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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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“Singular” Cases on Nondischarge and Dischargeability

Liar businessman with crossed fingers at back .

Two recent cases analyzed the misrepresentations of a debtor regarding a single asset and held a written misrepresented value of a single scheduled estate asset would result in nondischargeability under Section 727, and that a verbal misrepresentation of a pre-petition asset to a creditor did not result in an exception to discharge under Section 523.

In Worley v. Robinson,[1]/ the Fourth Circuit affirmed nondischarge where a financially sophisticated debtor’s Schedules substantially undervalued his estate’s only substantial asset.  In Appling v. Lamar, Archer Cofrin LLP,[2]/ the Eleventh Circuit reversed a district decision and held that a false oral statements to a creditor regarding one pre-petition asset would not render the associated debt nondishargeable because they were statements of “financial condition” that must be in writing to support denial of discharge of a debt.

Litigation seeking nondischarge under Section 727 or the dischargeability of a debt under the exceptions of Section 523 is a broad topic. In general terms:

  • Section 727 provides a broad scope of discharge for the debtor, but sets out certain misconduct that will result in nondischarge, which denies the remedy of discharge of any of the debtor’s obligations.  The scope of such misconduct is generally some manner of fraudulent representation or activity in the context of the bankruptcy case, though it can involve pre-petition conduct.  The issue of nondischarge is raised procedurally by an objection to discharge filed by a creditor, the Trustee, or the U.S. Trustee.
  • Section 523, on the other hand, provides for exceptions to the general discharge of the debtor. These exceptions can render a specific obligation nondischargeable. Many of the exceptions are based on legal policies surrounding the character of the indebtedness, like certain taxes, child support obligations, and student loans.  But the commonly litigated exceptions generally involve some manner of pre-petition fraud upon a specific creditor.  The offended creditor typically initiates an adversary proceeding to obtain such an exception to discharge.

The Worley and Appling cases offer illustrations of nondischarge and dischargeability from the most singular perspective where the debtor’s misrepresentation pertains to only one asset.  The very limited facts regarding the assets actually help to identify the very important governing principals and policies of these different Bankruptcy Code treatments of alleged debtor misconduct.

In Worley, the debtor suffered nondischarge where he used a capitalization of income method to value an investment at $2,500, but the Court found it to be worth at least $13,200 under different considerations.  While just those facts may make it seem the Court was slicing it pretty thin against this debtor, other facts leveraged the adverse holding.  The debtor was an MBA with 10 years of brokerage experience who assumedly knew that the valuation method he used would undervalue the basically non-income producing asset, and that the “no asset” appearance of his bankruptcy Schedules would tend to chill further investigation by creditors or the trustee or even lead to abandonment of the property.  The Court found no clear error in the bankruptcy court’s denial of discharge under Section 727(a)(4), for the making a false oath or account.

Appling also involved very simple facts: the debtor lied to his lawyers to obtain pre-petition legal services on credit, first saying that he expected a big tax refund that would enable him to pay his legal bills, then after getting the refund, using it in his business and telling his lawyers he didn’t get the refund.  But again, the simple facts regarding this asset assist the clarity of the legal issues involved.  Section 523(a)(2)(A) and (B) both provide for exceptions from a discharge a debt obtained by misrepresentations.  However, (B) governs any misrepresentation “respecting the debtor’s … financial condition”, and requires that the misrepresentation be in writing.  Misrepresentations regarding other topics are governed by (A), and may be oral statements.  So, the question in Appling turned to whether debtor’s oral statements about this one asset were statements “respecting the debtor’s … financial condition.”  If they were, then Section 523(a)(2)(B) controls, and if the creditor does not have a written statement, the creditor loses.  Here, the existence vel non of a tax refund did relate to financial condition, and lacking any writing by the debtor about it, the debt was dischargeable.[3](We at The Bankruptcy Cave found this confusing – what oral statements do not relate to financial condition, and thus could lead to nondiscahrgeability?  The opinion answers it – “false [oral] representations about job qualifications and lies about the purpose and recipient of a payment,” for example, are the stuff that can lead to nondischargeability.  But if the creditor is complaining about a falsehood regarding financial condition, it should have gotten it in writing, the Eleventh Circuit held.)

Together the Worley and Appling cases show the varied levels of legal scrutiny of debtor intent and creditor reliance, and variable levels of materiality in the landscapes of nondischarge and dischargeability.  (My colleague Mark Duedall from BC Atlanta also wrote recently on this, in the context of a lender’s failure to perform any real diligence on a debtor’s statements, rendering the lender’s reliance unreasonable and foiling another effort to deny a discharge, here.)  It is intuitively useful to first remember that discharge and a “fresh start” are basically the whole point of the Code, and that variance of that result would be relatively rare.  (See a nice collection of Supreme Court statements on this point here.)

In the context of Section 523 dischargeability and misrepresentations, there is, in practical effect, a relatively lower expectation of debtor intent and a higher scrutiny of creditor reliance. For example, the Appling case arguably weighs “fresh start” against a legally sophisticated creditor’s unsecured lending to a financially distressed guy based on his oral statement that he was going to get a tax refund.  Is that really the creditor due diligence or underwriting standard that the Courts are endeavoring to protect in the scheme of Code policy goals?  Is that the creditor we should break “fresh start” for?  Is it too much to ask for unsecured creditors to obtain written statements of the borrower’s financial condition?  Were the oral statements really material to any reliance upon which credit was extended?  The result in Appling would indicate a negative answer to each of those rhetorical questions.

