The effect of bankruptcy on debts

 

Bankruptcy releases the bankrupt person from most of their debts and prevents creditors from seeking further payment of those debts from the bankrupt person.

After bankruptcy a bankrupt is released from most “provable” debts. A bankrupt is not released from any “non-provable” debts.

Provable debts

The term “provable” means that a creditor can lodge a proof of debt or a claim to be paid, and then be paid a proportion of the money (if any) raised by the sale of the bankrupt’s property. Most debts for which the bankrupt was liable at the date of bankruptcy are provable in bankruptcy.

Provable debts that are not wiped by bankruptcy

Some provable debts are not wiped by bankruptcy (s 153). Provable debts that are not wiped by bankruptcy are debts:

incurred by fraud;

under a maintenance agreement order; or

in relation to a bond or to certain other criminal law penalties.

Non-provable debts

The main categories of debts that are non-provable (and so not wiped by bankruptcy) are:

debts incurred after the date of bankruptcy;

court fines;

HELP debts under the Higher Education Support Act 2003 (Cth); and

unliquidated damages (an amount claimed by a creditor for damages that has not yet been fixed by formal agreement or by the court).

Secured debts

The trustee’s rights to a secured property are subject to the rights of the secured creditor. A secured creditor keeps its interest in any secured goods or land (property) by way of its security even after bankruptcy.

The secured creditor’s right to sell the security property

A secured creditor can only force a sale of the property if the debtor is in breach of the contract.

Under section 302 of the Bankruptcy Act, any provision in a mortgage, bill of sale, mortgage lien or charge that provides that a borrower might be in breach of a secured credit contract merely by entering into bankruptcy is void. Therefore, a creditor who has a mortgage etc. cannot take action against a debtor simply because the debtor bankrupts.

The trustee’s right to sell the security property

The trustee can sell a security property whether or not the bankrupt has defaulted in payments. The trustee can sell a property if there is sufficient equity to make it commercially practicable. If sold, the proceeds of sale pay the secured creditor and the balance goes to the bankrupt estate.

Security over furniture and other household goods

Some fringe lenders have taken mortgages over people’s essential household goods to secure payment of debts. The threat to repossess goods is then used to force payment of the debt even after bankruptcy. For credit contracts entered into on or after 1 July 2010, these types of mortgages are void under the National Credit Code (s 50). For credit contracts entered into before 1 July 2010, or for other types of contracts, this type of mortgage could breach laws relating to unfair contract terms or unconscionable conduct.

Seek advice from an organisation such as the Consumer Action Law Centre (tel: 1800 466 477) or Consumer Affairs Victoria (tel: 1300 558 181) if this is happening to you or your clients.

Mortgages over houses and land

The trustee has no power to prevent the sale of a house by the mortgagee if the bankrupt is in default under the mortgage. If the bankrupt is not in default, the mortgagee will not be able to take action against the debtor. In this case, the bankrupt might be able to stay in the house and continue making payments, but the property will vest with the trustee and could be sold years later. (SeeHouses and land”.)

Guaranteed debts

The bankrupt as guarantor

A debtor who has guaranteed someone else’s debt will be released from any liability under the guarantee after bankruptcy. Such a debt should be included on the bankrupt’s statement of affairs as a debt.

The bankrupt’s friend or relative as guarantor

A bankrupt will be released from debts that have been guaranteed by someone else. However, the guarantor will not be released from the debt. The guarantor, or the person guaranteeing the bankrupt’s debt, is usually a friend or relative. Once the bankrupt stops paying the debt, the creditor usually takes action against the friend or relative under the guarantee. Therefore, many bankrupts want to continue paying such debts. The Bankruptcy Act does not prevent the bankrupt from doing this.

Although a mortgage cannot include a term providing that if the debtor becomes bankrupt the mortgage is breached (s 302), this provision does not apply to guarantees. Therefore, a creditor might be able to say that a guarantee has been breached due to the bankruptcy of the primary debtor and so claim payment from the guarantor. This will depend on the terms of each guarantee.

Debts to friends or relatives

Debts owed to friends and relatives usually result from a verbal not written contract. These debts should be shown on the statement of affairs as unsecured debts, regardless of whether or not the contract is in writing. A bankrupt can, if they wish, continue to pay such debts after the date of bankruptcy.

Unliquidated damages

Unliquidated damages debts are not wiped by bankruptcy (ss 82, 153). This is a technical area of law. However, it is an issue that affects many consumer debtors, especially debtors who have car accident debts.

Damages are “unliquidated” if a court has not assessed them or if the parties involved have not agreed on the amount of damages. The most common example of unliquidated damages for consumer debtors is a claim for property damage as a result of a car accident.

Under section 82(2), “demands in the nature of unliquidated damages” are not provable in bankruptcy unless they arise out of a breach of contract or breach of trust. A discharged bankrupt is only released from debts that are provable in the bankruptcy (s 153) and therefore will not be released from debts arising from unliquidated damages.

