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No Notice: How Unnotified Creditors Can Violate a Discharge Injunction

Here is the scenario: You are a creditor.  You hold clear evidence of a debt that is not disputed by the borrower, an individual.  That evidence of debt could be in the form of a note, credit agreement or simply an invoice.  You originated the debt, or perhaps instead it was transferred to you — it does not matter for this scenario.  At some point the borrower fails to pay on the debt when due.  For whatever reason, months or even years pass before you initiate collection efforts.

Finally, you seek to collect on the unpaid debt. Those collection efforts include letters and phone calls, and maybe even personal contact, all of which are ignored.  Then you employ an investigator and an attorney.  You eventually obtain a default judgment from a state court, which the borrower (unsurprisingly) refuses to pay.  You then garnish the borrower’s wages to pay the debt.  You collect a few payments before the borrower informs you that the debt was discharged in bankruptcy.  Wait . . . how could that be?  You never received notice of the bankruptcy, you didn’t have an opportunity to file a proof of claim, until now you never saw the discharge order.  Indeed, you come to find out that the borrower never listed you on his bankruptcy schedules and you never received notice that there was a bankruptcy.

The way the borrower informs you of the bankruptcy is even more disturbing. The borrower serves a Motion for Sanctions that he filed in the bankruptcy court.  He is asking the bankruptcy court to set aside your state court judgment, for the return of his garnished wages, for emotional distress damages, and for a whole bunch of attorney’s fees that he incurred to reopen the case and file the Motion for Sanctions.[i]

You say to yourself, “No way!” Surely, the bankruptcy court cannot punish you for a case you knew nothing about.  After all, isn’t it the Debtor’s burden to list all of his creditors.  There was no way that your debt was discharged.  Think again, you could be in trouble!

Here’s why. Due to the complicated interaction of multiple sections of the bankruptcy code and the way in which courts have interpreted that interaction in no-asset Chapter 7 Bankruptcy cases, your debt was discharged and your collection efforts were in violation of the discharge injunction despite the fact that you lacked knowledge of the bankruptcy.  In a Chapter 7 case, § 727(b) discharges a debtor “from all debts that arose before the date of the order for relief” except as provided in § 523.  Section 524, also known as the discharge injunction, applies to any “debt discharged under section 727” and operates as an injunction against the commencement or continuation of an action, or an act, to collect, recover or offset any personal liability of a debtor.  Generally speaking, Debtors receive a discharge under § 727(a), and the scope of that discharge is set forth by § 727(b).  Pursuant to § 727(b), a prepetition debt is discharged as a matter of law, unless it is nondischargeable under § 523.

Ahah-your debt must fall under § 523, or so you think. After all, § 523(a)(3)(A) states “A discharge under section 727 . . . does not discharge an individual debtor from any debt neither listed nor scheduled under section 521(a)(1) of this title, with the name, if known to the debtor, of the creditor to whom such debt is owed, in time to permit . . . timely filing of a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing.”  You never had notice, did not to get to file that proof of claim, and you knew nothing about the case until that sanctions motion arrived on your doorstep.  Sure you are protected by § 523, right?

Not so fast. Section 523 does not apply to all Chapter 7 cases.  It is “well accepted that the failure to give notice to a creditor will be disregarded in a Chapter 7 no asset case and that in such cases failure to schedule a prepetition debt will not preclude the discharge of that debt.”[ii] When a debtor’s case is administered as a no-asset case with no set claims bar date and, therefore, has no cut off for the “timely filing of a proof of claim,” an unlisted creditor is not deprived the opportunity to file a timely proof of claim.[iii]  Because the time to file a proof of claim never passes, it matters not that the debtor failed to list a creditor in the first place.  Nor does it matter why the debt was not listed.  The 10th Circuit, for example, says that “equitable considerations,” such as the Debtors’ reasons for failing to schedule the debt or the creditor, “do not impact the dischargeability” of the prepetition debt under § 523(a)(3)(A).[iv]

All this bouncing around the Bankruptcy Code takes us back to § 524 for an explanation of why no notice is actually required. Section 524(a)(2) of the Bankruptcy Code, which creates the discharge injunction, is unambiguous and makes no distinction between debts which are discharged following notice to a creditor and those that are discharged despite a lack of notice. Section 524 provides:

(1)        discharge in a case under this title–

(2)        operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived[v]

Thus, a lack of knowledge of the discharge does not provide a defense for a creditor who attempts to collect in violation of the discharge injunction.

