Articles Posted in Exceptions to Discharge

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Microsome at the German language Wikipedia [GFDL (http://www.gnu.org/copyleft/fdl.html) or CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0/)], via Wikimedia CommonsAn extravagant lifestyle was not enough to overcome the presumption that debts incurred prior to filing for bankruptcy, including tax debts, are dischargeable, according to the Ninth Circuit. Hawkins v. Franchise Tax Bd. of California, No. 11-16276, slip op. (9th Cir., Sept. 15, 2014). The court considered whether the debtor’s tax debt was not subject to discharge under the exception for “willful[] attempt[s]…to evade such tax.” 11 U.S.C. § 523(a)(1)(C). After noting that the question of the mental state required to prove a “willful attempt to evade tax” was a matter of first impression, it held that the statute requires proof that a debtor specifically intended to evade tax liability. The debtor’s spending prior to filing bankruptcy, while “lavish,” was not out of the ordinary for him, and the tax debt was therefore dischargeable in bankruptcy.

The debtor made a substantial amount of money in the technology industry. He was an early employee of Apple, which he left to found the software and video game company Electronic Arts (EA). In 1990, he left EA to run a newly-created EA subsidiary called 3DO, which was entering into the video game and console market. By 1996, his net worth was around $100 million. He sold much of his EA stock and invested in 3DO. The Ninth Circuit’s opinion describes a series of accounting techniques using offshore corporations in order to claim losses on the sales of EA stock.

3DO filed for Chapter 11 bankruptcy in 2003 and later converted the case to a Chapter 7 liquidation. The debtor never received any substantial payouts from the liquidation of the business. The IRS began challenging his tax shelters in the late 1990s, and in 2005 it and the California Franchise Tax Board (FTB) assessed a total balance of over $36 million in unpaid taxes, penalties, and interest. The debtor sold some real property and applied all of the proceeds to the IRS balance in 2006, and the FTB also seized some financial accounts. In September 2006, the debtor and his wife filed for bankruptcy. The IRS and FTB filed proofs of claim for $19 million and $10.4 million, respectively. Continue reading

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OpenClips [Public domain, CC0 1.0 (http://creativecommons.org/publicdomain/zero/1.0/deed.en)], via PixabayA federal district court in California considered a request to discharge federally guaranteed parent loans, which the debtors took out to pay for one of their children’s education. In re Mees, No. 2:13-cv-01892, order (E.D. Cal., Jul. 22, 2014). Student loan debt is not dischargeable in bankruptcy except in rare case of “undue hardship.” 11 U.S.C. § 523(a)(8). The bankruptcy court ruled that the parent loans were not dischargeable, applying the same legal standard used for student loans. The debtors appealed, arguing in part that the bankruptcy court erred in applying this standard. The district court considered this question but ultimately remanded the case to the bankruptcy court, finding that it applied the test incorrectly.

The debtors, a married couple, took out federally guaranteed parent loans for their son, the older of two, to pay for his college education. Parent loans, known as PLUS Loans, typically have a much higher borrowing limit and might be used to cover any gaps in financial aid available directly to the student. Unlike a student loan co-signed by parents, the student is not liable on a PLUS loan. No payments are due until the student completes or leaves school.

The debtors’ son never completed his degree. The balance of the parent loans is about $35,000. By the time of the court’s ruling, both of the debtors had been unemployed for substantial periods of time:  three years for the husband and 30 years for the wife. Their younger son is still a minor. The debtors filed for Chapter 7 bankruptcy in September 2011. They filed an adversary proceeding several months later, seeking discharge of the parent loans. The bankruptcy court ruled against them, citing the three-prong test for determining “undue hardship,” known as the Brunner test after Brunner v. New York State Higher Educ. Svcs., 831 F.2d 395 (2d Cir. 1987). Continue reading

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By Viriditas (Own work) [CC-BY-SA-3.0 (http://creativecommons.org/licenses/by-sa/3.0) or GFDL (http://www.gnu.org/copyleft/fdl.html)], via Wikimedia CommonsA creditor filed an adversary proceeding in a Chapter 13 bankruptcy case, seeking an exception from discharge based on alleged fraud and willful and malicious injury. The creditor had been involved in a business venture with the debtor and made numerous allegations of accounting irregularities and financial misrepresentations. After a bench trial, at which the plaintiff-creditor presented expert testimony from a forensic accountant and a certified public accountant, the bankruptcy court held that the plaintiff did not meet his burden of proof under either claimed exception to discharge and ruled in favor of the defendant/debtor. In re Olsen, No. 2:13-bk-60733, memorandum (D. Mont., Aug. 28, 2014).

