Leverage is the key component when working through a troubled loan. Both creditors and debtors attempt to maximize their respective positions during a “workout” in order to achieve their desired result. However, too many times a debtor overplays his hand by threatening to file for bankruptcy, or actually filing for bankruptcy. In negotiating with a debtor in a distressedsituation a creditor should not fear a bankruptcy filing. In fact, if handled correctly, a creditor can gain an advantage when a debtor eludes to his/her willingness to file for bankruptcy by understanding, among other things, how to carve out the creditor’s debt from the debtor’s discharge.
TYPES OF BANKRUPTCY DISCHARGES
Nondischargeable debts fall into two categories: (1) debts incurred because of the debtor’s misconduct; or (2) priority payments considered by Congress to be non-nondischargeable in bankruptcy.
DEBTS THAT SURVIVE IF A CREDITOR SUCCESSFULLY CHALLENGES ITS DISCHARGE
Debts incurred because of the debtor's dishonesty, fraud, larceny, embezzlement, or wilful or malicious behavior are generally not dischargeable. However, it is vitally important for a creditor to challenge the discharge of its debt by filing an adversary complaint within 60 days of the debtor’s first creditors’ meeting. This is a firm deadline. If a creditor fails to comply with this requirement, it waives its claim. The dischargeability of the debtor’s debt will be determined at a hearing akin to a civil trial.
Obligations Based on Fraud [§523(a)(2)]
If a debtor obtained credit through a fraudulent representation, then the debt is nondischargeable. Section 523(a)(2) provides general unsecured creditors their most potent tool to prevent a discharge. A creditor should carefully analyze their debtor’s credit application, since it is fairly common that a borrower may provide false information on his/her credit application— particularly about their income. This can provide a creditor with the ability to object to a debtor’s dischargeability.
If the debtor obtained credit based on false pretenses or representations, or actual fraud, then the debt is not dischargeable under §523(b) if the false information was material in assessing the debtor's financial condition.
There are 4 elements commonly required to prove fraud:
Debtor made a false representation of a material fact;
Debtor knew it was false and made the false statement with intent to deceive;
Creditor justifiably relied on the misinformation; and
Debtor caused injury by not repaying the loan before filing for bankruptcy.
If the false information was about the debtor's financial condition, then §523(b) attempts to prevent a debtor from not obtaining a discharge for simple mistakes on the loan or credit application.
It must be in writing;
It must be materially false;
Debtor's intention was to deceive; and
Creditor must have reasonably relied upon it.
Although the burden of proof is generally on the creditor to prove fraud, §523(c) establishes a presumption of fraud if the debt was incurred shortly before bankruptcy. In a creditor finds itself with this fact pattern, then the burden is placed on the debtor to rebut the presumption that the debt was not obtained fraudulently. Much of the litigation in this area depends upon what constitutes luxury goods and services, since the Bankruptcy Code only specifies that it does not include goods or services reasonably necessary for the support of either the debtor or the debtor's dependent.
Creditors should know that the Bankruptcy Code also attempts to discourage frivolous challenges by creditors. Section 523(d) allows the court to award attorney fees to the debtor if the nondischargeability action was not substantially justified, and if it would not otherwise be unjust to award such fees.
Debts Due to the Debtor's Dishonesty as a Fiduciary, or From Embezzlement or Larceny [§523(a)(4)]
If the debtor obtained funds by embezzlement or larceny, i.e., theft, or if the debtor was a fiduciary and took funds through fraud or defalcation, then the debt is not dischargeable.
Debts for Wilful or Malicious Injury [§523(a)(6)]
Debts incurred because of the wilful and malicious injury to an entity or their properties are excluded from discharge. Wilful means that the debtor intended the act and was not just negligent. Malicious means that the consequences of the act were also intended.
DEBTS THAT AUTOMATICALLY SURVIVE BANKRUPTCY
This article will not discuss in detail debts that automatically survive bankruptcy, except to inform the reader that these exceptions exist. These exceptions rarely (if ever) apply to armslengths commercial business transactions.
Priority Taxes [§523(a)(1)]
Generally, unpaid taxes for timey filed returns that were due within 3 years of the bankruptcy filing are nondischargeable. Also, for returns that were filed late, within 2 years of the bankruptcy, taxes that were not paid because the debtor did not file a return, filed a fraudulent return, or tried to evade the tax are not dischargeable.
Unlisted or Unscheduled Debts [§523(a)(3)]
If a debtor did not list a creditor in his bankruptcy schedules, then the debt may survive the bankruptcy and is not discharged unless the creditor learned, in some other way, about the bankruptcy soon enough to file a claim or to challenge the discharge of its debt. If a debtor already received the discharge or the creditor had grounds to challenge the discharge but was time barred because it learned of the bankruptcy too late, then the debt is not dischargeable. Some court’s have adopted a “no harm, no foul” approach when applying this rule. In other words, some courts will still grant a debtor a discharge for debts not listed on their schedules, if a creditor cannot show that it was prejudiced by its lack of notice.
Domestic Support Obligations [§523(a)(5)]
Domestic support obligations are never dischargeable. The Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) have elevated domestic support obligations as the top priority payment, even higher than the administrative expenses of the trustee in the bankruptcy case. Domestic support obligations include maintenance, alimony, and child support. However, the payments must actually be for support and not simply characterized as such.
Government Fines, Penalties, and Forfeitures [§523(a)(7)]
Government fines, penalties, and forfeitures that were assessed, not as compensation fornpecuniary loss, but to punish the debtor are also not dischargeable.
Educational Loans and Benefits [§523(a)(8)]
Debts incurred to finance education are not dischargeable, unless the debtor can prove that henwould suffer an undue hardship without the discharge. If the court decides that the education loans are an undue hardship, then the court can either allow the entire debt to be discharged, or it can lower the amount of the debt or payments so that it would no longer be a hardship.
Liability for Driving Under the Influence of Drugs or Alcohol [§523(a)(9)]
Liability for injuries or death resulting from driving while under the influence of alcohol or other drugs is not dischargeable.
Prior Debts Where Discharge Was Waived or Denied in a Prior Case [§523(a)(10)]
If the debtor had filed bankruptcy before and either waived the discharge of a particular debt or was denied a discharge on grounds of §§727(a)(2) – (7), , then the debt is forever nondischargeable.
Order of Restitution Payments in Federal Cases [§523(a)(13)]
Payments required by an order for restitution resulting from a conviction of a crime in a federal case.
Matrimonial Debts that are not Domestic Support Obligations [§523(a)(15)]
Any debts incurred as the result of a divorce decree or separation or property settlement are nondischargeable.
A creditor can use the bankruptcy courts to their advantage. Not all commercial debts can be discharged by a bankruptcy petition. A creditor that knows that a bankruptcy petition is not an ideal option for a borrower, can, and should exploit this fact while negotiating a workout. If you would like more information relating to nondischargeable debts or any other banking or finance need, please do not hesitate to contact me at email@example.com or by phone at 312-428-2740.
Very truly yours,
Adam B. Rome