All is not lost. Despite the mandate of § 524, not all bankruptcy courts (which are still courts of equity) have divorced themselves from equitable principals. The court in In re Wilcox refused to sanction an unlisted creditor for violation of the discharge injunction despite the creditor’s prosecution of a state-court collections case. The Wilcox Court stated that it:

cannot blame the Creditors for their confusion which, after all, proceeds in large measure from the Debtor’s incomplete disclosure in Schedule F and the mailing matrix. Under the circumstances, and up to this point in time, their filing and prosecution of the [state court] lawsuit is not contemptuous. If, however, they continue to pursue their claims against the Debtor without also seeking a declaration . . . that their claims are excepted from discharge under § 523(a)(3), they run the risk of violating the Discharge, especially now that they have a better understanding of their rights.[vi]

The ultimate lesson to be learned is that creditors need to exercise the utmost caution in their pursuit of borrowers, especially if there is reason to believe that borrower filed bankruptcy. A search of public bankruptcy filings before collection efforts are begun, may be the ounce of prevention that is worth a pound of cure.  If the borrower produces a bankruptcy discharge, a creditor should retain counsel to review the case and determine whether § 523 applies to the case.  Lack of notice is not enough to prevent liability.

[i]  The scenario is based on the recent case out of the District of Utah, In re Slater, No. 09-21947, 2017 WL 2656119, at *1 (Bankr. D. Utah June 20, 2017), where the Court concluded that creditor “should be placed in civil contempt for violation of the discharge injunction of 11 U.S.C. § 524. The Default Judgment in the State Action is void pursuant to § 524(a).”  The court also found the creditor liable to Debtors for actual damages for all wages garnished, as well as costs and reasonable attorney fees incurred by the Debtors in bringing the motion to enforce the discharge order. Other cases in other jurisdictions have come to similar conclusion based on similar rational, although facts and the creditors level of knowledge of the bankruptcy tend to vary slightly. Cf. In re Greenberg, 526 B.R. 101 (Bankr. E.D.N.Y. 2015) and In re Haemmerle, 529 B.R. 17, 20 (Bankr. E.D.N.Y. 2015).

[ii]   In re Delafied 246 Corp., No. 05-13634ALG, 2007 WL 2332527, at *2 (Bankr. S.D.N.Y. Aug. 14, 2007)); In re Herzig, 238 B.R. 5 (E.D.N.Y.1998).

[iii] It should be noted that there is currently a Circuit split on the issue of whether an unlisted debt in a no-asset bankruptcy is automatically discharged by operation of law. The Third, Sixth, Ninth, and Tenth Circuits follow the “mechanical approach” and hold that any such debt is discharged by operation of law; therefore, there is no need to reopen the case and determine dischargeability regardless of the debtor’s reason for failing to list the debt. See In re Parker, 264 B.R. 685, 694 (10th Cir. 2001); In re Madaj, 149 F.3d 467, 471 (6th Cir. 1998); In re Judd, 78 F.3d 110, 115 (3d Cir. 1996); In re Beezley, 994 F.2d 1433 (9th Cir. 1993); see also In re Cruz, 254 B.R. 801, 807 (Bankr. S.D.N.Y. 2000) (summarizing cases).  In contrast, the First, Fifth, Seventh, and Eleventh Circuits have held that motions to reopen a no-asset Chapter 7 case should be granted to amend the list of creditors—thus subjecting the unlisted creditor to the bankruptcy discharge—unless the omission was the result of fraud or intention. See Colonial Surety Co. v. Weizman, 564 F.3d 526 (1st Cir. 2009); In re Faden, 96 F.3d 792, 797 (5th Cir. 1996); In re Baitcher, 781 F.2d 1529, 1534 (11th Cir. 1986); In re Stark, 717 F.2d 322 (7th Cir. 1983).  In these jurisdictions, the Debtor’s basis for failing to list the Debt could be scrutinized as part of the process to reopen the case.  While this doesn’t mean that the debt will not be discharged, it adds a level of scrutiny to the debtor’s failure to list the debt in the first place and provides a creditor additional notice of the bankruptcy.

[iv] In re Parker, 313 F.3d 1267, 1268 (10th Cir. 2002).

[v] See 11 U.S.C. § 524(a)(2). See Green v. Welsh, 956 F.2d 30, 32 (2d Cir.1992).

[vi] In re Wilcox, 529 B.R. 231, 238 (Bankr. W.D. Mich. 2015); see also In re Johnson, 521 B.R. 912, 916 (Bankr. W.D. Ark. 2014)(finding that the debtor failed to notify the creditor. Therefore the creditor was under no obligation to return the money it had collected from the debtor’s state tax return and the debtor’s motion for contempt was denied.)

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Ruined, Missing Wine leads to Million Dollar Hangover for Debtor

Old wine bottles in a wooden crate.

