Divorce and Bankruptcy: Time for the Government to Change the Rules

Posted in Personal Bankruptcy
Posted by J. Douglas Hoyes, CA, CPA, LIT, CIRP, CBV

divroce-and-bankruptcy-time-for-changeUsually on the Hoyes Michalos Blog we discuss technical matters, like taxes and student loans. Occasionally, however, we “kick it up a notch” and take a more aggressive position, arguing against injustices we see in the bankruptcy system.

I wrote a post back in September, 2009 on a Small Victory in the Fight for Fairness in Bankruptcy Rules, where I described a “dirty little trick” the government had pulled, forcing people who declare bankruptcy to disclose their educational background. I found it offensive that the government was forcing people to admit that they dropped out of high school, or admit that they had a university education but still experienced financial problems. I didn’t see the need to disclose any more information than necessary, and after writing letters and making phone calls, the government changed the rules.

I’m not saying my letters changed the rules. There were certainly lots of others who also made their opinions known, and together we changed the rules.

Another example of our efforts to bring fairness to the bankruptcy system occurred on February 7, 2008, when Ted Michalos and I became the only independent trustees to testify for a full hour before the Senate Standing Committee on Banking, Trade and Commerce in Ottawa. Here’s a brief clip of my comments on student loans and bankruptcy in Canada.

In February 2008 I traveled to Ottawa to make the argument that forcing former students to wait ten years before being able to discharge their student loans in a bankruptcy was too long. I argued for a two year rule, and later that year the rule was changed to a seven year student loan rule, with a five year limit in cases of hardship.

Again, the rule wasn’t changed just because Ted Michalos and Doug Hoyes traveled to Ottawa, but I like to think that our voice was one of the many voices that helped change the rules.

So here we are again, faced with another bankruptcy rule that requires changing.

On July 14, 2011 the Supreme Court of Canada, released its decision in the case of Schreyer v. Schreyer, and they confirmed the principle that equalization payments after separation or divorce disappear in bankruptcy in Canada. Here are the facts: Mr. and Mrs. Schreyer divorced in 1999, and as is standard procedure, their assets were to be divided amongst them. Mr. Schreyer was to make an equalization payment to Mrs. Schreyer of about $41,000, for her share of the value of the family farm.

Before he made the payment, due to his other debts, he filed bankruptcy. As a result Mrs. Schreyer became a creditor in Mr. Schreyer’s bankruptcy, and as is the case with most debts, the amount he owed her was discharged in the bankruptcy.

Because the Schreyer’s live in Manitoba where family farms are exempt from seizure, Mr. Schreyer got to keep the family farm, even though he was bankrupt.

(Please note that if you declare bankruptcy in Ontario real estate is not exempt, so in Ontario if the bankrupt owned a farm worth $80,000, the trustee may sell the farm and distribute the proceeds to the creditors. If this had happened in Ontario, Mr. Schreyer would have lost the farm when he went bankrupt, or he would have been required to pay into his estate the value of the farm).

In summary, Mr. Schreyer went bankrupt and got to keep the family farm, and his wife, who would have received $40,000 if he hadn’t declared bankruptcy got nothing.

Are the Bankruptcy Rules Fair?

You could argue that the purpose of bankruptcy is to eliminate your debts, which is exactly what happened in this case, so on that basis yes, this rule is fair.

However, you could also argue that in a separation if the spouses should divide their assets equally, that’s exactly what should happen. Obviously that didn’t happen in this case.

As I stated earlier this case couldn’t happen here in Ontario, because the husband would lose the farm. However, it could happen with other exempt assets, such as an RRSP. Consider this scenario:

Mrs. Smith has a good job, and she contributes to her RRSP every month. Mr. Smith stays home with the children. They separate, and the only asset they have is Mrs. Smith’s RRSP. Under normal family law rules, Mr. Smith should receive half of the value of the RRSP.

If Mrs. Smith’s RRSP was worth $100,000, Mr. Smith would normally be entitled to an equalization payment of $50,000. However, if Mrs. Smith declared bankruptcy in Ontario before making the equalization payment, Mr. Smith would get nothing. Under bankruptcy law Mrs. Smith gets to keep her RRSP if she goes bankrupt, except for any contributions she made in the last year. That potentially means that Mrs. Smith gets to keep most or all of her $100,000 RRSP, and Mr. Smith gets nothing.

Most would argue that that’s not fair.

In fact, the Bankruptcy & Insolvency Act does give special treatment for child support, in section 178 (1) (c), which states that the following debt or obligation is not discharged in a bankruptcy:

any debt or liability arising under a judicial decision establishing affiliation or respecting support or maintenance, or under an agreement for maintenance and support of a spouse, former spouse, former common-law partner or child living apart from the bankrupt;

In other words, if you go bankrupt, you are still required to pay child and spousal support.

Clearly Canadian bankruptcy law is not fair. Spousal support and child support doesn’t go away if you go bankrupt, but equalization payments do.

So what should be done? Parliament should close the loophole. It would be a relatively simple change. In fact, all they would need to do is add a few words to the end of section 178 (1) (c) to make court ordered equalization payments non-dischargeable.

Will that happen? Probably, since that’s exactly what the Supreme Court said should happen. We will see.

And yes, I’ll probably write a letter or two……..