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Divorcing a bankrupt: where insolvency law meets ancillary relief

Henry Clayton of 4 Paper Buildings summarises the law on the interface between bankruptcy and ancillary relief in the light of the decision of Jackson J in Mekarska v Ruiz

Henry Clayton, barrister, 4 Paper Buildings

Henry Clayton, barrister,4 Paper Buildings

It is now crucial, if you are acting for a client whose financial claim might be prejudiced by a bankruptcy order against the other party, not to wait to deal with it. Any application to annul the bankruptcy should be made sooner rather than later in a court with bankruptcy jurisdiction to ensure that the facts of Mekarska v Ruiz & Boyden [2011] EWHC 913 (Fam) are not repeated. Practitioners are urged to read the case summary also available on Family Law Week. This article will deal in more general terms with the applicable principles where one party is bankrupt at the time financial remedy proceedings are heard.

How does bankruptcy work?
A petition may be issued by either the debtor himself (Insolvency Act 1986 s.272) or creditors who are owed more than £750 as a result of the debtor's failure to comply with a court order or statutory demand (s.267). Once the order is made, the bankrupt's assets (subject to certain exceptions in s.283, including for domestic or personal items necessary for the bankrupt's business) vest initially in the official receiver until the appointment of a trustee in bankruptcy (usually an accountant) who will then administer the estate so as to satisfy the claims of the bankrupt's creditors who have so-called provable debts as best as he is able until such time as the bankruptcy order is discharged (s.305-306). Following discharge the bankrupt is no longer liable for the balance of the debts (s.281). The trustee's professional costs (including any disbursements for legal representation) are paid out of the bankrupt's estate.

What financial remedies (ancillary relief) can be ordered against a bankrupt?
Property adjustment orders cannot be made save for a residue of sale proceeds following discharge of the bankruptcy (see Ram v Ram (No.2) [2004] EWCA Civ 1684 [2005] 2 FLR 75).

Lump sums can only be ordered in respect of residue of the estate once the bankruptcy is discharged provided the judge has a clear picture of what the assets will be in the future (Hellyer v Hellyer [1996] 2 FLR 579 (CA)) or where the lump sum is to be paid from income (Re G (Children Act 1989 Schedule 1) [1996] 2 FLR 171).

Pensions rights do not vest in the trustee, therefore they will normally be available as the subject of pension sharing or attachment orders (Welfare Reform and Pensions Act 1999 s.11-12).

Periodical payments can be ordered against a bankrupt, although during the currency of the bankruptcy the assessment of quantum is not binding on the bankruptcy court, which can make an income payments order which will override the periodical payments order. The income payments order must provide for the reasonable domestic needs of the bankrupt and his family. It can last until up to three years after the discharge of the bankruptcy (Insolvency Act 1986 s.310).

It should be noted that subsequent discharge from bankruptcy does not release the bankrupt from a debt arising from an order in family proceedings or a CSA maintenance calculation (Insolvency Act 1986 s.281(5)).

When will a court typically set aside a bankruptcy order in the context of ancillary relief / financial remedy proceedings?
Section.282(1) of the Insolvency Act 1986 reads:

The court may annul a bankruptcy order if it at any time appears to the court –

(a) that, on any grounds existing at the time the order was made, the order ought not to have been made, or

(b) that, to the extent required by the rules, the bankruptcy debts and the expenses of the bankruptcy have all, since the making of the order, been either paid or secured for to the satisfaction of the court.

For practical purposes, family practitioners are likely to be concerned only with ground (a). It is important to note that the word 'may' in s.282(1) confers a discretion on the court whether to annul or not. 

To summarise the principles set out in the relevant case law, in deciding whether to annul a bankruptcy order, the court is likely to consider the following:

(a) Should the bankruptcy order have been made in the first place? (if the answer is 'yes' then that is the end of the matter);

(b) If not, should the court exercise its discretion not to annul, taking into account the following non-exhaustive factors:

(i)  Whether the bankruptcy was tactical or an abuse of process;
(ii)  Delay in making the application;
(iii)  Likely effect of the annulment on the applicant and the bankrupt (who are unlikely to be the same person in a family law context);
(iv)  Whether the debtor will be able to meet his liabilities;
(v)  What provision is made for the trustee in bankruptcy's costs.

(a)  Should the bankruptcy order have been made?
The first question is whether the order should have been made in the first place. The relevant ground for a bankruptcy order under s.272(1) of the Insolvency Act is that the debtor is unable to pay his debts. Some clarification was provided by Lord Justice Wilson (as he then was) in Paulin v Paulin [2009] EWCA Civ 221 [2009] 2 FLR 354 at [41]. Wilson LJ explained that the relevant test is not balance sheet insolvency (whether the bankrupt's liabilities outweighed his debts) but rather commercial insolvency (whether he could meet his liabilities as they fell due). Wilson LJ went on to quote David Oliver QC sitting as a deputy High Court judge in Re Coney (A Bankrupt) [1998] BPIR 333 at 335-336:

"Inability to pay one's debts, at least in the context of insolvency, has historically long been construed as an inability to pay one's debts at the time they are due… it would not normally be right to annul a bankruptcy order unless at least it is shown that as at the date of the order the debtor was in fact able to pay his debts, or had some tangible and immediate prospect of being so able…"

Wilson LJ suggested that the burden of proof lies with the person seeking the annulment unless the bankrupt's assets outweighed his liabilities at the date of the bankruptcy.