A Chapter 7 debtor’s failure to comply with a bankruptcy court order to preserve a $2 million dollar-plus collection of fine wines has led to the imposition of sanctions of over $1 million, most of which could be charged against the debtor’s otherwise exempt property.

The wine in question, after three years of litigation, was determined to be part of the bankruptcy estate of Jeffrey Prosser.  Prosser used to own companies that provided telephone, internet and cable television service to the U.S. Virgin Islands.  Both he and his companies filed bankruptcy in 2006.  A recent, 66-page opinion from the U.S. District Court in the Virgin Islands sets forth this saga of the wine collection in great detail; if you are taken to oenophilia, be ready to despair.  See In re Jeffery L. Prosser, Bankruptcy Case 2006-3009, Civil Action 3:2013-0087 (February 23, 2017, Doc. No. 58).

In its opinion, the district court largely upheld orders by the U.S. Bankruptcy Court of the Virgin Islands holding both Prosser and his wife, Dawn, in contempt for allowing the dissipation and destruction of the wine collection, but reversed an order of the bankruptcy court that would have empowered the trustee to sell real property held by the Prossers to satisfy a $528,086 monetary sanction that would reimburse the trustee for his expenses in prosecuting the contempt action.  The property in question, held by the Prossers as tenants by the entireties (the “TBE Property”), had previously been adjudicated as exempt under 11 U.S.C. § 522(b)(3)(B).

The district court held that a sanction intended to reimburse the estate for attorney’s fees and expenses constituted an administrative expense and was barred by 11 U.S.C. § 522(k).  However, the district court refrained from ruling on whether exempt property could be ordered sold to satisfy a separate contempt sanction in the amount of $419,136, which was the lost value of the wine collection.  Further briefing was ordered.


The Prossers’ wine collection was initially appraised at $2.1 – $2.3 million; Dawn Prosser claimed that that she owned at least a 50-percent interest in the wine.  In December 2008, the bankruptcy court approved a stipulation under which one-half of the wine collection would be turned over to the trustee for sale and the other half retained in Dawn Prosser’s possession until her interest in the wine was adjudicated.

The bulk of the wine was stored (climate controlled, of course, or so everyone thought!) the Prossers’s homes Florida and the U.S. Virgin Islands. The wine had been inventoried in January 2008.  Since December 2007, the Prossers (along with their children) had been subject to a preliminary injunction that required them to “safeguard certain property that the trustee contended was part of the bankruptcy estate in secure locations and to protect the property from destruction, damage, theft, removal or transfer pending its turnover to the trustees.”  The Prossers were further forbidden to “spend, consume, damage, dispose of, sequester, abscond with, secrete or transfer the property” without written consent of the trustees.  The stipulation that allowed Dawn Prosser to retain possession of half the wine collection specifically stated that the preliminary injunction continued in force.

In February 2011, three years since the wine was inventoried, the bankruptcy court determined Dawn Prosser had no interest in the wine and so her half of the collection was to be turned over to the Chapter 7 trustee.  One month later, the wine stored in Palm Beach was inspected, and four months after that, the wine at the Virgin Islands residence was inspected.  What was found was not good; if any of you have ever taken a vacation with the kids left in charge of the house, and then checked the liquor cabinet upon your return, then you know what is coming next.

At the Palm Beach residence, only 459 of the 939 bottles inventoried in 2008 were still in storage. At the U.S. Virgin Islands residence, only 527 bottles remained of the original 980.  Furthermore, at the U.S. Virgin Islands residence, the air conditioners were no longer operating and the room had been given over to storage of “miscellaneous household junk.”  Mold and insect damage was noted.  Most of the labels were damaged and of six bottles sampled, none remained in a condition suitable for sale (although we at The Bankruptcy Cave will drink anything, so we are trying to obtain a bottle).  The expert who inspected the wine opined that “the entire collection has been destroyed by careless or willfully negligent storage.” The wine stored at the U.S. Virgin Islands residence was eventually sold “as is, where is” for just $15,739. Total loss of value to the wine collection was $419,136.

In August 2011, the trustee filed a “Motion to Enforce Turnover Order, for Contempt and for Sanctions” against both Jeffrey and Dawn Prosser. The motion sought, among other things, a finding of contempt, sanctions in the form of all legal fees and expenses associated with the trustee’s investigation and liquidation of the wine, and an order permitting the trustee to collect the value of the missing and damaged wine.  In a series of orders in 2013, the bankruptcy court ordered the Prossers to pay the estate $528,086 to reimburse it for legal fees and costs associated with obtaining turnover of the wine collection and the related contempt proceedings (“Fee Sanction”) and $419,136 for the diminished value of the wine (“Loss of Value Sanction”).

