DISCHARGE AND DISCHARGEABILITY

Transcription

1 DISCHARGE AND DISCHARGEABILITY Michael D. Sabbath Walter Homer Drake Professor of Bankruptcy Law Mercer University Walter F. George School of Law Macon, Georgia

2 Table of Contents I. INTRODUCTION... 1 II. NOTICE REQUIRED TO DISCHARGE DEBTS New Section Section 523(a)(3) and Unscheduled Debts Section 1141(d) and Lack of Notice Section 1328(a) and Lack of Notice... 7 III. APPLICABILITY OF COLLATERAL ESTOPPEL IN NONDISCHARGEABILITY ACTION... 8 IV. WILLFUL AND MALICIOUS INJURY TO PERSON OR PROPERTY V. RELIANCE ON MISREPRESENTATIONS VI. TRANSFORMING A NON-DISCHARGABLE DEBT INTO A DISCHARGEABLE OBLIGATION Debts Incurred to Pay Taxes Nondischargeable Debts and Settlement Agreements VII. AUDITS AND REVOCATION OF DISCHARGE Audits New Section 727(d)(4) VIII. SECTION 1141 AND DISCHARGE IN INDIVIDUAL CASES... 24

3 DISCHARGE AND DISCHARGEABILITY I. Introduction Debtors who file voluntary bankruptcy petitions generally do so with the expectation that all of their debts will be erased. Of course, this is not necessarily true. Certain obligations are not affected by a discharge. Sometimes, a discharge is withheld because of some form of dishonesty or lack of cooperation by the debtor. This paper discusses just a few of the many issues that may arise concerning the dischargeability of debts. II. Notice Required to Discharge Debts 1. New Section 342 The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA) significantly amended section 342, which is the Bankruptcy Code s notice section. 1 While the intent may have been to simplify the process for creditors, it certainly makes things quite confusing for debtors (particularly consumer debtors), and the new section is so poorly drafted that one commentator has stated that [t]here is a temptation to ask who was smoking what when this new section was stuffed into BAPCPA. See Lundin, Section 342 after BAPCPA: Notice Corrupted in Bankruptcy Cases, Norton Bankruptcy Law Adviser, no. 7 (July 2005) (an excellent and entertaining discussion of new section 342). Basically, section 342(c)(2)(A) now provides that if a creditor has supplied the debtor, in at least two communications within ninety days before bankruptcy, with the current account number of the debtor and the address at which the creditor requests to receive correspondence, then bankruptcy notices must include that account number and must be sent to that address. Any notice concerning an amendment to the schedule of assets and liabilities also must include the full taxpayer identification number in the notice sent to the creditor, though only the last four digits of that number are required in the copy filed with the court. 1 Any reference herein to a section is to a section of Title 11, U.S.C. 101 et seq. (the Bankruptcy Code ). 1

4 See Section 342(c)(2)(B). In a case under Chapter 7 or Chapter 13, where the debtor is an individual, a creditor may at any time both file with the court and serve on the debtor a notice of address to be used to provide notice to the creditor in that case, and any notice required to be sent to that creditor (later than 5 days after the court and debtor receive this notice of address from the creditor) must be sent to such address. See Section 342(e)(1) and (2). In addition, section 342(f)(1) permits a creditor to file with a bankruptcy court a notice of the address it prefers, which thereafter must be used by other bankruptcy courts or by the particular bankruptcy courts as specified. This national noticing scheme (for which there is no mechanism in place) only applies to notices required to be provided by the court. See section 342(f)(2). Notices provided by the debtor should use the address as set out in sections 342(c) and (e). The former version of section 342 provided that failure of a notice to contain the information required by section 342 shall not invalidate the legal effect of such notice. This provision was stricken from current section 342, and section 342(g)(1) now generally provides that a notice that fails to comply with the notice requirements in section 342 shall not be effective notice until such notice is brought to the attention of the creditor. Brought to the attention of the creditor would appear to have a broad meaning, but section 342(g)(1) provides that if a creditor designates a person or organizational subdivision to be responsible for receiving notices and establishes reasonable procedures to assure that notices received by the creditor are delivered to that designated person or subdivision, then a notice shall not be considered to have been brought to the attention of the creditor until such notice is received by such designee. The effect of this change in language is not clear. New section 342(g)(1) could be read as providing that failure to precisely follow the requirements of 342 vitiates the general effectiveness of notices in a bankruptcy case. Such a reading would enable a creditor to argue that the claims bar date or the discharge does not apply if notice is not effective in accordance with section

5 A more appropriate reading, though, is to consider section 342(g)(1) in conjunction with section 342(g)(2), which provides that a monetary penalty may not be imposed on a creditor for a violation of the section 362 automatic stay or the section 542 and 543 turnover requirements unless the conduct that violates the stay or turnover requirements occurs after such creditor receives notice effective under this section. Read in this manner, even without effective notice under section 342, the effects of the automatic stay will still apply, though monetary penalties cannot be awarded for violation of the stay. Also, under such a reading, section 342 does not affect the discharge of debts or violations of the discharge injunction. In arguing that section 342(g)(1) must be read in conjunction with, and is limited by section 342(g)(2), one commentator explains: Any other reading could create difficulties for implementation of bankruptcy policy and would be inconsistent with the in rem nature of a bankruptcy case. For example, if the discharge did not apply to creditors who did not have effective notice, even if they have actual notice, there would be tremendous gaps in the fresh start policy. Creditors dealing with property of the estate might be immune from the bankruptcy court s power to avoid unauthorized transactions. In sum, [this reading] is consistent with the language of 342(g) and with the creditor protection policy it embodies and seems more consistent with the Bankruptcy Code as a whole. See Levin and Ranney-Marinelli, The Creeping Repeal of Chapter 11: The Significant Business Provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, 79 Am. Bankr. L.J. 603, 633 (2005). See also 3 Collier on Bankruptcy (15 th ed. Rev. 2005) (While no monetary penalty for violation of the automatic stay or the turnover provisions can be imposed on a creditor who has not received effective notice, section 342 does not affect the discharge of debts or violations of the discharge injunction. Nor does it preclude other remedies against the creditor, or remedies against other entities, such as a creditor s attorney. Thus, as amended, section 342 is likely to have little practical effect. ). 3