The facts of the case might be best summarized as a business venture where the parties had different understandings of the business relationship. The defendant was the majority shareholder of Human Interactive Products, Inc. (HIPinc), a “business incubator” engaged in a wide range of activities, known as as “profit centers,” under different trade names. HIPinc had a system, including accounting methods, for evaluating the performance of its profit centers.

The plaintiff, a native plant restoration specialist, approached the defendant about starting his own business in 2006. He accepted an offer of employment with HIPinc as “Operations Manager/Senior Restoration Ecologist” with a venture called Great Bear Restoration (GBR). The defendant would be his supervisor. The plaintiff did not contribute any capital towards GBR but received a salary from HIPinc. Continue reading

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Constant Wauters [Public domain], via Wikimedia CommonsBankruptcy offers relief to people and businesses in financial distress, allowing them to pay down debts over a period of time, or pay them down quickly by liquidating assets. A court may then grant a discharge of some unpaid debts. The bankruptcy process is not, however, supposed to give people a way out of debts incurred because of dishonest or unlawful acts. Congress has placed provisions in the Bankruptcy Code that except certain types of debt from discharge. A California district court recently considered the appeal of creditors who alleged that their claim against a debtor was excepted from discharge because it involved false pretenses. In re De Long, No. 2:14-cv-02947, order (E.D. Cal., Jan. 7, 2016).

The Bankruptcy Code bars a wide range of debts from discharge. 11 U.S.C. § 523(a). In some cases, such as child support obligations and student loans, an entire class of debt is excepted from discharge. Other exceptions are based on the manner in which the debtor incurred the debt, including debts for something of value “to the extent obtained by…false pretenses, a false representation, or actual fraud…” Id. at § 523(a)(2)(A). Creditors may ask a bankruptcy court to find that a debt is not subject to discharge under this section, after providing notice to all parties and conducting a hearing. Id. at § 523(c)(1).

The debtor in the De Long case owned and operated a construction company in Sacramento, California. The creditors, a married couple, hired the company to work on their home. The original contract between the parties, signed in June 2010, included a total project cost of $246,000 and a payment schedule. The creditors eventually paid the construction company a total of $189,400, but they hired another contractor in late 2011 to complete the job.

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debtsA bankruptcy court may grant a discharge of remaining debts at the end of a case, allowing a fresh start for the debtor. Certain debts, however, are not eligible for discharge. A bankruptcy judge in California recently considered a creditor’s argument that an alleged debt was nondischargeable on one or more fault-based grounds, since it was incurred as a result of fraud or false pretenses, fraud by a fiduciary, or willful and malicious acts resulting in injury. 11 U.S.C. §§ 523(a)(2)(A), (a)(4), (a)(6). The judge reviewed the standard of proof for each alleged ground and ruled that the creditor failed to provide sufficient evidence to support her claims. In re Ogilvie, No. 13-bk-31179, Adv. Proc. No. 13-ap-03221, mem. dec. (N.D. Cal., Feb. 23, 2015).

A debt involving something of value obtained through “false pretenses, a false representation, or actual fraud” is not dischargeable. 11 U.S.C. § 523(a)(2)(A). The Ninth Circuit, which includes California, uses a five-part test in this sort of claim:  (1) the debtor made statements or representations to the creditor, (2) which they knew at the time were false, (3) with fraudulent intent, (4) and the creditor reasonably relied on these statements or representations in making the transaction and (5) suffered damages as a result. In re Eashai, 87 F.3d 1082, 1086 (9th Cir. 1996). A creditor must establish each element by a preponderance of the evidence.

Debts incurred through fraud while acting in a fiduciary capacity are not dischargeable. 11 U.S.C. § 523(a)(4). A creditor has to prove, by a preponderance of the evidence, the existence of an express trust, the actual act of fraud, and the fiduciary relationship. In re Stanifer, 236 B.R. 709 (B.A.P. 9th Cir. 1999). Proving a trust requires evidence of a trust agreement, including “sufficient words to create a trust.” Ogilvie, mem. dec. at 9.

