuaded that creditors will suffer greater prejudice in the absence of consolidation than the debtors will suffer from its imposition.

The court held that the bankruptcy court properly analyzed the evidence, which included the debtors’ statements of financial affairs and schedules.  In particular, the court found it peculiar that one debtor claimed to own the couple’s home, while the other spouse claimed ownership of the household goods.  Further, in addition to the joint assets and liabilities discussed above, the court noted that the debtors’ separate statements of financial affairs indicated that they had jointly withdrawn funds from IRA accounts.  The court found that this evidence was sufficient to establish a substantial identity between the debtors.

Finally, the court found that if the debtors’ estates were not substantively consolidated, creditors would receive no distribution or significantly less distribution than they would in a joint case.  In particular, the court noted that if the debtors were allowed to exempt their home and annuities under different exemptions, their separate estates would have significantly less value than if they were combined and forced to choose either the federal or state exemptions, significantly harming their creditors.  The court therefore held that the bankruptcy court did not abuse its discretion in ordering substantive consolidation of the estates.

Conclusion

Although this decision applies to individual debtors, the concept of substantive consolidation affects corporations as well.  Determining whether a “substantial identity” exists between two individuals, particularly two individuals who ostensibly are no longer living together, certainly raises different questions than those typically asked in the corporate context.  What would “piercing the individual veil” mean?  Is there a concept of “individual separateness” that should be respected?  We also could muse on the different philosophical views of the “individual” – empiricism, Hegelian, existentialism, Buddhism, and objectivism (among others) – and how those might be applied to bankruptcy law.  We will leave that intellectual exercise, however, to the philosopher kings (and queens) among us.