6 2. Section 523(a)(3) and Unscheduled Debts Section 523(a)(3) deals with situations in which the debtor fails to schedule a creditor and the creditor lacks timely notice of the bankruptcy. Under section 523(c)(1), the debtor is discharged from a debt of the kind specified in section 523(a)(2) [obligations incurred by fraud], section 523(a)(4) [breach of fiduciary duty], or section 523(a)(6) [willful and malicious injury], unless on the request of the creditor to whom the debt is owed, and after notice and a hearing, the court determines that the debt should be excepted from discharge. Obviously, the creditor must have notice of the bankruptcy in order to file a dischargeability complaint. Section 523(a)(3)(B) provides that the debt is nondischargeable if the debt is neither listed nor scheduled under section 521(1) unless the creditor holding such a claim has notice or actual knowledge of the case in time to file a dischargeability complaint in bankruptcy court. See., e.g., In re McGhan, 288 F.3d 1172, 1176 (9 th Cir. 2002) (debt for malicious and willful injury will not be discharged if the creditor was neither listed nor scheduled and did not have notice or actual knowledge of the case in time to file a timely proof of claim and timely request for a determination of dischargeability). Section 523(a)(3)(A) applies when the debt is not of a kind specified in section 523(a)(2), (4) or (6). Section 523(a)(3)(A) provides that a debt is nondischargeable if it was neither listed nor scheduled under section 521(1) unless the creditor to whom the debt is owed has notice or actual knowledge of the case in time to file a proof of claim. The purpose of this section is to protect the creditor s right to file a proof of claim, and so to participate in any distribution of the assets of the estate. In a no-asset case, in which no bar date is established for the filing of claims and so there is no time limit for the timely filing of a proof of claim, the lack of notice does not deprive the creditor of the opportunity to file a timely proof of claim. Therefore, unless the debt falls within section 523(a)(2), (4) or (6), courts generally find that the debt is discharged. See, e.g., In re Nelson, 383 F.3d 922 (9 th Cir. 2004); In re Deutsch-Sokol, 290 B.R. 27 (S.D.N.Y. 2003); In re McDaniel, 217 B.R. 348 (Bankr. N.D. Ga 1998). But see In re Faden, 96 F.3d 792, (5 th Cir. 1996) (it is necessary to amend the debtor s schedules to include the omitted creditor in order for the 4

7 claim to be discharged; if leave to amend is denied, the debt is nondischargeable). The circuit courts of appeals are split on whether a debtor s intent in failing to schedule a claim is relevant to a bankruptcy court s decision to reopen a case in which there are not assets and no bar date, or whether a more mechanical analysis should apply. Compare Samuel v. Baitcher (In re Baitcher) 781 F.2d (11 th Cir. 1986) (intent is relevant) with In re Parker, 313 F. 3d 1267, 1268 (10 th Cir. 2002) (the more mechanical approach is better reasoned and more faithful to the language of the Bankruptcy Code ). Even where there are assets to be distributed, it would seem that a creditor without notice should have a nondischargeable debt under section 523(a)(3)(A) only in the amount of the distribution it would have received if it had been able to file a timely claim (together with interest from the date of the distribution). Otherwise, the nondischargeable debt may exceed the actual loss caused to the debtor. For example, in Duerkop v. Jongquist, 125 B.R. 558 (Bankr. D. Minn. 1991), Duerkop, who was owed $29,999, was omitted from the debtor s schedules and received no notice. If he had received proper notice and had filed a timely claim, Duerkop would have received only a few dollars. Nevertheless, the court found that the entire $29,999 debt was nondischargeable, concluding that section 523(a)(3) protects a creditor s right to file a timely claim, and that it makes no distinction between minimal asset cases and those in which substantial distributions are made to creditors. It would seem more appropriate to limit the amount of the nondischargeable debt to the actual loss caused by the lack of notice of the bankruptcy (in Duerkop, just a few dollars). 3. Section 1141(d) and Lack of Notice Section 1141(d)(1) states that confirmation of a plan discharges the debtor from any debt that arose before the date of confirmation (or that, under certain provisions of sections 502, are deemed to have arisen before the date of confirmation), except as otherwise provided in section 1141(d), in the plan itself, or in the order confirming the plan.. It further provides that these debts are discharged regardless of whether a proof of claim was filed or deemed to be filed, the claim was allowed under section 502, or the holder of the claim accepted the plan. The section 1141(d)(1) also discharges any claim or interest which exists 5