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mireyaqh [Public domain, CC0 1.0 (https://creativecommons.org/publicdomain/zero/1.0/deed.en)], via PixabayPersonal bankruptcy under Chapters 7 and 13 offer ways for people to obtain financial relief when their income is not high enough to continue making required payments on their debts. The federal Bankruptcy Code deals with different types of debt in different ways. The Bankruptcy Code establishes that certain types of debt have priority over others, and these creditors are therefore entitled to payment from the bankruptcy estate first. While many debts may be subject to discharge at the end of a personal or business bankruptcy case, some debts are expressly excepted from discharge, such as debts for recent taxes or child support obligations. However, these priority debts can be paid back via a Chapter 13 over a period of 3 to 5 years. Understanding how bankruptcy law treatss various types of debt is critical to planning and preparing for a bankruptcy filing.

Secured vs. Unsecured Debt

A key distinction in bankruptcy is between secured and unsecured debts. A secured debt has one or more specific items of property attached to it, known as collateral. See 11 U.S.C. § 506. A secured creditor has the right to take possession of the collateral if the debtor defaults on their repayment obligation. A mortgage, for example, is typically secured by the real property purchased with the mortgage loan.

Unsecured debt does not have collateral. The Bankruptcy Code divides unsecured debts into priority and nonpriority debts. 11 U.S.C. § 507. Many priority unsecured debts are also included in the list of debts excepted from discharge. 11 U.S.C. § 523.

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Unsplash [Public domain, CC0 1.0 (https://creativecommons.org/publicdomain/zero/1.0/deed.en)], via PixabayChild support, spousal support, and any other “domestic support obligation” (DSO), as defined by the Bankruptcy Code, are treated differently in a bankruptcy case from most other types of debt. DSOs have the highest priority for payment of any unsecured claim. 11 U.S.C. § 507(a)(1). They are excepted from discharge. Id. at § 523(a)(5). Property claimed as exempt under bankruptcy law could still be liable for DSO debts. Id. at § 522(c)(1). The bankruptcy trustee has additional duties when a creditor files a claim for amounts owed under a DSO.

The Bankruptcy Code broadly defines a DSO as any debt “owed to or recoverable by” a debtor’s spouse, ex-spouse, child, child’s parent or guardian, or governmental agency that is “in the nature of alimony, maintenance, or support,” and that is part of a court order or court-approved agreement. 11 U.S.C. § 101(14A). This includes orders for child support and spousal support under California law. See Cal. Fam. Code §§ 4000 et seq., 4330 et seq.

Courts around the country have found that other debts may meet the Bankruptcy Code’s definition of a DRO. These include an award of attorney’s fees in a proceeding for a modification of child support, In re Johnson, 445 B.R. 50 (Bankr. D. Mass. 2011); a duty to make mortgage payments on a former spouse’s residence, In re Westerfield, 403 B.R. 545 (Bankr. E.D. Tenn. 2009); and juvenile detention costs payable by a parent under state law, In re Rivera, 511 B.R. 643 (BAP 9th Cir. 2014). Courts found that each of these debts was excepted from discharge under § 523(a)(5). A monetary award that was part of the property division in a pre-bankruptcy divorce decree, however, was not a DRO, and therefore it was discharged at the end of the ex-husband’s Chapter 13 case. In re Mooney, 532 B.R. 313 (Bankr. D. Id. 2015).

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click [morgueFile license (http://www.morguefile.com/license/morguefile)], via morgueFileStudent loans present one of the greatest challenges for debtors in Chapter 7 and Chapter 13 personal bankruptcy cases. Federal law prohibits the discharge of almost all student loan debt, except when a debtor proves that denying a discharge would cause “undue hardship” to them and their dependents. 11 U.S.C. § 523(a)(8). Most courts have interpreted “undue hardship” very narrowly, using the three-part Brunner test. See Brunner v. N.Y. State Higher Educ. Servs. Corp., 831 F.2d 395 (2d Cir. 1987); In re Pena, 155 F.3d 1108 (9th Cir. 1998). While this has been the standard in most of the country for years, a few voices of dissent have emerged. A 2013 decision from the Ninth Circuit’s Bankruptcy Appellate Panel (BAP), for example, criticized the Brunner test as “too narrow,” stating that it “no longer reflects reality and should be revised.” In re Roth, 490 B.R. 908, 920 (BAP 9th Cir. 2013) (Pappas, J. concurring). Whether these voices have a lasting impact remains to be seen.