When the Prossers failed to pay, the bankruptcy court once against found them in contempt and entered an order requiring the Prossers to pay the Fee Sanction by way of 60 monthly payments of $8,801. If they failed to make the required payments, the Prossers were further ordered to convey title to the TBE Property to the trustee.  The Prossers never made a single monthly payment and then refused to convey the TBE Property to the trustee.

Upon the trustee’s motion, the bankruptcy court next entered an order pursuant to Rule 70 of the Federal Rules of Civil Procedure (the “Rule 70 Order”) directing the trustee to execute quit claim deeds and any other documents required to transfer the TBE Property to the bankruptcy estate. The property, which had been valued at approximately $2.2 million, was to be sold and the proceeds first applied to the Fee Sanction, with any surplus then applied to the Loss of Value Sanction.

The Prossers appealed everything. The district court upheld the decisions of the bankruptcy court, except for the Rule 70 Order, which was partially reversed, with further briefing ordered on a single issue.  Among the district court’s holdings:

  • The Prossers’ argument that the bankruptcy court lacked subject matter jurisdiction to impose the injunction was untimely and should have been filed when the order commanding turnover of the wine (and making the preliminary injunction permanent) was entered in 2011.  Consequently, subject matter jurisdiction had been established as the law of the case.
  • The bankruptcy court did not err as a matter of law nor abuse its discretion in finding the Prossers in civil contempt for violating the injunction regarding the preservation of assets.
  • That the imposition of sanctions against the Prossers was not barred due to the trustee’s failure to insure the wine (which the Prossers had maintained was not property of the estate).
  • The bankruptcy court’s rejection of a Daubert challenge to the trustee’s wine expert was affirmed. The expert, Mary Ewing-Mulligan, is the author of “Wine for Dummies.” The district court also noted that one argument made by the Prossers, that the expert was not qualified because she had not previously been qualified to provide expert testimony, if accepted would create a world without experts, as every expert witness has to have a first time.
  • The bankruptcy court did not err in denying the Prossers’s motion that the ruined wine be abandoned as an asset of the estate, noting that it would set an unfortunate precedent if a debtor was allowed to destroy a valuable estate asset in violation of a court order and then seek to compel the trustee to abandon the ruined asset.
  • That the as-is, where-is auction of the damaged wine was not commercially unreasonable, an argument the Prossers supported in part by claiming the trustee’s prosecution of the contempt proceeding created bad publicity that disparaged the wines throughout the Virgin Islands.

In all, the district court rejected 12 of 13 arguments made by the Prossers.  However, by reversing (at least in part) the bankruptcy court’s Rule 70 Order, the district court has so far preserved the exemption of the TBE Property.  The district court rejected two arguments for affirming the Rule 70 Order made by the trustee.

First, the trustee took the position that the TBE Property was no longer exempt property because by obtaining sanctions against the Prossers, he had become a creditor of both the husband and wife. Under Virgin Island law, property held as tenants by the entireties is not exempt from process as to creditors of both spouses. The district court held that the bankruptcy estate was created upon the filing of the case and, at that time, the TBE Property was exempt and remained so despite the Prossers having incurred a joint, post-petition debt to the estate.

Having determined that the TBE Property remained exempt, the district court next considered whether the bankruptcy court’s sanction authority under 11 U.S.C. § 105(a) allowed, after a finding of contempt, exempt property to be sold to reimburse the trustee for administrative expenses incurred in the contempt litigation and reimburse the bankruptcy estate for the lost value of the wine.

At least with regard to the administrative expenses that were to be reimbursed under the Fee Order, the district court held that the bankruptcy court lacked authority to order the sale of the TBE Property, relying on a 2014 U.S. Supreme Court decision in Law v. Siegal, 134 S. Ct. 1188 1188.  In Law, the Supreme Court reversed a decision that allowed a trustee to surcharge a debtor’s homestead exemption to recover fees and expenses incurred in overcoming a lien the debtor had fraudulently created in an effort to preserve equity in his home beyond the statutory exemption.

The Supreme Court held that the powers created under 11 U.S.C. § 105(a) did not include the power to override an explicit mandate in another section of the Bankruptcy Code. The Supreme Court held that the prohibition contained in 11 U.S.C. § 522(k), which provides that exempt property “is not liable for payment of any administrative expense,” precluded the surcharge. The district court held the Law case to be applicable here; the Fee Sanction constituted an administrative expense and therefore exceeded the authority provided under 11 U.S.C. § 105(a).

Finally, the district court stated that the effect of Law upon the Loss of Value Sanction, which called for the Prossers to reimburse the estate for losses caused by their contemptuous actions, was less clear.  Noting that Law was issued after briefing on the Prosser appeal had been concluded and that neither party subsequently brought the case to the district court’s attention, the parties were ordered to provide additional briefing on the issue.  Pursuant to a schedule established by the district court, the additional briefing should be concluded by April 6, 2017.