8 as of the date of confirmation and invalidates any lien securing a creditor s claim unless the lien is provided for in the plan. See Section 1141(c). On its face, this broad language seems to allow confirmation to extinguish secured and unsecured claims and equity interests even though the holder of the claim or interest has received no notice of the case, and even though no effort has been made to inform the holder of the claim or interest of the entry of the order for relief or of the pending confirmation of the plan or reorganization. But such a reading would certainly raise constitutional problems. As the Tenth Circuit Court of Appeals noted in Reliable Electric Co. v. Olson Construction Co., 726 F.2d 620, 623 (10 th Cir. 1984): Sections 1141(c) and (d) ostensibly allow any claim to be discharged even though the claimholder has not received notice of the proceeding or of the confirmation hearing. However, we hold that notwithstanding the language of section 1141, the discharge of a claim without reasonable notice of the confirmation hearing is violative of the fifth amendment to the United States Constitution..... A fundamental right guaranteed by the Constitution is the opportunity to be heard when a property interest is at stake. Specifically, the reorganization process depends upon all creditors and interested parties being properly notified of all vital steps in the proceeding so they may have an opportunity to protect their interests. We will not require Olson [a creditor] to subject its claim to a confirmed reorganization plan that it had no opportunity to dispute. [citations omitted]. Indeed, even if a creditor has actual notice of a bankruptcy case, a number of courts have found that it will not be bound by the provisions of a confirmed plan if the creditor did not receive notice of the bar date or the confirmation hearing. See, e.g., in re Kendavis Holding Co., 249 F.2d 383 (5 th Cir. 2001) (former employee s pension plan termination claim not discharged because he did not receive formal notice of the case or that his rights might be affected, though he did have actual knowledge of the case); In re Spring Valley Farms, Inc., 863 F.2d 832 (11 th Cir. 1989) (discharge does not operate to bar claim of creditor who did not receive notice of claims bar date even if creditor knew of pendency of Chapter 11 case). It should be noted that section 1141(d)(2) provides that a discharge under Chapter 11 does not discharge an individual debtor from any debt excepted from discharge under section 523. This would include those debts in section 523(a)(3) not listed or scheduled in 6

9 time to permit the debtor to timely file a proof of claim or, if the debt is nondischargeable under section 523(a)(2), (4) or (6), in time to file a proceeding to determine dischargeability. If the creditor would not have received a distribution even if a claim had been filed (e.g., plan paid nothing to unsecured creditors), the lack of knowledge should not bar discharge of the debt unless it was nondischargeable and the creditor did not obtain notice in time to file a nondischargeability proceeding. 4. Section 1328(a) and Lack of Notice Section 1328(a) directs a court to grant the debtor a discharge as soon as practicable after the completion of all payments under the Chapter 13 plan. With a few exceptions, this discharge extends to all debts provided for by the plan. The phrase provided for by the plan is not defined in the Bankruptcy Code, and creditors have tried to argue that a plan that does not provide for payment on a debt does not provide for that debt. They have argued that there is no practical difference between a plan with a zero-payment provision and a plan without any provision for unsecured debts. But the Ninth Circuit Court of Appeals rejected this argument, quoting from the bankruptcy appellate panel which had noted that there is a significant difference between a plan that does not acknowledge an unsecured claim and a plan which proposes to pay nothing on a claim. In the former case, the unsecured creditor has no ability to object, in a meaningful way, to confirmation of the debtor s plan. See Lawrence Tractor Co. v. Gregory (In re Gregory), 705 F.2d 1118, 1122 (9 th Cir. 1983). The Ninth Circuit concluded that to provide for a claim, a plan need only make a provision for it, i.e., deal with it or refer to it. 705 F.2d at This broad definition of provided for was later adopted by the Supreme Court in Rake v. Wade, 508 U.S. 464, 473 (1993) (the most natural reading of the phrase to provide for by the plan is to make a provision for or stipulate to something in a plan). So long as claimants have proper notice and an opportunity to object to confirmation, their claims will be discharged even if the plan proposes to pay nothing to those claimants. But courts have held that a creditor that is not scheduled and that does not have notice of the Chapter 13 case in time to file a claim or to participate in the confirmation process has 7

10 not been provided for in the plan. See, e.g., In re Hairopoulos, 118 F.3d 1240 (6 th Cir. 1997) (discharging the debt after the lack of notice would result in lack of fairness and due process). The 2005 amendments added as an exception to discharge the exception under section 523(a)(3) for debts not listed or scheduled in time to permit the creditor to file a timely proof of claim or, if the debt is nondischargeable under section 523(a)(2), (4) or (6), in time to file a proceeding to determine dischargeability. See Section 1328(a)(2). Here again, if the creditor would not have received a distribution even if a claim had been filed, the lack of knowledge should not bar discharge of the debt unless it was nondischargeable and the creditor did not obtain notice in time to file a nondischargeability proceeding.. III. Applicability of Collateral Estoppel in Nondischargeability Actions Generally, Congress has delegated to the federal courts the exclusive right to determine the dischargeability of certain debts in bankruptcy. See Brown v. Felson, 442 U.S. 127, 138 (1979). But while the determination of discharge status is a federal question, some of the factors that give rise to a determination of nondischargeability may have been litigated prior to the bankruptcy case. The Supreme Court has held that collateral estoppel principles apply in bankruptcy cases and can be used in nondischargeability actions to prevent relitigation of issues already decided. See Grogan v. Garner, 498 U.S. 279, 284, n.11 (1991) ( We now clarify that collateral estoppel principles do indeed apply in discharge exception proceedings pursuant to section 523(a) ). Collateral estoppel (also referred to as issue preclusion ) has, on occasion, been successfully raised by a debtor who prevailed on issues litigated in the pre-bankruptcy litigation. See, e. g, In re Greenberg, 71 F.3d 1177, 1181 (5 th Cir. 1996) (debtor s acquittal of gross negligence in state court was preclusive in debtor s favor on issue of whether his actions were willful and malicious for purposes of section 523(a)(6) dischargeability claim). Most often, though, collateral estoppel is invoked by creditors who seek to bar debtors from re-litigating matters already decided prior to bankruptcy. Courts have stated that, under federal law, a party may successfully invoke the doctrine of collateral estoppel only if it can establish that: (1) the issues in both proceedings 8

