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29 Jun 2012

How Relevant is a Rule Created in 1728 to a 21st Century Bankruptcy?

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5 min

Section 110 of the Bankruptcy Act states:

1. In the case of joint debtors, whether partners or not, the joint estate shall be applied in the first instance in payment of their joint debts, and the separate estate of each joint debtor shall be applied in the first instance in the payment of his or her separate debts.

2. If there is a surplus in the case of any of the separate estates, it should be dealt with as part of the joint estate and if there is a surplus in the case of the joint estate, it should be dealt with as part of the respective separate estates in proportion to the right and interest of each joint debtor in the joint estate.

It appears that the origin of the rule that joint creditors should be paid out of the joint estate, and separate creditors should be paid out of the separate estates dates from 1728, and the policy promulgated by Lord King in Ex parte Cook. Presumably the policy was predicated on the basis that joint assets have arisen out of credit provided by joint creditors, and assets that are solely owned by individual debtors had arisen by virtue of some perceived contribution by the individual creditors, and that consequently the rule would provide a more equitable outcome than would otherwise be the case.

Although on first flush the rule seems sensible and equitable, we believe that in practice it has had its day and should be repealed. We justify our position on two grounds.

Firstly, it may have been the position in 1728 that there was a nexus between separate assets and separate creditors on the one hand and a nexus between sole assets and sole creditors on the other, but such a nexus very rarely exists today. Our experience is that the acquisition of both classes of assets (sole and joint) can, and probably will, be financed from whatever class of credit is most readily available or possibly from a mixture of classes.

Secondly the timing of bankruptcies can distort the whole picture. Consider a joint estate in the following position. The husband has one separate liability, a loan from his mother of $120,000. The joint estate of the husband and wife comprise partnership debts of $350,000 in respect to a failed retail shop. The wife has one liability being a loan from a friend of $50,000. The only asset is $100,000 equity in the joint matrimonial home.

Interestingly the application of section 110 can result in different outcomes. If the husband and wife become bankrupt at the same time, their interest in the matrimonial home will be treated as a joint asset and used in the first instance to discharge joint liabilities. That is, the $100,000 of assets will be distributed to the joint creditors (being the partnership liabilities of $350,000) so that a dividend of 28 cents in the dollar is payable to the joint creditors. The sole creditors (the mother and the friend) are treated as “second class creditors” and get no dividend. Is this really equitable? If the monies borrowed from the mother and the friend had been invested by the bankrupts into the partnership business (as could well be the case) the section makes no allowance for that. Again is this equitable? Surely not!

Consider the position if the husband and wife don’t become bankrupt at the same time. Suppose the husband becomes bankrupt first and the wife waits a week before she becomes bankrupt. By virtue of operation of law, the joint tenancy in the matrimonial home is severed on the bankruptcy of the husband. That is it is no longer a joint asset. The respective equities are now held as tenants in common. And just because of the different bankruptcy dates the whole picture changes.

Because the bankruptcies occurred on separate dates we no longer have any joint property.
Each separate bankrupt estate gets the proceeds from the sale of the (now) separate assets. This is past on as dividends of $50,000 to each of the mother and the friend. Now it is the joint creditors who are “the second class creditors” and who miss out entirely. Again, this surely is not equitable. To take it one step further, what if the equity in the house had been financed by excess drawings from the partnership; does the section address this position? No it doesn’t.

Apart from the lack of nexus mentioned above and the distortion potentially caused by differing bankruptcy dates it seems to us that the section could be manipulated by debtors to obtain outcomes favourable to related parties. Further, the application of the section also appears to be contrary to the usual rule in insolvency of pari passu distribution of bankrupt’s assets.

It’s not a major element, but as an aside we mention that I.T.S.A closely monitors (as it must) that bankruptcy trustees strictly comply with the requirements of S110. All of this takes time and cost which arguably add nothing to equity in bankruptcy or a better return to creditor.

Time for change? We think so.

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