Certainly, this is a sad tale, a complete loss of value and waste of money, and the Prossers come out of this tale with red grape stains running down their formal wear.  By the same token, we are surprised that the trustee did not insure the wine collections, or follow up on their storage.  The case is a helpful reminder to all of the need to really pay attention to collateral or other assets that are so easily moved, spoiled, or drank and celebrated.


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Over Four Hundred Years of Law on Fraudulent Transfers, Flushed Down the Drain

In 1571, Parliament enacted a law, sometimes known as the Statute of 13 Elizabeth, creating one of the greatest means of creditor protection – the proscription of fraudulent transfers.  As Professors Baird and Jackson stated, the law prevents an “Elizabethan deadbeat [from selling] his sheep to his brother for a pittance.”[1]  The law has progressed, covering not just intentional acts to hinder, delay, or defraud creditors, but also “constructively fraudulent transfers” in which a third party who is not in on any con nonetheless gets something from an insolvent debtor for less than reasonably equivalent value.

These are simple, straightforward principles, with which no bankruptcy professional (or really, anyone) could quibble.  You got stuff and you didn’t pay for it, so you need to give it back.  There are some exceptions.  Voiding transfers in the securities industry, for instance, could up-end financial markets.  So Congress added Sections 548(d)(2)(B) – (E) of the Bankruptcy Code to protect various securities-related transfers from avoidance as constructively fraudulent transfers.  Likewise, Congress has excluded some charitable contributions and tithes from attack. 11 U.S.C. § 548(a)(2).

Now, a Bankruptcy Judge (which is not, the last time we checked, a Congressional body which can change the law), has grafted another exception to Section 548: transfers by a parent to help an adult child, where the adult child might (or might not, who knows) return the favor sometime in the future.  This is the law under DeGiacomo, as Chapter 7 Trustee v. Sacred Heart Univ. (In re Palladino), Case No. 15-01126, Bankr. D. Mass., Docket No. 76 (August 10, 2016) (Here’s a link to the opinion).  In Palladino, the Chapter 7 Trustee sued a university, which had received tuition money from the insolvent Debtors.  But the Debtors didn’t get anything for the payments – it went to pay the tuition of the Debtors’ adult child.  Thus the Chapter 7 Trustee sought to get the money back from the university, and distribute it to rightful creditors.

In Palladino, one of the parents / debtors defended the payments on moral grounds, stating “I am her mother and she shouldn’t have to come out of [Sacred Heart University] saddled with thousands of dollars in loans.”  Morality has nothing to do with constructively fraudulent transfers, and so we don’t know why this statement made it in the opinion.  Instead, the Bankruptcy Judge ruled against the Chapter 7 Trustee by holding that future, entirely speculative benefit can somehow provide “reasonably equivalent value” such that a transfer is not voidable.  As the Court held, “[a] parent can reasonably assume that paying for a child to obtain an undergraduate degree will enhance the financial well-being of the child which in turn will confer an economic benefit on the parent.  This, it seems to me, constitutes a quid pro quo that is reasonable and reasonable equivalence is all that is required.”  Wow.  No caselaw is cited by the Court for this proposition.  Indeed, none of us at the Bankruptcy Cave have ever heard of future, speculative benefits serving as a defense to a constructively fraudulent transfer action.  As to children taking care of parents, we suggest a review of King Lear (you know, “how sharper than a serpent’s tooth . . .”).

Future debtors, please take note of this remarkable opinion.  If you want to help a family member, then give them money before bankruptcy, for any plausible (or implausible reason).  Sick relative?  Down on their luck relative?  Relative that wants to invest in uranium stock, purchase the Brooklyn Bridge, or bail a Nigerian prince out of jail?  The Palladino ruling creates a debtor-friendly “it tugs on your heartstrings” / “blood is thicker than water” defense to fraudulent transfer actions.  And preferences too!  Why not?  Palladino is a safe haven for most or all of these wrongful actions.

Now, we understand the basis for the Palladino ruling.  Palladino was one of those “every possible ruling seems unfair” cases, in which a Chapter 7 Trustee was suing the child’s university, seeking to recover pre-petition tuition payments made by the insolvent parents for the benefit of the innocent child.  These cases are awful.  The child did nothing wrong.  The university did nothing wrong.  Indeed, the university really can’t police against this, unless it enacts a rule that every tuition payment must come from a check written on the student’s account.[2]  And even then, that would just make the innocent child / student the defendant.  That sticks in some people’s craw.[3]  On the other hand, creditors are unpaid – why should a kid get free or subsidized college when creditors have to lick their wounds? In any event, a bill is now kicking around Congress to exempt payments like these from fraudulent transfer attack under Section 548 of the Bankruptcy Code, as Lynne Xerras of Holland and Knight has written here.