If a debtor has a property damage debt and legal action for the debt appears unlikely in the short term, the debtor should consider whether:

1 it is worth bankrupting on this debt – if this is the only debt it may not be worth bankrupting;

2 they are able to wait until the other party gets a court judgment against them; or

3 they can replace the claim for unliquidated damages with a claim under a contract or a deed by settling the claim.

Replacing a claim for unliquidated damages with a claim under a deed or contract

A settlement of a damages claim in a deed, or via an exchange of letters, can liquidate a damages claim. If the exchange of letters forms a contract the creditor will then have a claim in contract. If the settlement is in a deed, the creditor will have a claim under the deed. As a claim under a contract or a deed is provable in bankruptcy, the bankrupt should then be released from the claim by the bankruptcy.


WARNING

Debtors should be aware that a creditor could always challenge this type of settlement and, if such a challenge were successful, the debt would then become unprovable and so not extinguished by the bankruptcy.


The debtor must prove that the liquidation occurred at least the day before the hearing of the creditor’s petition or a few days before the presentation of a debtor’s petition. The debt will not be included in the bankruptcy if the liquidation occurs after the date of the bankruptcy.

Maintenance/child support

Maintenance debts under a maintenance agreement or order, and child support debts, are provable in bankruptcy. However, a bankrupt is not released from maintenance debts or child support debts on discharge unless the court orders otherwise (s 153(2)(c)).

Taxation

Tax debts that arise before the date of the bankruptcy

Tax debts for the period before the date of bankruptcy are provable and extinguished after bankruptcy whether or not they have been assessed by the Australian Taxation Office (ATO).

If tax has not been assessed at the time of bankruptcy

If the ATO has not issued and served a notice of assessment at the time of the bankruptcy, a tax liability is a contingent liability and is provable under section 82.

If a debtor becomes bankrupt before the end of a financial year, the Taxation Commissioner can issue a tax assessment for the year to date. Once the bankrupt gets this separate assessment they should only be liable for any tax amounts that arise after the bankruptcy.

If the ATO refuses to issue a separate assessment for the year to the date of the bankruptcy, the bankrupt can consider appealing this decision (see Deputy Commissioner of Taxation v Jones [1999] FCA 308 (29 March 1999)).

Tax debts that arise after the date of the bankruptcy

Debts arising from tax periods after the date of bankruptcy are not provable.

Tax refunds

The ATO’s rights to take refunds

The ATO can take refunds during the period of the bankruptcy if the bankrupt has a tax debt from before the bankruptcy. If a bankrupt is entitled to a refund, the ATO can offset the refund due during the period of the bankruptcy against tax debts, including those provable tax debts incurred prior to bankruptcy.

In general under the Bankruptcy Act, a creditor is not entitled to take any action in respect of a provable debt once a bankruptcy has commenced (s 58(3)). However, the Federal Court in Taylor v Commissioner of Taxation [1987] FCA 166 decided that the offset provisions of the Income Tax Assessment Act 1936 (Cth) (“ITAA 1936”) override section 58(3).

The trustee’s right to take refunds

The trustee can take a refund if it relates to a year prior to the bankruptcy. If the refund relates to a year after the date of the bankruptcy, it is treated as income and the trustee takes the amount into account when calculating income contribution.

Centrelink debts

Except in limited circumstances, Centrelink debts are wiped by bankruptcy. However, this is a complicated area of law and debtors should seek advice from the Social Security Rights Victoria or another solicitor experienced in social security law and bankruptcy (for contact details, see Legal services that can help). Financial counsellors also have extensive experience in dealing with Centrelink debts and bankruptcy (for a list of services, see Financial counselling services).

Generally, the following applies:

As soon as Centrelink receives notification of a client’s bankruptcy from AFSA, it should stop all debt recovery action on the client’s Centrelink debts (including withholding action).

Centrelink should stop all debt recovery action for the period of the bankruptcy; it should also refund any payments/withholdings that it has deducted after the date of bankruptcy and before discharge.

Non-fraudulent Centrelink debts are generally extinguished by bankruptcy.

Fraudulent Centrelink debts are not extinguished by bankruptcy. Centrelink will recommence withholdings for fraudulent debts when the debtor is discharged from bankruptcy.

(See Secretary, Department of Social Security v Southcott [1998] FCA 323.)

Centrelink overpayments

Centrelink debts are not wiped by bankruptcy if the debt occurred as a result of a consumer’s fraudulent behaviour. Centrelink can make incorrect decisions as to what constitutes fraudulent behaviour. As a result, many discharged bankrupts might be repaying Centrelink debts that should have been wiped by the bankruptcy. Dobson; Department of Family & Community Services [2000] AATA 41 indicates that not all overpayment debts are fraudulent.

If a debtor is bankrupting (or has bankrupted) and has a Centrelink debt, they should get advice on:

1 whether there are circumstances to support an application that the debt was not fraudulently incurred;

2 the review processes within Centrelink and the Social Securities Appeals Tribunal in relation to challenging a Centrelink decision to pursue the debt after bankruptcy; and

3 if the debtor has already been discharged from bankruptcy, whether they can apply for a refund of any payments made to Centrelink or taken by Centrelink.