In Mekarska v Ruiz, although the value of the former matrimonial home vastly eclipsed the husband's debts, the judge found that there was no tangible and immediate  prospect of him being able to pay off those debts. His Lordship suggested that an immediate annulment application coupled with an acknowledgment that the former matrimonial home had to be sold rapidly might have altered this conclusion, but as things were there were no grounds upon which the court could  annul (at [82]).

(b) Discretion whether to annul
Even if it is found that the bankruptcy order should not have been made, the court still retains a discretion not to annul. In Paulin, Wilson LJ sought guidance from the words of Mr Justice Walker in Artman v Artman [1996] BPIR 511:

"The statutes does not lay down any particular matters to be taken into account in the exercise of the court's discretion, but the likely effect of any annulment order on the applicant, on the bankrupt where he is not the applicant, and on the bankrupt's other creditors must, it seems to me, be among the most important matters to be taken into account. So must any element of abuse of process in the obtaining …of the bankruptcy order."

Other bankruptcy authorities suggest that a critical factor is whether the debtor would be able to meet his liabilities if the bankruptcy was annulled (e.g. Owo-Sampson v Barclays Bank & Boyden [2003] EWCA Civ 714 [2003] BPIR 1373 per Carnwath LJ at [35]).

One of the key questions is whether the bankruptcy was tactical. In Paulin v Paulin, a bankruptcy order which affected ancillary relief proceedings was annulled. In that case, the husband manufactured a debt in order to procure his own bankruptcy with the intention of defeating his wife's claims. By contrast, in Mekarska v Ruiz the judge found that the bankruptcy was not tactical but rather motivated by the husband's belated wish to put his affairs in order (at [82]).

Peter Jackson J held that, even if the initial hurdle in s.272(1)(a) had been crossed, he would not have exercised his discretion to annul. This was partly because the wife's resistance to the sale of the home caused 'a scale of expense that was beyond the normal powers of foresight', partly because the creditors would not be paid if there was an annulment, and partly because there was no basis on which to deprive the trustee of his costs and therefore any residue would be insufficient to re-house the wife and child in any case (see [84]).

Delay was also clearly an important factor. The wife's solicitors had threatened to apply to annul several months before the final hearing in the ancillary relief case. As it happened, the annulment application was not made until 18 months after the final hearing.

Trustees' costs
One of the most damaging effects of a bankruptcy order is that the trustee in bankruptcy's costs are deducted from the bankrupt's estate before any residue can be paid out to a spouse claiming a financial remedy. In Mekarska v Ruiz this caused the entire 'pot' to be wiped out (the costs were so high because the wife had resisted the sale of the matrimonial home which caused further litigation).

If the bankruptcy order is annulled it will normally be conditional upon the trustee's costs being paid from the estate.

Even where the person applying for the annulment has been wrongly affected by the order, any delay in making the application may result in the trustee's costs coming from the estate (e.g. LB Redbridge v Mustafa [2010] EWHC 1105 (Ch) [2010] BPIR 893, in which there was an 18-month delay). Moreover, the fact that the bankrupt spouse wrongfully obtained a bankruptcy order does not mean that the trustee should be denied his costs (Thornhill v Atherton [2004] EWCA 1858 [2005] BPIR 437). What is required is that the bankruptcy was an abuse of process and the trustee himself acted improperly (see Ella v Ella [2008] EWHC 3258 (Ch) [2009] BPIR 441 for an example of an annulment without provision for the trustee's costs).

Practitioners should note that there is a means by which a person in the wife's position in Mekarska v Ruiz  may challenge the scale of the trustee's costs (see [92A] of the judgment, which refers to Practice Statement: the Fixing and Approval of the Remuneration of Appointees (2004) [BCC] 912).

Sale of the matrimonial home
Practitioners have to be mindful that the existence of a bankruptcy order may mean that the former matrimonial home is sold at a lower price, which effectively further diminishes the 'pot' available for division, already having been reduced by its liability for the trustee's costs. The court's considerations when facing an application to enforce a sale of the matrimonial home are different if there is a bankruptcy order in place. After one year, the interests of the creditors will outweigh all other considerations, unless the circumstances are truly exceptional (Insolvency Act 1986 s.336(5)).

In Mekarska v Ruiz what caused the trustee's costs to grow exponentially until they eclipsed the entire value of the estate was litigation between the wife and the trustee as to the sale price of the former matrimonial home. The difference in their valuations was £20,000. By contesting the sale at the lower price, the wife effectively wiped out her entire award. However, had there been no bankruptcy the wife's prospects of delaying a sale until she obtained the price she wanted would have been significantly better.

It is hoped that the above serves as a useful introduction where practitioners have to advise on cases involving these issues. Of course, it does not deal with the situation whereby a party becomes bankrupt shortly after the making of a final financial relief order (and the question of whether that order can stand). That is a separate topic for a future article.