So we understand the ruling.  But we still don’t like it.  Bankruptcy judges are not legislative bodies.  Bankruptcy judges can’t change the law, or create exceptions based on subjective principles of fairness.  If lawsuits like Palladino shouldn’t be allowed, it is up to Congress to make that decision, and not bankruptcy judges.  We are afraid that the Bankruptcy Code, the Statute of 13 Elizabeth, and creditor protections of all sort, all just got a little weaker through Palladino.

[1]           Baird & Jackson, Fraudulent Conveyance Law and Its Proper Domain, 38 Vand. L. Rev. 829, 852 (1985)); a full copy of this classic is located here.

[2]           And even then, would the school be automatically immune from attack as an immediate transferee under Section 550(a)(2)?  Ug.  More briefing on legal issues is not the solution to this problem.

[3]           The WSJ’s bankruptcy blog has covered this issue a lot.  See; for Friday’s coverage of Palladino, if you have a WSJ subscription, you can click here.



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Are Those Taxes Owing On Your Late-Filed Tax Return Dischargeable? Maybe, But You Better Be In The Right Circuit

File Tax Return!

Individual debtors with old tax debts relating to late-filed tax returns may be surprised to find that those tax debts may not be dischargeable under section 523(a) of the Bankruptcy Code due to the lateness of the tax filing.  There is a current Circuit split regarding whether a late tax filing constitutes a “return” at all, which is critical to the dischargeability inquiry.  The Ninth Circuit weighed in last week in In re Smith, 2016 WL 3749156 (9th Cir. July 13, 2016), further cementing the split.  Individuals considering whether to file bankruptcy to obtain a discharge of old tax debts would be well-advised to assess the current legal landscape and plan accordingly.

Section 523(a)(1)(B)(i) Exemption From Discharge For Tax Debts

Section 523(a)(1)(B)(i) of the Bankruptcy Code exempts from discharge any debt for a tax “with respect to which a return, or equivalent report or notice, if required . . . was not filed or given.”  In other words, a debtor may not obtain a discharge for taxes where it has failed to file a required tax return.  For a late-filed tax return, the issue becomes whether it is a “return” at all.

Prior to the 2005 BAPCPA amendments, the Bankruptcy Code did not define “return.”  Courts generally adopted the Tax Court’s definition of return set out in Beard v. Comm’r of Internal Revenue, 82 T.C. 766 (1984), which is commonly articulated as a tax filing that: (1) purports to be a return; (2) is executed under penalty of perjury; (3) contains sufficient data to allow calculation of tax; and (4) represents an honest and reasonable attempt to satisfy the requirements of the tax law.  Where a debtor files a late Form 1040 or similar tax form, elements one through three generally will be satisfied. It is element four that has been the subject of significant dispute.

In the 2005 BAPCPA amendments, Congress defined “return” in a new hanging paragraph at the end of section 523(a).  Under this definition, a return is “a return that satisfies the requirements of applicable nonbankruptcy law (including applicable filing requirements).”  This new definition has given rise to a significant split in authority regarding late-filed tax returns.

The Majority View.

Under the majority view followed in the Fourth, Sixth, Seventh, Eighth, Ninth, and Eleventh Circuits,[1] the Beard test governs the “return” inquiry.  As elements one through three are usually satisfied where a tax payer files an appropriate tax form, even if late, the inquiry inevitably becomes whether the debtor’s late filing represents an honest and reasonable attempt to satisfy the tax law requirements.  The timing of the late filing is generally considered relevant,[2] as is the debtor’s justification for the late filing, whether the IRS has already assessed the past-due taxes, and whether the late filing serves the purposes of the tax system.

The Ninth Circuit’s recent In re Smith decision is instructive.  There, the debtor failed to timely file his 2001 federal tax return.  The IRS calculated the debtor’s 2001 tax liability based on information gathered from other sources, and in 2006 assessed a deficiency against him.  In 2009, the debtor filed a Form 1040 for the 2001 tax year and thereafter sought to reach a compromise with the IRS on the 2001 taxes.  Unable to do so, the debtor filed his chapter 7 petition and sought a discharge of the 2001 taxes.  The bankruptcy court granted the discharge, and the district court reversed.

In affirming the district court, the Ninth Circuit considered the fourth Beard element and ruled that the debtor’s “belated acceptance of responsibility” was not a reasonable attempt to comply with the tax laws where, without justification, he waited three years after the IRS assessment and seven years after the tax return due date to file his Form 1040.  To the court, this simply was not a close case.  Because the debtor’s late-filed Form 1040 did not constitute a “return,” the debtor’s 2001 tax debt was exempt from discharge under section 523(a)(1)(B)(i).