Fines

Section 82 of the Bankruptcy Act states that, with the exception of proceeds of crime orders, penalties or fines imposed by a court in respect of an offence against a law, are not provable in bankruptcy. In Victoria v Mansfield [2003] FCAFC 154 (18 July 2003), the full Federal Court held that parking fines issued by a local council were not provable in bankruptcy. However, the application of the Bankruptcy Act to fines is a complex area of law and legal advice should be sought where a person is considering bankrupting on a fine, as the particular circumstances surrounding the imposition of a fine may impact upon whether or not that fine is extinguished upon discharge from bankruptcy.

Debts resulting from fraud

A debt incurred by fraud, or fraudulent breach of trust, can be provable in bankruptcy, but generally is not extinguished on discharge from bankruptcy (s 153(2)).

Note that there is some case law holding that if a civil judgment has been made in relation to the debt, this might extinguish the debt (Power v Kenny [1977] WAR 87).

After bankruptcy a debtor can apply under section 60(1) to stay an action by the creditor in relation to a fraudulent debt. Such an application, if successful, would have the same effect as extinguishing the debt.

Debts arising from restitution or compensation orders

There are various types of restitution or compensation orders (e.g. ss 74, 77, 84, 85B Sentencing Act 1991 (Vic); and sections on pecuniary penalty orders in the Proceeds of Crime Act 2002 (Cth)).

Non-provable orders

Section 82(3A) of the Bankruptcy Act provides that an “amount payable under an order made under a proceeds of crime law is not provable in bankruptcy”.

Provable orders

The Bankruptcy Act does not categorise other types of restitution orders as being either provable or not provable. In the past it was argued that a restitution order was not provable; however, the court decided in Re Lenske; Ex parte Lenske [1986] FCA 21 that a debt payable under a restitution order is a provable debt. (Note that the debt in Re Lenske was not wiped by the bankruptcy even though it was held to be provable, rather the debtor applied to the court to stay enforcement of the orders insofar as they required payment of restitution.)

Deciding whether to cease payment under the order

Before deciding that bankruptcy means that you can cease payment under a restitution order, first get a copy of the order to decide what type of restitution order has been made. Check that:

it is not an order made under proceeds of crime legislation; and

the debtor will not face a criminal penalty or other adverse consequence for failure to pay;

the debtor does not need to apply for a stay of restitution.

Other adverse consequences of non-payment

Even if the order is not one made under proceeds of crime legislation, check to see if the order has any adverse consequences on non-payment. For example, the order might include a condition that breach of the order results in imprisonment; if so, this condition may apply regardless of whether the debtor has bankrupted.

However, note that under section 60(1) of the Bankruptcy Act, the court may exercise discretion to stay any legal process against the debtor, including imprisonment for non-payment of a restitution or compensation order. For examples of cases where the courts have exercised this discretion, see Storey v Lane [1981] 147 CLR 549; Re Lenske; Ex parte Lenske [1986] 9 FCR 532; and Moore-McQuillan v Scott [2006] FCA 63.

Restitution/compensation orders and fraud

If the restitution order has been made in relation to a fraud, the debt arising under the order might be provable but might not be extinguished after bankruptcy (seeDebts resulting from fraud”).

Joint debts

Where a debt is in joint names and one debtor is bankrupt, the non-bankrupt debtor, in almost all cases, continues to be liable for the whole of the debt. (See alsoGuaranteed debts”.)

Rent

Rent debts are wiped in bankruptcy. However, this does not prevent the landlord from evicting a tenant for non-payment of rent.

Office of Housing rent debts

A bankrupt who rents from the Office of Housing may continue their tenancy effectively without disruption, subject to approval of the Office of Housing. Therefore, before bankrupting, a debtor should discuss their circumstances with the Office of Housing to confirm what arrangements can be made.

If the Office of Housing issues a notice to vacate, the tenant should seek advice from the Tenants Union of Victoria (tel: 9416 2577).

Utilities and telecommunications

The practices of different companies vary. The law is that bills relating to the period up to the date of bankruptcy are wiped by the bankruptcy, but the bankrupt will still owe bills relating to the use of these services after the date of bankruptcy. After the bankruptcy, utility and telco companies sometimes open a new account, and require payment of a security deposit, or restrict the service in some way. For example, Telstra may disconnect its service and then reconnect it with a bar on STD calls.

HELP debts (previously HECS)

On 1 January 2005, the Higher Education Loan Program (HELP) came into effect, incorporating the Higher Education Contribution Scheme (HECS), with changes. On 1 June 2006, existing accumulated HECS debts converted to new accumulated HELP debts. HELP debts that arise under the Higher Education Support Act 2003 (Cth), are not provable in bankruptcy (s 82(3AB) Bankruptcy Act). Accordingly, they may be recovered during and after bankruptcy.

For more information regarding the conversion of HECS debts to HELP debts and its effect on bankruptcy, contact AFSA on 1300 364 785 or the ATO’s personal tax information line on 13 28 61.