Most jurisdictions, including the Ninth Circuit, use the Brunner test, which requires a debtor to establish (1) that continued payment of the student loans would prevent them from maintaining even a basic standard of living, (2) that this state of affairs is likely to continue for the foreseeable future, and (3) that the debtor has attempted to make payments on the loans in good faith. Brunner, 831 F.2d at 396. Other jurisdictions use a “totality of the circumstances” test, which takes an individual debtor’s circumstances more into account. See In re Long, 322 F.3d 549 (8th Cir. 2003).

The “good faith efforts” requirement of Brunner can cause problems for debtors, since it invites a bankruptcy judge to second-guess how a debtor has prioritized debt payments before filing for bankruptcy. The term “good faith” is inherently ambiguous, which can also make it difficult to evaluate different debtors in different circumstances. This difficulty played a key role in the Roth case.

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By Government of California (Government of California) [Public domain], via Wikimedia CommonsA California federal district court ruled that fines assessed under a California law that allows employees to enforce state labor law as “private attorneys general” are not dischargeable in a Chapter 7 bankruptcy proceeding. Medina v. Poel, No. 1:14-cv-01302, order (E.D. Cal., Jan. 20, 2015). Federal bankruptcy law excepts certain fines and other penalties payable to a government entity from discharge. 11 U.S.C. § 523(a)(7). The debtor argued that any damages awarded in a lawsuit brought by an individual under the California Private Attorney General Act (PAGA), Cal. Labor Code § 2698 et seq., do not fit the definitions established in § 523(a)(7) and therefore should be subject to discharge. While the bankruptcy court agreed with the debtor, the district court reversed that holding, finding that PAGA provides for civil penalties that are excepted from discharge.

The creditor filed suit under PAGA against the debtor in state court in 2010 for alleged wage and hour law violations. PAGA allows employees to sue an employer for civil penalties for violations of state labor laws. The California legislature enacted PAGA in recognition of state officials’ inability to “keep pace with the sprawling and often ‘underground’ economy.” Medina, order at 5, citing Iskanian v. CLS Transp. Los Angeles, LLC, 59 Cal.4th 348, 379 (2014). It therefore decided to “deputize and incentivize employees uniquely positioned to detect and prosecute[] violations.” Id.

The state PAGA lawsuit was still pending when the debtor filed for Chapter 7 bankruptcy in August 2012. The debtor filed an adversary proceeding against the creditor. In a motion for summary judgment, the debtor claimed that any liability under the PAGA lawsuit was not excepted from discharge under § 523(a)(7), and that any liability had already been discharged by the general discharge issued by the bankruptcy court in June 2013. The bankruptcy court granted the debtor’s motion, and the creditor appealed to the district court. The two questions presented to the district court on appeal were whether the bankruptcy court erred in ruling that civil penalties under PAGA do not fall under the exception to discharge in § 523(a)(7), and whether the court erred in ruling that the creditor’s claims were already discharged.

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geralt [Public domain, CC0 1.0(http://creativecommons.org/publicdomain/zero/1.0/deed.en)], via PixabayA bankruptcy court reopened a Chapter 7 case after granting a discharge on the debtor’s motion, although not for the reason stated by the debtor. In re Sullivan, No. 11-38246-A-7, memorandum (Bankr. E.D. Cal., Feb. 23, 2015). The debtor asked the court to reopen the case in order to amend the schedules to include one or more creditors who had not been included at the beginning of the case. The court held that amending the schedules was not necessary under the circumstances, but it also noted that the creditors may be able to claim an exception to discharge under 11 U.S.C. § 523. The court reopened the case in order to allow the creditors the opportunity to challenge the discharge of their debts.

The debtor filed a Chapter 7 petition on July 26, 2011. The case was determined to be a “no asset” case, so no proofs of claim were requested from the creditors. The trustee was not able to find any nonexempt assets to liquidate and filed a “no distribution” report with the court. No creditor objected to the trustee’s report. The court ordered a discharge and closed the case. Since the case was a “no-asset, no-bar-date-case,” Sullivan, mem. at 1, any dischargeable debt was discharged by the court’s order, whether or not the debt was included in the schedules or the creditor received notice of the case. See 11 U.S.C. § 727(b).

At some point after the discharge and closing of the case, the debtor moved to reopen on the grounds that the schedules did not include one or more creditors and needed to be amended. Since the discharge affected all creditors, not just the ones listed on the schedules, the court held that amending the schedules was not necessary. The court noted that a procedure exists for creditors who did not have the opportunity to object to discharge, but it held that amending the schedules would not address that issue.

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