The test adopted by the majority is fact-intensive, but provides an avenue for the honest but unfortunate debtor to obtain a discharge of tax debts where there is some justifiable excuse for the untimely tax filing.  This is not the case under the minority view.

The Minority View.

Under the minority view adopted in the First, Fifth, and Tenth Circuits, tax debts are not dischargeable if the tax return is filed after the applicable deadline—even if late by a single day.[3]  The rationale for this so-called “one-day-late rule” is that, under the plain language of the BAPCPA amendments’ new definition, a tax filing is only a return if it satisfies the requirements of the applicable nonbankruptcy law, “including applicable filing requirements.”  Under this view, the applicable filing requirements include filing deadlines.  Thus, late tax filings simply do not constitute returns for purposes of section 523(a).

The minority view is quite hostile even to the most honest debtor seeking to discharge tax debts for which he or she filed a late return.  But, to these courts, Congress has determined that debtors who miss tax filing deadlines simply are not entitled to a discharge of the associated tax debts.


The Ninth Circuit’s In re Smith decision reaffirms the stark divide between the majority and minority views on the dischargeability of tax debts where the debtor failed to timely file a return.  Unless and until the split is resolved by the Supreme Court, an individual debtor with significant tax liabilities should consider carefully whether a bankruptcy filing is appropriate in light of the current legal landscape.


[1]           In re Moroney, 352 F.3d 902 (4th Cir. 2003); In re Hindenlang, 164 F.3d 1029 (6th Cir. 1999); In re Payne, 431 F.3d 1055 (7th Cir. 2005); In re Colsen, 446 F.3d 836 (8th Cir. 2006); In re Smith, 2016 WL 3749156 (9th Cir. July 13, 2016); In re Hatton, 220 F.3d 1057 (9th Cir. 2000); In re Justice, 817 F.3d 738 (11th Cir. 2016).

[2]           In the Eighth Circuit, “the honesty and genuineness of the filer’s attempt to satisfy the tax laws should be determined from the face of the form itself, not from the filer’s delinquency or the reasons for it. The filer’s subjective intent is irrelevant.” In re Colsen, 446 F.3d at 840.

[3]           In re Fahey, 779 F.3d 1 (1st Cir. 2015); In re McCoy, 666 F.3d 924 (5th Cir. 2012); In re Mallo, 774 F.3d 1313 (10th Cir. 2014).

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High Court Broadens the Definition of “Actual Fraud” under Section 523(a)(2)(A)

The Supreme Court’s Decision:

On May 16, 2016, in Husky International Electronics, Inc. v. Daniel Lee Ritz, Jr., Case No. 15-145, the Supreme Court held that the term “actual fraud” in § 523(a)(2)(A) of the Bankruptcy Code encompasses fraudulent conveyance schemes, even if the scheme does not involve a false representation to the creditor.  In reversing the judgment of the Fifth Circuit, the Supreme Court’s ruling settled a split among the circuits regarding whether “actual fraud” under § 523(a)(2)(A) requires a misrepresentation or misleading omission to the creditor. Compare In re Ritz, 787 F.3d 312 (5th Cir. 2015) with McClellan v. Cantrell, 217 F.3d 890 (7th Cir. 2000), and Sauer V. Lawson, 791 F.3d 214 (1st Cir. 2015).

The Appeal:

On March 1, 2016, the Supreme Court heard arguments as to whether the “actual fraud” exception to discharge under § 523(a)(2)(A) applied narrowly (i.e. only when the debtor has made a false representation) or broadly (i.e. in situations where the debtor did not make a misrepresentation but entered into a scheme that was intended to defraud a creditor).

Between 2003 and 2007, Husky International Electronics, Inc. (Husky) sold and delivered electronic equipment worth approximately $164,000 to Chrysalis Manufacturing Corp. (Chrysalis).  Chrysalis failed to pay for the goods it purchased on credit.  While this debt was outstanding, between 2006 and 2007, Daniel Ritz (Ritz), a director and partial owner of Chrysalis, transferred funds from Chrysalis to various other ventures in which he owned stock.  In 2009, Husky sued Ritz seeking to hold him personally responsible for payment on the outstanding debt based on the allegation that Ritz’ transfers of Chrysalis’ funds were “actual fraud” and Ritz was therefore liable under a Texas statute.  Ritz then filed his own Chapter 7 bankruptcy petition, and Husky filed an adversary proceeding to have the debt declared nondischargeable under § 523 of the Bankruptcy Code on the basis that the same transfers constituted “actual fraud” under the exception to discharge in § 523(a)(2)(A).  Ritz argued that because he didn’t make a false misrepresentation to Husky, the debt should not be excepted from discharge.  The bankruptcy court ruled that Husky had failed to prove “actual fraud,” by false representation.  Husky appealed to the district court, which affirmed the bankruptcy court’s determination.  Likewise, the U.S. Court of Appeals for the Fifth Circuit also affirmed the lower court judgments and held that the debt was dischargeable, because, in its view, “actual fraud” requires a misrepresentation from the debtor to the creditor.