11 were identical, (2) the issue in the prior proceeding was actually litigated and actually decided, (3) there was full and fair opportunity to litigate in the prior proceeding, and (4) the issue previously litigated was necessary to support a valid and final judgment on the merits. See, e.g., NLRB v. Thalbo Corp., 171 F.3d 102, 109 (2d Cir. 1999); NLRB v. Kentucky May Coal Co., Inc., 89 F.3d 1235, 1239 (6 th Cir. 1996). This is consistent with the general rule of issue preclusion set out in the Restatement (Second) of Judgments: When an issue of fact or law is actually litigated and determined by a valid and final judgment, and the determination is essential to the judgment, the determination is conclusive in a subsequent action between the parties, whether on the same or a different claim. Not all courts, however, use the same test for issue preclusion. In some instances, these federally-developed rules of collateral estoppel differ from those applied by the states. In some states, actual litigation is not a prerequisite to issue preclusion, so that even a default judgment can preclude subsequent challenges in a different forum. While it certainly seems appropriate for a bankruptcy court to defer to prior state court judgments when an issue relevant to dischargeability has been fully litigated, it is quite another matter when a default judgment has been entered in the state court and the issue was never litigated at all. The Supreme Court s decision in Marrese v. American Academy of Orthopaedic Surgeons, 470 U.S. 373 (1985) has caused a number of courts to conclude that it is appropriate to apply state issue preclusion rules, including preclusion based on a default judgment, in dischargeability proceedings. In Marrese, the Court stated that: The preclusive effect of a state court judgment in a subsequent federal lawsuit generally is determined by the full faith and credit statute, which provides that state judicial proceedings shall have the same full faith and credit in every court within the United States... as they have by law or usage in the courts of such State... from which they are taken. 28 U.S.C This statute directs a federal court to refer to the preclusion law of the State in which the judgment was rendered. It has long been established that 1738 does not allow federal courts to employ their own rules of res judicata in determining the effect of state judgments. Rather, it goes beyond the common law and commands a federal court to accept the rules chosen by the State from which the judgment is taken. 9

12 470 U.S. at 380 (Citing Kremer v. Chemical Construction Corp., 456 U.S. 461, (1982)). The Court indicated that 1738 requires that a federal court must first look to state preclusion law in determining the preclusive effects of a state court judgment; an exception to 1738 will not be recognized unless a later statute contains an express or implied repeal. See 456 U.S. at 381. Marrese dealt with the res judicata effect of a state court judgment in a subsequent federal proceeding. Courts, however, have applied its reasoning in determining the collateral estoppel effect in a nondischargeability proceeding of a default judgment that has been previously rendered in a state court. For example, the Sixth and Ninth Circuit Courts of Appeals concluded that the issues of fraud and defalcation were decided conclusively in prior state court default judgments because Florida and California law, which governed the prior proceedings in those cases, did not require issues to be actually litigated for issue preclusion purposes. See Bay Area factors v. Calvert, 105 F.3d 315 (6 th Cir. 1997); Gayden v. Nourbakhsh, 67 F.3d 798 (9 th Cir. 1995). Even though no evidence of fraud or defalcation was presented during the state court proceedings, these debts were deemed to be nondischargeable in subsequent bankruptcy cases without any litigation on the merits. Other courts have been reluctant to apply collateral estoppel where a default judgment has been entered in the state court, at least where the default was not preceded by some significant participation by the debtor. See, e.g., In re Raynor, 922 F.2d 1146, 1150 (4 th Cir. 1991) ( because the issue of fraud was not actually litigated, [creditor] cannot invoke the default judgment to bar [debtor s] discharge by relying on res judicata or issue preclusion. ); In re Myers, 52 B.R. 901, , n.1 (Bankr. E.D. Va. 1985) ( it is well established that a state court default judgment does not have collateral estoppel effect because it is not the result of actual litigation ); In re Anderson, 49 B.R. 655, 656 (Bankr. E.D. Wis. 1984) ( a default judgment is not an adjudication on the merits for collateral estoppel purposes because it is not the result of actual litigation ). See generally 4 Collier on Bankruptcy (15 th ed. Rev. 2005) ( Most courts have thus been reluctant to invoke collateral estoppel where the 10

13 debtor did not fully participate in the prior litigation or where a default judgment had been entered against the debtor. ), Some courts have distinguished between default judgments where the defendant/debtor made no appearance, and those in which the debtor did participate in the lawsuit before the default judgment was entered. See, e.g., Bush v. Balfour Beatty Bahamas Ltd., (In re Bush), 62 F.3d 1319 (11 th Cir. 1995) (collateral estoppel invoked where pro se debtor engaged in discovery disputes, but allowed a default judgment to be entered against him). Others appear more willing to apply collateral estoppel where the default judgment was entered as a result of discovery abuse or other improper behavior by the defendant/debtor while he was participating in the state court proceeding. See, e.g., In re Doctoeroff, 133 F.3d 210, 215 (3d Cir. 1997) ( We do not hesitate in holding that a party... who deliberately prevents resolution of a lawsuit, should be deemed to have actually litigated an issue for purposes of collateral estoppel application. ). See also In re Bush, 62 F.3d 1319, 1325 (11 th Cir. 1995). Commentators do not agree on the proper approach for courts to take in this area. One believes that the better view is to apply the same collateral estoppel effect to a judgment as would the court issuing the judgment. 3 Norton Bankr. L. & Prac. 2d 47:72 (2005). On the other hand, another believes: In view of the strong federal policy of assuring that the exceptions to discharge under section 523(a)(2), (4), and (6) not be entered upon a default of a debtor in a nonbankruptcy court, which is evidenced by the exclusive jurisdiction given to the bankruptcy courts to decide these matters, the decisions applying collateral estoppel in cases in which the debtor has not substantially participated are erroneous and should not be followed. 4 Collier on Bankruptcy (15 th ed. Rev. 2005) 11

