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Bankruptcy, Divorce and Marital Settlement Agreements (Mejia v. Reed)

In Mejia v. Reed, 31 Cal. 4th 657 (2003), the California Supreme Court held that: 1) transfers of real property under a Marital Settlement Agreement (“MSA”) may be fraudulent transfers under the Uniform Fraudulent Transfer Act (“UFTA”); 2) for purposes of determining insolvency, the value of future child support should not be considered; and 3) unearned income is not an asset for purposes of the UFTA unless it is subject to levy by a creditor.

Facts and Procedure:

Danilo Reed (Husband) had an extramarital relationship with Plaintiff Rhina Mejia that led to the birth of a child. In the subsequent divorce proceeding between Husband and Violeta Reed (Wife), a marital settlement agreement (“MSA”) was entered into, pursuant to which Husband transferred all his interests in jointly held real property to Wife and Wife conveyed all her interest in Husband’s medical practice to him. The MSA also provided that Husband would be solely responsible for his extramarital child support obligation. Within less than 2 years, Husband abandoned his medical practice, moved in with his mother and had no assets and little income.

Plaintiff Rhina Mejia then instituted this proceeding, asserting that the MSA was a fraudulent transfer under the UFTA. Plaintiff claimed that that the MSA was a fraudulent transfer by Husband to Wife with intent to hinder Plaintiff in her collection of future child support. Husband moved for summary judgment for failure by Plaintiff to provide evidence of intent to defraud on the part of Husband. Additionally, Husband claimed that the value of his medical practice at the date of separation was reasonably equivalent to the real property interests he conveyed to Wife. Plaintiff argued that the fair market value of the Husband’s medical practice was less than the present discounted value of Husband’s future child support, and thus Husband was insolvent at the time of the transfer rendering the MSA subject to the fraudulent transfer laws under the UFTA for making a transfer for less than reasonably equivalent value at a time when the debtor was insovent.

The trial court ruled that the UFTA applied to the MSA but granted Husband’s summary judgment motion on the grounds that no evidence was presented of actual intent to defraud and that the transfer did not render Husband insolvent. The Court of Appeal reversed, agreeing that the UFTA applied to MSAs and that the existence of triable issues of fact precluded summary judgment.

Analysis:

The trial court granted Husband’s motion for summary judgment and the court of appeal reversed. The California Supreme Court had to harmonize family law and fraudulent transfer statutes in this case in order to determine whether MSAs were generally subject to fraudulent transfer laws and how to value future income and future child support obligations with respect to defining insolvency for constructive fraud.

The UFTA is a series of statutes that provide remedies for creditors against transfers that would impede their ability to collect on their claims in certain circumstances. Under the UFTA, there are two main types of fraudulent transfers. First, an actual fraudulent transfer is a transfer made with actual intent to hinder, delay, or defraud any creditor of the debtor. Cal. Civ. Code §3439.04(a). This actual intent is often proven using “badges of fraud”, which are statutorily enumerated bad actions by the debtor from which an intent to defraud his or her creditors can be inferred. Second, a constructive fraudulent transfer is where the debtor did not receive a reasonably equivalent value in exchange for the transfer and either 1) the debtor was insolvent at the time of the transfer, or 2) the debtor became insolvent as a result of the transfer. Cal. Civ. Code §3439.05.

Under Family Code §916 (formerly Civil Code 5120.160), upon the dissolution of a marriage, any property received by a married person in the division is not liable for a debt incurred by the person’s spouse before or during marriage, and the person is not personally liable for the debt, unless the debt was assigned for payment by the person in the division of the property. Under Family Code §2550, “the court shall divide the community estate of the parties equally.” Absent an exception, a court’s “equal division” would constitute reasonably equivalent value, and thus not be considered constructively fraudulent. However, the Court in Mejia v. Reed used the preface of §2550, which states “[e]xcept upon the written agreement of the parties, or on oral stipulation of the parties in open court,” clarifying the exception to the general rule. In other words, if parties enter into a MSA, California law does not require that they divide marital property equally and courts do not scrutinize MSAs to ensure that they set out an equal division. Thus, MSAs are not per se equal distributions. Accordingly, MSAs are not disqualified from being considered a constructive fraudulent transfer.

In Mejia, the California Supreme Court rejected arguments on both sides regarding canons of statutory interpretation and legislative history due to the fact that the arguments made were based on the absence of legislative intent and action. Transfers before and after dissolution can be set aside as fraudulent conveyances per the Family Code and UFTA statutes; however the issue was whether the MSA itself can be considered a fraudulent transfer. Therefore, the Court viewed the two sets of statutes in light of the policy of protecting creditors, namely that it was unlikely that the Legislature “intended to grant married couples a one-time-only opportunity to defraud creditors by including the otherwise fraudulent transfer in an MSA” by failing to address this issue within the two statutory codes. Thus the court held that the UFTA applies to property transfers under MSAs.

The California Supreme Court found no triable issues of fact on the question of insolvency because support payments present a special type of claim under the UFTA: First, support payments are based on actual earnings (rather than liquidation of preexisting assets) and; Second, child support payments can be changed (in some cases retroactively) if there is a change in actual earnings or earning capacity. Thus, future child support obligations, according to the Court, should not be considered a “debt” under the UFTA. The Court explained that income not yet earned is not an asset under the UFTA unless it is subject to levy by a creditor, and it would be unfair to consider future child support payments should as a debt while the earning capacity from which they will probably be paid is not considered an asset (which would lead to the absurd result of unfairly tipping the scales in favor of finding insolvency in every case dealing with child support payments).

The Court remanded the case, finding that there were no triable issues of fact remaining as to constructive fraud (even though the transfer may have been for less than reasonably equivalent value), because the Husband was not insolvent at the time of the transfer nor did the transfer render him insolvent. Triable issues remained as to actual fraud.

Author’s Note:

The main takeaway for purposes of family law and bankruptcy law attorneys is that Marital Settlement Agreements can be fraudulent transfers under the UFTA. The likely path to avoid such findings is the costly and adversarial process of a divorce trial as opposed to a written or oral agreement by both Husband and Wife. Can a divorce trial be undertaken with intent to defraud, hinder or delay creditors? Can a creditor argue that the debtor went through a divorce trial with the intent to defraud creditors as opposed to the dissolution of the marriage? However, be aware that the creditor could argue that the entire divorce trial was a sham if the sole reason for divorce is for asset protection purposes and thus a fraud on the court and the creditors. Absent the divorce trial being a fraud on the court, it would be difficult to argue actual fraud in a divorce trial context. How can a creditor claim that a transfer was made for less than reasonably equivalent value when the family law judge is under a duty to divide property equally? It would be difficult for a creditor to argue that a transfer of marital assets in a divorce trial was constructively fraudulent unless there was a conspiracy to defraud the divorce court and judge. Finally, there could potentially be res judicata and collateral estoppel arguments to be made by a debtor who participated in a divorce trial which could bar a creditor from arguing that those transfers are constructively fraudulent in a bankruptcy court context.

Subsequent Case Law:

In Litke O’Farrell, LLC v. Tipton 204 Cal.App.4th 1178 (2012), the court held that the Family Code empowers a husband and wife to alter their property rights by a marital property agreement at any time without respect to court approval, and such an agreement is binding upon agreement. Thus court approval in a dissolution proceeding is not a prerequisite to the enforcement of an MSA in an independent action unless the agreement requires such approval. Once the MSA is agreed to and signed it becomes an enforceable contract that effects a division of community property and thus could be considered a fraudulent transfer.