Analysis and Conclusion:

Justice Sotomayor, writing for the eight justice majority, concluded that the common-law term “actual fraud” is broad enough to incorporate forms of fraud that may not include a misrepresentation, such as a fraudulent conveyance.  At common law, fraudulent conveyances do not require a misrepresentation from a debtor to a creditor.  The Supreme Court also rejected Ritz’ argument that this interpretation of “actual fraud” renders § 523(a)(2)(A) redundant of other subsections of § 523 and of § 727(a)(2).  The Supreme Court noted that although there is overlap between each of these sections and § 523(a)(2)(A), there is also meaningful distinction and that it could “see no reason to craft an artificial definition of ‘actual fraud’ merely to avoid narrow redundancies that appear unavoidable.”  The Supreme Court also rejected Ritz’ argument, which was adopted by Justice Thomas’ dissent, that § 523(a)(2)(A) requires that the debt be “obtained by . . . actual fraud” and therefore the fraud must occur at the inception of the credit transaction.  The Supreme Court distinguished the dissent’s conclusion, and the prior precedent upon which it relies, on the basis that a reliance requirement is imposed only when the fraud is perpetrated through a misrepresentation to the creditor, which was not the case here.

This case potentially opens an avenue for creditors to defensively use a fraudulent transfer scheme that is outside of the one year limitation in § 727(a)(2) to prevent discharge of their claim.  As the Supreme Court noted, “Section 727(a)(2) is broader than § 523(a)(2)(A) in scope—preventing an offending debtor from discharging all debt in bankruptcy.  But it is narrower than § 523(a)(2)(A) in timing—applying only if the debtor fraudulently conveys assets in the year preceding the bankruptcy filing.  In short, while § 727(a)(2) is a blunt remedy for actions that hinder the entire bankruptcy process, § 523(a)(2)(A) is a tailored remedy for behavior connected to specific debts.”

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U.S. Supreme Court: Inherited IRA Funds not “Retirement Funds”

On June 12, 2014, the Supreme Court issued a unanimous opinion in Clark v. Rameker, Dkt. No. 13-299, 573 U.S. ___ (2014), holding that funds held in inherited Individual Retirement Accounts are not “retirement funds” within the meaning of 11 U.S.C. § 522(b)(3)(c) and therefore not exempt from the bankruptcy estate. This opinion limits retirement funds that remain out of creditors’ reach when an individual files a bankruptcy case.

In Clark, Heidi Clark inherited a traditional IRA account established by her mother. Clark then filed a Chapter 7 bankruptcy case and claimed the inherited IRA account as exempt from the bankruptcy estate under Section 522(b)(3)(C). The trustee and unsecured creditors objected, arguing that the inherited IRA funds were not “retirement funds” within the meaning of the statute.

The Court distinguished between inherited IRAs and traditional IRAs, noting that holders of inherited IRAs are prohibited from making contributions to those accounts, setting them apart from traditional retirement accounts; that holders of inherited IRAs are required to withdraw money from such accounts, regardless of how many years they may be from retirement; and that holders of inherited IRAs may withdraw the entire balance of the account at any time and for any purpose, without penalty. Observing that the funds in an inherited IRA could be spent on even a “vacation home or a sports car,” the Court expressed concern that allowing an inherited IRA to be exempt from the bankruptcy estate would convert the Bankruptcy Code’s purposes of providing a “fresh start” into a “free pass.”

The Clark opinion resolves a split among Circuits. The Fifth Circuit ruled in In re Chilton, 674 F. 3d 486 (5th Cir. 2012) that inherited IRAs constituted retirement funds within the “plain meaning” of § 522 of the Bankruptcy Code and were thus exempt from the bankruptcy estate, under § 522(d)(12) (the federal exemptions). The Seventh Circuit, in Clark, disagreed, emphasizing that the Bankruptcy Code should not be used to exempt from creditors’ reach funds that were freely accessible for current use by the debtor, without penalty.

Although Clark excludes inherited IRAs from exemption under Section 522(b)(3)(c), some states, including Missouri, provide a separate exemption for inherited IRAs under state law. The Clark decision is not likely to affect bankruptcy cases and practices in these states.

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