However, in the context of Section 727 nondischarge and misrepresentations, there is, in practical effect, a relatively higher expectation of debtor intent and a lower scrutiny of creditor reliance.  For example, the Worley case arguably weighs the debtor’s “fresh start” against his own financially sophisticated methods of asset valuation without any consideration of whether reasonably diligent creditors or trustees would have, in fact, been fooled.  Section 727 is itself the “fresh start”, and so the expectations of debtor conduct in the proceeding are high.  Does a debtor have to be scrupulously honest in characterizing his financial condition?  Can a Court scrutinize errors in a debtor’s Court statements down to the level of a single asset and the debtor’s subjective experience and expertise?  In the right circumstances, can a single asset be so material as to support nondischarge?  The result in Worley would yield positive answers to all those questions.

While the Worley and Appling cases involve unusual matters in their analysis of single asset factual disputes, the cases do illustrate that disputes involving nondischarge and dischargeability do not tend to provide safe harbors, and rather always involve a facts-and-circumstances analysis and a result that will largely depend on issues of intent, reliance, and materiality.

 

[1]/          Worley v. Robinson (In re Worley), 15-2346 (4th Cir. Feb. 28, 2017).

[2]/          Appling v. Lamar, Archer Cofrin LLP (In re Appling), 16-11911 (11th Cir. Feb. 15, 2017).

[3]/          The Appling Court noted a substantial Circuit split on this issue.

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A Debtor’s Allegedly False Financial Statement Doesn’t, At All, Excuse a Lack of Lender Diligence

A decision rendered during the sometimes peaceful interlude between Christmas and New Year’s is worth reading, and heeding.  Hurston v. Anzo (In re Hurston), Adv. Proc. No. 15-2026 (Bankr. N.D. Ga. Dec. 27, 2016) is a helpful reminder to anyone representing lenders or creditors which are hell-bent-for-leather to pursue a non-dischargeability claim against a debtor that submits a false written statement (e.g., a personal financial statement) to obtain credit.  Often, in the fervor of the start of a bankruptcy case, the creditor (and its lawyer) will make great hay from the fact that a debtor may have lied in a pre-petition credit application, or forbearance agreement, or other written medium.  However, the facts of Hurston show that a creditor (and its lawyer) should pause, take a breath, and critically evaluate whether the creditor actually relied on the pre-petition writing from the debtor, and whether that creditor’s reliance was also, in fact, reasonable.  If not, then the creditor deserves a serious challenge from its own counsel on the wisdom of pursuing a expensive, and likely unsuccessful, non-dischargeability claim.

We don’t need to go in detail on the debtor’s alleged falsehoods – that is not the point of Hurston.  Instead, Judge Sacca of the Bankruptcy Court for the Northern District of Georgia covered in great detail how the creditor didn’t not rely on the allegedly false statements, and even if it did, its reliance was not reasonable.  The key takeaways from the opinion – and helpful advice for any lawyer that is thinking about taking on a “false statement” non-dischargeability action under 11 U.S.C. sec. 523(a)(2)(B) – are what the creditor in Hurston did and didn’t do.

First, where the creditor does not perform any material diligence on the false statement (here, a personal financial statement), then the creditor will have a difficult or impossible time showing that it “reasonably relied” on the allegedly false financial statement.  The creditor should ask for bank statements, tax returns, information from accountants, or other, third party evidence to back up information form a debtor.  If the creditor didn’t perform any follow up diligence, you should advise the creditor (right at the outset) that its claim may fail.

Second, this is especially true where the creditor and debtor do not have a prior relationship.  A prior relationship might (we emphasize, might) provide indicia of reliability of the debtor and its financial wherewithal to overcome a lack of diligence.  But if there is no prior relationship, the creditor should be ready to show that it did more diligence.

Third, where a financial statement (or other writing on which the non-dischargeability claim is based) contains “red flags,” including matters a reasonable creditor would question or that the specific creditor should know to question, the creditor must show that it followed up on those “red flags.”

Fourth, a debtor with an alleged strong financial reputation, or that appears to be wealthy based on appearance and community activity, does not excuse the creditor’s obligation to perform diligence on any written statement or financial statement.  In short, an argument based on “the debtor was a pillar of the community” will not go to show reasonable reliance by the creditor on an otherwise questionable financial statement or other writing.

Fifth, the creditor should be able to show it had established criteria to evaluate the credit being extended – and that those criteria were used and evaluated as a critical part of making any decision to extend credit.  A lack of rules and procedures to evaluate financial statements or other written submissions, or a failure to follow those procedures, will be very harmful to the creditor’s claim.

When you read 11 U.S.C. sec. 523(a)(2)(B), and in particular its requirement that the creditor “reasonably relied” on any alleged false statement, the Hurston decision is not surprising.  But Hurston remains a very helpful reminder for any creditor’s lawyer to critically examine the creditor’s case at the start of the matter.  The lawyer must cross-examine the creditor to get past the allegations of the debtor’s falsehoods (which the creditor will trumpet as much as you let it), and spend a great deal more time on whether the creditor did any diligence on the allegedly false written statements.  This can be an awkward conversation with your client – and perhaps perceived as blaming the victim – but it will be far more awkward to later explain to your client why the non-dischargeability action did not succeed.

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