14 IV. Willful and Malicious Injury to Person or Property Section 523(a)(6) makes nondischargeable a debt for willful and malicious injury by the debtor to another entity or to the property of another entity. Certainly, it would not be appropriate for a debt to be discharged that arises out of the debtor s physical assault on some individual, or that arises out of the debtor s intentionally destroying another s property. When such a high degree of moral culpability is involved, discharge of the debt should be denied. But in most of the cases that reach the bankruptcy court where there has been injury to person or property, the degree of moral culpability by the debtor is much lower. Most of the cases brought under section 523(a)(6) fall into two categories: (1) those involving personal injuries, often resulting from automobile accidents caused by drunk drivers, and (2) those involving conversion of property, most often involving allegations by a secured party that the debtor sold encumbered collateral without authority. At the behest of Mothers Against Drunk Driving, the drunk driving issue was resolved by the addition in 1984 of section 523(a)(9). As amended by the Criminal Victims Protection Act of 1990, and BAPCPA (which added vessel, or aircraft ), section 523(a)(9) now specifically excepts from discharge those debts for death or personal injury caused by the debtor s operation of a motor vehicle, vessel, or aircraft if such operation was unlawful because the debtor was intoxicated from using alcohol, a drug, or another substance. In other cases involving injury to person or property, the court must decide whether the injury was willful and malicious. Prior to 1998, some courts found that the section 523(a)(6) discharge exception encompassed negligent or reckless conduct. See, e.g., Perkins v. Scharffe, 817 F.2d 392 (6 th Cir.), cert. denied, 484 U.S. 853 (1987). In Kawaauhau v. Geiger, 523 U.S. 57 (1998), however, the Supreme Court held that negligent or reckless conduct does not constitute willful and malicious conduct and so does not fall within the section 523(a)(6) exception to discharge. In affirming the court of appeals, the Supreme Court held that the section 523(a)(6) exception to discharge is limited to conduct which may be classified as intentional torts, reasoning that: 12

15 The word willful in (a)(6) modifies the word injury, indicating that nondischargeability takes a deliberate or intentional injury, not merely a deliberate or intentional act that leads to injury. Had Congress meant to exempt debts resulting from unintentionally inflicted injuries, it might have described willful acts that cause injury. Or, Congress might have selected an additional word or words, i.e., reckless or negligent, to modify injury. Moreover, as the Eighth Circuit observed, the (a)(6) formulation triggers in the lawyer s mind the category intentional torts, as distinguished from negligent or reckless torts. Intentional torts generally require that the actor intend the consequences of an act, not simply the act itself. 523 U.S. at While Geiger established that section 523(a)(6) does not apply to debts arising from unintentionally inflicted injuries, it did not decide whether the debtor must have actual knowledge that harm is a substantially certain consequence of her behavior, or if it is enough that the debtor reasonably should have known that her actions were substantially certain to injure the creditor. The circuits are divided on this question. The Sixth and Ninth Circuits adopt a subjective standard: a debt is nondischargeable under section 523(a)(6) only if the debtor intended to cause the harm or actually knew that the harm was a substantially certain consequence of her behavior. See In re Markowitz, 190 F.3d 455 (6 th Cir. 1999); In re Su, 290 F.3d 1140 (9 th Cir. 2002). The Fifth Circuit, on the other hand, adopts an objective standard: the debtor s state of mind is disregarded, and the court considers whether an objective, reasonable person would have known that the actions in question were substantially certain to injure the creditor. See In re Miller, 156 F.3d 598 (5 th Cir. 1998). Courts have not clearly defined the standard for maliciousness. The First Circuit has stated that: malicious means an act done in conscious disregard of one s duties. No special malice toward the creditor need be shown. Printy v. Dean Whitter Reynolds, Inc. (In re Printy), 110 F.3d 853, 859 (1 st Cir. 1997). The Eleventh Circuit also concluded that a specific intent to harm another is not necessary to establish malice, and that an act can be malicious even in the absence of personal hatred, spite or ill-will. Walker v. Hope (In re Walker), 48 F.3d 1116 (11 th Cir. 1995). But courts also have found that [m]alice requires conduct which is targeted at the creditor, at least in the sense that the conduct is certain or 13

