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September 14, 2016

The Doctrine of Exoneration and how it can Salvage More than a Draw


This is arguably the most common scenario faced by a Bankruptcy Trustee upon an appointment:

  • Husband and wife are the owners of a real property (usually the family home) as joint tenants;
  • There is a mortgage and there is some equity available after accounting for this mortgage; and
  • The husband has fallen on hard times and has either voluntarily filed for bankruptcy or his estate has been sequestrated by the courts (following a successful petition by a creditor).

The concept of “Joint Tenancy” (as distinct from Tenants in Common (“TIC”)) is a form of co-ownership common amongst (but not limited to) married couples. This is because that amongst other attributes, the principal of “survivorship” applies.

The bankruptcy of one spouse absent from the bankruptcy of the other spouse automatically severs the Joint Tenancy to property. This will see the trustee (who steps into the shoes of the bankrupt) and non-bankrupt spouse hold the subject property as TIC in equal shares (50/50). The 50% share held by the trustee is ordinarily available for the bankrupt estate (assuming there is equity in the property).

For all intents and purposes, this may be the end of the game, a 1-all draw. However, there are equitable and common law remedies and procedures that can alter the interests of the parties to a Joint Tenancy. One generally misunderstood and relatively underutilised mechanism for altering the implied 50/50 split is the application of the Doctrine of Exoneration (“DOE”).

 

What is the Doctrine of Exoneration?

Developing on our earlier example, suppose the bankrupt and non-bankrupt spouse’s property is valued at $1,000,000. The mortgage to the bank at the date of bankruptcy is $750,000. There is principally, $250,000 (ignoring costs of sale, etc.) in equity to be split 50/50 ($125,000 each) between the parties.

If this were the end of the matter, the bankrupt’s $125,000 would go to their estate and be available for their creditors. But what if upon drilling down further as to the make-up of the mortgage, we identify the following:

  • The $750,000 mortgage debt is made up of 2 separate / cross collateralised borrowings:
    1. 1st mortgage directly attributable to the original purchase of the property ($250,000);
    2. 2nd mortgage securing a (subsequent) working capital loan to a company to which the bankrupt is the sole director and shareholder ($500,000).

In its simplest form and application to a marriage, the equitable principals of the DOE dictate that any borrowings against jointly held property of the marriage and applied for the use of one party (say the bankrupt) to the marriage without benefit to the other (non-bankrupt spouse), should be satisfied from the benefiting party’s (bankrupt’s) share of the relevant property first.

In our example, the successful application of the DOE has a significant benefit to the non-bankrupt spouse, taking her share of the equity from $125,000 to $250,000, as depicted below:

Total Non Bankrupt Spouse’s Interest – DOE Applies Bankrupt’s Interest – DOE Applies
House Property (Value) 1,000,000 500,000 500,000
Less:
1st Mortgage (250,000) (125,000) (125,000)
2nd Mortgage (500,000) Nil (500,000)
Gross Equity 250,000 375,000 (125,000)
Less:
2nd Mortgage – Call on Surety (to cover Bankrupt’s Shortfall) Adjustment to Split (125,000) No Capacity
Net Share of Equity 250,000 250,000 Nil

*Bankrupt & non-bankrupt spouse entitled to 50% each of property value (i.e. $1,000,000 / 2 = $500,000). Bankrupt & non-bankrupt spouse’s share is reduced by $125,000 on account of the 1st mortgage which they both have an interest in ($500,000 – $125,000 = $375,000). As the non-bankrupt spouse has no interest in the 2nd mortgage (did not receive the benefit of the funds), the entire 2nd mortgage is then deducted from the bankrupt’s share first (i.e. $375,000 – $500,000 loan). This reduces the bankrupt’s interest to nil and leaves the non-bankrupt spouse liable for the shortfall of $125,000 on the 2nd mortgage (as surety).

 

Why is the Doctrine of Exoneration not applied correctly?

Relatively straightforward right? So why is it so misunderstood or invariably not applied / disallowed? The answer commonly lies with the role of the family adviser. Either advisers are not aware or do not understand the DOE concept and/or its non-application is a product of the asset protection structures established by advisers for their clients. As common as it is for married couples to hold their property interests as Joint Tenants, so too is the following income earning, household financing and asset protection structure of the household:

  1. Family (Trustee) Company – which operates the family business (husband is the sole director and shareholder – wife may be a shareholder if there is no underlying trust);
  2. That Company is Trustee of a Family (Discretionary) Trust (husband and wife both nominated as primary Beneficiaries); and
  3. It is from that financial structure that the majority, if not all, of the family’s cash flow (income) is generated – including what finances the payment of the household mortgage.

Whilst DOE claims are examined on a holistic basis, passive shareholding and/or rights (fixed or discretionary) to participate (past, present or future) as a beneficiary of any trust as well as the absence of alternative sources of finance to fund family expenditure, may inadvertently prohibit the application of the DOE for want of a conclusive lack of distinguishable benefit to one party.  For many bankrupts and their non-bankrupt spouses, there is commonly an absence of any actual profit being earned by the company/trust capable of being distributed to the passive shareholders and beneficiaries  and this makes a prohibitive DOE determination even harder to absorb.

Bankruptcy is commonly brought about by the failure of the family business and the subsequent exposure to personal guarantees or liability for company taxation debts. In many instances, the business relies upon the use of equity in the family home to bank roll its operations. The DOE can provide an effective means of achieving an equitable accounting of the residual financial interests in the family home and other property where the property is used to secure financing for the benefit of some but not all of the legal owners, including in a bankruptcy scenario.

SV Partners has a team of personal insolvency experts who have a comprehensive understanding of the theoretical and practical application of the DOE. If you feel the concept may apply to you or your client’s financial circumstances, feel free to seek out our assistance today on 1800 246 801.

Article written by Fabian Micheletto, Director, Melbourne

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