16 almost certain to cause financial harm. In re Logue, 294 B.R. 59, 63 (B.A.P. 8 th Cir. 2003). This has posed problems for creditors relying upon section 523 (a)(6) where their collateral was improperly disposed of by the debtor. In In re Logue, 294 B.R. 59 (B.A.P. 8 th Cir. 2003), for example, the debtor sold certain cattle that served as collateral in violation of the security agreement, and used the sale proceeds to feed and maintain the remaining herd rather than delivering the proceeds to the creditor. The debtor also failed to pursue other possible financing options. The appellate panel found that the bankruptcy court had properly weighed the evidence in concluding that the creditor had failed to meet its burden of establishing malice on the part of the debtor, explaining that: Debtors who wilfully break security agreements are testing the bounds of their right to a fresh start. But unless they act with malice by intending or fully expecting to harm the economic interests of the creditor, such a breach of contract does not, in and of itself, preclude a discharge.... A debtor s retention of proceeds of sales of collateral, while clearly a breach of a security agreement, is not enough to establish malice. Where a debtor has used the proceeds in an attempt, albeit unsuccessful one, to keep a business afloat, malice may not necessarily be inferred from the debtor s conduct. 294 B.R. at 63 (citations omitted). Similarly, in C.I.T. Financial Services, Inc. v. Posta (In re Posta), 866 F.2d 364 (10 th Cir. 1989), the creditor argued that a debt, secured by a mobile travel trailer, was nondischargeable under section 523(a)(6) because the debtors sold the trailer (for a small amount of cash and a promissory note) in violation of the security agreement. The creditor argued that, because the debtors intentionally sold the trailer, and because the sale was in violation of the security agreement and ultimately harmed the creditor, the malicious element was satisfied. The Tenth Circuit rejected this argument, reasoning that: Were we to accept CIT s argument, nearly any intentional conduct would fall within this exception to discharge, and the word malicious in this section would be rendered meaningless. Statutes should be construed to give effect to every word Congress has used. Although we agree that conduct which 14

17 violates the rights of a creditor is wrongful, we refuse to infer that it is, by its very nature, malicious. Instead, the focus of the malicious inquiry is on the debtor s actual knowledge or the reasonable forseeability that his conduct will result in injury to the creditor, not on abstract and perhaps moralistic notions of the wrongfulness of the debtor s act. 866 F.2d at 367 (citations omitted). The court then explained that a debtor s malicious intent can be shown in two ways: In the rare instances in which there is direct evidence that the debtor s conduct was taken with the specific intent to harm the creditor, the malice requirement is easily established.... More commonly, however, malicious intent must be demonstrated by evidence that the debtor had knowledge of the creditor s rights and that, with that knowledge, proceeded to take action in violation of those rights.... Such knowledge can be inferred from the debtor s experience in the business, his concealment of the sale, or by his admission that he has read and understood the security agreement. 866 F.2d at 367 (citations omitted). The court pointed out that the debtors in that case were inexperienced in business matters, had difficulty in understanding business concepts, and had not read the security agreement. In addition, the court noted that the debtors did not conceal the sale from CIT (the creditor), and that they intended to fulfill their loan obligations to CIT by applying to that loan the proceeds of the note that they had received upon sale of the trailer (which proceeds, unfortunately, were never received because the maker defaulted on the note). The court affirmed the order of the district court which found that the conversion of CIT s property was not malicious. A number of courts have found that transfers in breach of a security agreement did give rise to nondischargeable liability when the debtor s conduct was knowing and certain to cause financial harm. See, e.g., United States v Recker (In re Recker), 180 B.R. 540 (E.D. Mo. 1995) (debtor s conversion of crop proceeds in which government held a perfected security interest constituted willful and malicious injury, such as would warrant excepting debt from discharge); First of America Bank v. Afonica (In re Afonica), 174 B.R. 242 (Bankr. N.D. Ohio 1994) (debt secured by automobile which debtor transferred for scrap excepted from discharge as one for debtor s willful and malicious injury to property of the secured creditor). But unless the creditor can show that the debtor knew that a transfer of the 15

18 property was wrongful and substantially certain to cause financial harm to the creditor, the debt likely will be dischargeable. As one commentator cautions, [c]ourts must be careful not to equate a breach of contract, which happens to be a security agreement, with conduct causing willful and malicious injury. 4 Collier on Bankruptcy [3] (15 ed. Rev. 2005). It should be noted that section 523(a)(6), via incorporation by cross-reference, applies to cases brought under Chapters 7, 11 and 12. In addition, it applies to cases brought under Chapter 13, but only those Chapter 13 cases where a discharge is granted to a debtor who has not completed payments under the plan. In those Chapter 13 cases where a full compliance discharge is granted, one must consider new section 1328(a)(4), which was added by the 2005 amendments. Section 1328(a)(4) is similar to section 523(a)(6), but differs in three major respects. First, section 1328(a)(4) speaks of willful or malicious injury, which is a different standard than that contained in section 523(a)(6), which requires that the debt be the result of a willful and malicious injury. Second, section 1328(a)(4) applies only to damages for personal injury or wrongful death, and not to damages relating to property. Finally, section 1328(a)(4) speaks of damages awarded in a civil action, making it unclear whether a debt would be nondischargeable if the debtor can manage to complete the Chapter 13 plan before entry of a civil award. V. Reliance on Misrepresentations Section 523(a)(2), the most extensively invoked exception to discharge, covers two distinct types of fraudulent misrepresentation made by the debtor to induce the debt. Section 523(a)(2)(A) deals with conduct equivalent to common law fraud, and excludes from the discharge a debt for money, property, services, or new or renewed credit to the extent that it was obtained by false pretenses, a false representation or actual fraud. This covers most types of oral or written misrepresentations by the debtor, except for a statement respecting the debtor s or an insider s financial condition, which is specifically excluded by section 523(a)(2)(A). This form of representation, at least if it is made in writing, is dealt with in section 523(a)(2)(B), which is discussed below. (It appears that an oral statement of this kind 16

19 is not covered in either section 523(a)(2)(A) or (B), and so would not be a basis for exclusion from the discharge under section 523(a)(2)). Section 523(a)(2)(A) is augmented by a presumption set out in section 523(a)(2)(C), which deals with last-minute consumer spending sprees. Prior to 1995, the courts of appeals did not agree on the level of reliance that had to be demonstrated for a false representation to be dischargeable. Compare In re Allison, 960 F.2d 481 (5 th Cir. 1992) (a creditor need not prove that reliance was reasonable) with First Bank of Colorado Springs v. Mullet (In re Mullet), 817 F.2d 677 (10 th Cir. 1987) (reliance on false representation must have been reasonable under the circumstances). This conflict was settled by the Supreme Court in Field v. Mans, 516 U.S. 59 (1995), where the Court decided that, as section 523(a)(2)(A) does not prescribe a test for reliance, the common law standard of justifiable reliance is applicable. The inquiry is not whether reliance would have been reasonable to the hypothetical average person, but whether the falsity of the representation was or should have been readily apparent to the particular creditor to whom it was made. Justice Souter noted, though, that reasonableness is not irrelevant, for the greater the distance between the reliance claimed and the limits of the reasonable, the greater the doubt about reliance in fact... reasonableness goes to the probability of actual reliance. 516 U.S. at 76. Section 523(a)(2)(B) applies only to situations in which money, property, services, or new or renewed credit is obtained by a false written financial statement concerning the debtor or an insider. Here, section 523(a)(2)(B)(iii) specifically requires that the creditor must have reasonably relied on the false statement. In discussing why reasonable reliance is required in section 523(a)(2)(B), Justice Souter in Field v. Mans explained that it was because of the potential misuse of financial statements by creditors who know their bankruptcy law: The House Report on the Act suggests that Congress wanted to moderate the burden on individuals who submitted false financial statements, not because lies about financial condition are less blameworthy than others, but because the relative equities might be affected by practices of consumer finance 17

20 companies, which sometimes have encouraged such falsity by their borrowers for the very purpose of insulating their own claims from discharge. 516 U.S. at In determining whether a creditor s reliance on a debtor s false written financial statement was reasonable, courts have looked at the totality of the circumstances, taking into consideration various factors. See, e.g., Insurance Company of North America v. Cohn (In re Cohn), 54 F.3d 1108 (3d Cir. 1995); Coston v. Bank of Malvern (In re Coston), 991 F.2d 257 (5 th Cir. 1993); Sinclair Oil Corp. v. Jones (In re Jones) 31 F.3d 659 (8 th Cir. 1994). These factors are summarized in 4 Collier on Bankruptcy [2][d] (15 th ed. Rev. 2005) as follows: 1. whether there have been previous business dealings between the debtor and the creditor; 2. whether there were any warnings that would have alerted a reasonably prudent person to the debtor s misrepresentation; 3. whether minimal investigation would have uncovered the inaccuracies in the debtor s financial statement; and 4. the creditor s standard practices in evaluating creditworthiness and the standards or customs of the creditor s industry in evaluating creditworthiness. VI. Transforming a Non-Dischargeable Debt into a Dischargeable Obligation 1. Debts Incurred to Pay Taxes As part of the Bankruptcy Reform Act of 1994, section 523(a)(14) added to the category of nondischargeable debts a debt incurred to pay a tax to the United States that would be nondischargeable under section 523(a)(1). This provision was intended to facilitate the ability of individuals to borrow money to pay federal tax obligations by protecting those who extended credit to these individuals to pay their taxes. The 2005 amendments added section 523(a)(14A), which makes nondischargeable a debt incurred to pay a tax to a governmental unit, other than the United States, that would be nondischargeable under 18

21 paragraph (1). Therefore, if a debtor borrows money in order to pay a state or local tax, that debt is nondischargeable provided that the underlying tax also is nondischargeable under section 523(a)(1). New section 523(a)(14A) extends to creditors who extend credit to pay non-federal taxes the same protection against discharge that is given to creditors who extend credit to pay federal taxes. In both cases, now, the debtor is unable to transform a nondischargeable tax obligation into a dischargeable obligation. 2. Nondischargeable Debts and Settlement Agreements In Archer v. Warner, 538 U.S. 314 (2003), parties to a lawsuit alleging fraud settled the claim without a judgment on the fraud and with no mention in the settlement agreement of what should happen to the fraud claim in the event of bankruptcy. When the Warners failed to pay the first installment due under the settlement agreement and the Archers filed a lawsuit based on breach of contract, the Warners filed for bankruptcy. The bankruptcy court, the district court and the Court of Appeals for the Fourth Circuit all agreed that a contractual settlement that releases the defendant from liability on the underlying fraud claim transforms the nondischargeable fraud debt into a dischargeable contract claim. The Supreme Court disagreed. Prior to Archer, most bankruptcy and district court cases considering the issue of settled fraud claims held that the settlement debt was nondischargeable in bankruptcy, so long as the debtor could prove that fraud actually occurred. See, e.g., Giamo v. Detrano (in re Detrano), 266 B.R. 282, 286 (Bankr. E.D. N.Y. 2001), aff d, 326 F.3d 319 (2d Cir. 2003) (citing U.S. v. Spicer, 57 F.3d 1152 (D.C. Cir. 1995)); see generally Radwan, Domino Effect: The Continued Existence of Liability for Fraud in Bankruptcy Despite Good-Faith Settlement by the Honestly Unfortunate Settlor, 53 Cath. L. Rev. 81, 90 (2003). The circuit courts of appeals, however, were more divided. Some of these courts of appeals found that the settlement agreement, in which the creditor grants the obligor a release in consideration of the obligor s promises under the settlement agreement, constitutes a novation of the original obligation. Under this novation theory, the settlement agreement has the effect of transforming the original, potentially nondischargeable claim based on the alleged wrongful 19

22 conduct into a dischargeable claim. See, e.g., Archer v. Warner (In re Warner), 283 F.2d 230 (4 th Cir. 2001); In re West, 22 F.3d 775 (7 th Cir. 1994); Key Bar Invs., Inc. v. Fischer, 116 F.3d 388 (9 th Cir. 1997). Other circuit courts of appeals, however, believed it appropriate to analyze the circumstances behind the settlement agreement and to focus on the substance of the original obligation to accurately determine whether the debt had been obtained through fraud. See, e.g., United States v. Spicer (In re Spicer), 57 F.3d 1152 (D.C. Cir. 1995); Fuller v. Johannessen (In re Johannessen), 76 F.3d 347 (11 th Cir. 1996). See also Ed Schory & Sons, Inc. v. Francis (In re Francis), 226 B.R. 385 (B.A.P. 6 th Cir. 1998). The Supreme Court in Archer resolved this split between the courts of appeals. While conceding that the settlement agreement and releases may have worked a kind of novation, the Court concluded that this did not bar the Archers from showing that the settlement debt arose out of false pretenses, a false representation, or actual fraud and so was nondischargeable. 538 U.S. at 323. Thus, even though the settlement agreement did create a new contractual obligation, the debt retained its character as a debt arising from the allegedly wrongful conduct of the debtor; the debt could still amount to a debt for money obtained by fraud. Therefore, it could properly be the subject of an inquiry as to its dischargeability under section 523(a)(2). It should be noted that, without expressing an opinion on the issue, the Court in Archer did remand the case for further consideration of the debtor s argument that the release in the settlement agreement included a promise by the Archers that they would not make a claim of nondischargeability in a bankruptcy proceeding, as well as the argument that, under North Carolina law, dismissal of the original fraud action with prejudice barred the Archers from making their present claim on grounds of collateral estoppel. VII. Audits and Revocation of Discharge 1. Audits BAPCPA added new provisions in 28 U.S.C. 586(f) which require audits of cases designated by the United States trustee in accordance with procedures established under 20

23 section 603(a) of Public Law No The purpose of these audits is to determine the accuracy, veracity and completeness of the petitions, schedules and other information individual debtors are required to provide in Chapter 7 and Chapter 13 cases. Congress has given the U.S. Trustee Program (USTP) the task of implementing many of BAPCPA s new provisions, including the supervision of these audits, and the USTP has established working groups to develop implementation plans. The Acting Director of the Executive Office for U.S. Trustees has written that the USTP is committed to implementing the new legislative changes as smoothly as possible, that he looks forward to working with all participants in the bankruptcy community in this endeavour, and that he anticipates sharing more news regarding bankruptcy system improvements in the months ahead. See White, Bankruptcy Reform Implementation Now Underway at the USTP, 24-JUN Am. Bankr. Inst. J. 14 (2005). At this point, I obtained the following information from the USTP: United States Trustee Program Implementation of Debtor Audits under the Bankruptcy Abuse Prevention and Consumer Protection Act The U.S. Trustee Program is preparing to assume its new responsibilities in supervising random and targeted audits of an individual s bankruptcy documents. The Program s Civil Enforcement Unit, located within the Program s Executive Office in Washington D.C., is directing the planning and implementation efforts and will have oversight for the Program in this area of responsibility. The Program s regional offices and field offices will also assist in the process. The debtor audit provisions of the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) take effect 18 months after enactment, or on October 20, Individual Chapter 7 and Chapter 13 cases will be subject to audit. The United States Trustee for each judicial district is authorized to contract with auditors to perform the audits of the debtors bankruptcy documents. The auditors will be independent Certified Public Accountants or licensed Public Accountants. The BAPCPA requires two types of audits random and targeted. 21

24 A random audit will be conducted in no less than one out of every 250 cases. The United States Trustee field office in the district in which the debtor filed will send the debtor s attorney, or the debtor if unrepresented, a letter notifying the debtor that the case has been selected for audit within 7 days of petition filing. The debtor has 21 days to respond and provide the requested materials to the auditor. Once the debtor s response to the audit request is deemed complete, the auditor has 21 days to conduct the audit and issue the audit report. The auditor files the report with the court. The clerk of court sends notice to all creditors if the auditor files a report indicating the debtor made material misstatements. Documents potentially subject to audit include the petition, schedules, statement of financial affairs, statement of current monthly income, list of creditors and the chapter 13 plan. The new law provides that it is grounds to revoke a discharge if a debtor does not explain satisfactorily a failure to make available for inspection all necessary accounts, papers, documents, financial records, files and other papers that are requested in connection with an audit. 2. New Section 727(d)(4) Section 727(d) sets out various grounds under which the trustee, a creditor, or the United States trustee may, after notice and a hearing, request that the court revoke a discharge. The grounds for revocation include: (1) the discharge was obtained through the debtor s fraud, and the party requesting the revocation was unaware of the fraud until after the granting of the discharge [section 727(d)(1)]; (2) the debtor acquired property that is property of the estate, or became entitled to obtain property that would be property of the estate, and knowingly and fraudulently failed to report this acquisition of or entitlement to the property, or to deliver or surrender the property to the trustee [section 727(d)(2)]; (3) the debtor committed an act specified in section 727(a)(6) (failure to obey a lawful order of the court or to respond to a material question approved by the court or to testify) [section 727(d)(3)]. Section 727(e) provides that a request for revocation of a discharge under section 22