WHAT IS AN ADVERSARIAL PROCEEDING IN BANKRUPTCY?
WHAT IS AN ADVERSARIAL PROCEEDING IN BANKRUPTCY?
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WHAT IS AN ADVERSARIAL PROCEEDING IN BANKRUPTCY?

| Oct 3, 2018 | Firm News

In 2005, past laws were significantly affected by the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”).

First, understanding the Bankruptcy Discharge is important.

The primary goal for most bankruptcy cases is the discharge of debt. The process begins when a debtor files a bankruptcy petition and fully discloses all assets and liabilities. Additionally, the debtor provides disclosure of certain financial information such as transfers of property, history and sources of income, lawsuits involving the debtor, and all other pertinent information that assists creditors and the bankruptcy trustee in analyzing the case. In exchange for compliance, and absent any other issues, a debtor typically receives a discharge of debts.

Chapter 7 discharge orders are granted pursuant to authority of 11 U.S.C. § 727.

Chapter 13 discharge orders are granted pursuant to authority of 11 U.S.C. § 1328(a) (discharge after completion by the debtor of all payments under the plan), or §1328(b) (discharge by other circumstances); the difference between “a” and “b” are significant, as explained in more detail below.

However, a discharge of certain debts and liabilities can be contested in a bankruptcy.  How can a creditor obtain a “no discharge” of his debt?  This can be achieved by what is called an “Adversarial Proceeding” in the bannkruptcy matter; a lawsuit within. What are the circumstances in which a creditor or trustee can bring an Adversarial Proceeding in a bankruptcy matter against a debtor?

Section 523(a)(2)(A): False Pretenses

Section 523(a)(2)(A) excepts from discharge any debt for money to the extent obtained by false pretenses. A creditor must show that the debtor’s actions were purposefully deceptive or misleading. Courts infer requirements establishing intent, reliance and materiality.

To provide that a debtor acted by false pretenses, the objecting creditor must show the following: (1) an implied misrepresentation or conduct by the debtor; (2) promoted knowingly and willingly by debtor; (3) to create a contrived and misleading understanding of the transaction on the part of the objecting creditor; and (4) which wrongfully induced plaintiff to advance money, property, or credit to the debtor. The frauds covered by this concept are those which in fact involve moral turpitude or intentional wrong.

Section 523(a)(2)(A): False Representation

Section 523(a)(2)(A) excepts from discharge any debt for money to the extent obtained by false representation. A creditor must show that the debtor’s actions were purposefully deceptive or misleading. Courts infer requirements establishing intent, reliance and materiality.

To provide that a debtor acted by false representation, the objecting creditor must show the following: (1) debtor made an express false or misleading statement; (2) with the intent to deceive; (3) on which the creditor justifiable relied; (4) in order to induce the creditor to turn over money or property to the debtor; and (5) that resulted in a loss to creditor caused by the false representation.

Section 523(a)(2)(A): Fraud

Section 523(a)(2)(A) excepts from discharge any debt for money to the extent obtained by “actual fraud.” The term “actual fraud” means common law fraud. A creditor must show that the debtor’s actions were purposefully deceptive or misleading. Courts infer requirements establishing intent, reliance and materiality.

To provide that a debtor committed “actual fraud,” the objecting creditor must show the following: (1) a representation made by debtor to the objecting creditor; (2) debtor’s knowledge of the falsity when the representation was made; (3) debtor’s intent to deceive in making such representation; (4) creditor’s justifiable reliance; and (5) creditor’s damage as a result. A creditor must plead and prove each element of fraud in order to sustain a finding that a debt is nondischargeable, including intent on the part of the debtor to deceive at the time the debt was created.

Section 523(a)(2)(B): False Representation

Section 523(a)(2)(B) excepts from discharge any debt for money, propety, services, or an extension, renewal, or refinancing of credit, to the extent obtained by false representation or fraud. To prove a Section 523(a)(2)(B) claim, a creditor must show the following: (1) debtor made a statement in writing; (2) that is materially false; (3) respectinng the debtor’s or an insider’s financial condition; (4) on which the creditor to whom the debtor is liable for such money reasonably relied; and (5) that the debtor caused to be made or published with intent to deceive.

Section 523(a)(4): Fraud or defalcation while acting in a fiduciary capacity

Section 523(a)(4) provides an exception to the general discharge provisions. Pursuant to §523(a)(4), a discharge under Section 727 does not discharge an individual debtor from any debt for fraud or defalcation while acting in a fiduciary capacity. An objecting creditor must plead and prove the following to except debts from discharge: (1) debtor acted in a fiduciary relationship when the alleged wrongful acts giving rise to the objecting creditor’s claim occurred; and (2) debtor committed fraud or defalcation.

Defalcation requires a showing of conscious misbehavior or extreme recklessness. Such a standard ensures that the term defalcation complements but does not dilute the other terms of the provision — fraud, embezzlement, and larceny –– of which require a showing of actual wrongful intent.

Section 523(a)(4): Embezzlement

Section 523(a)(4) provides an exception to the general discharge for debtors who embezzle assets of an objecting creditor. Courts look to the federal common law definition of embezzlement for purposes of non-dischargeability as the fraudulent appropriation of property by a person to whom such property has been entrusted, or into whose hands it has lawfully come.

To establish a claim of embezzlement under §523(a)(4), a creditor must show that (1) property owned by another is rightfully in the possession of debtor; (2) debtor’s appropriation of such property to a use other than the use for which the property was entrusted to debtor; and (3) circumstances indicating fraudulent intent. Absent intent to defraud, a debtor’s appropriation of funds does not arise to the level of embezzlement.

Section 523(a)(4): Larceny

Section 523(a)(4) provides an exception to the general discharge for a debtor who wrongfully takes the assets of an objecting creditor. Larceny is distinguishable from embezzlement because in larceny, the original taking of the property must be unlawful. Where payments are lawfully received pursuant to a contract, larceny cannot exist for purposes of excepting a discharge.

In re Ormsby, 591 F.3d 1199 (9th Cir. 2010). The debtor argued that summary judgment was inappropriate because a state court judgement against debtor for larceny should not preclude debtor from contending that debtor did not commit larceny within the federal definition of the term. The 9th Circuit disagreed and held that summary judgment against debtor was appropriate because the state court judgment was sufficient to preclude relitigation of whether debtor’s conduct meets the requirements of Section 523(a)(4).

The court cited Collier on Bankruptcy, which states that for purposes of Section 523(a)(4), a bankruptcy court is not bound by the state law definition of larceny but, rather, may follow federal common law, which defines larceny as a “felonious taking of another’s personal property with intent to convert it or deprived the owner of the same.”

The 9th Circuit determined that it was not bound to the state court’s judgment. Nevertheless, the 9th Circuit found that the state court judgment provided enough information to determine that debtor’s action amounted to fraud, since “intent may properly be inferred from the totality of the circumstances and the conduct of the person accused. Citing Kaye v. Rose (In re rose), 934 F.2d 901, 904 (7th Cir. 1991).

Section 523(a)(6): Willful and malicious injury

Section 523(a)(6) prevents an individual debtor from discharging any debt that is the result of willful and malicious injury. The terms “willful” and “malicious” are separate elements. An objecting creditor must prove both elements in order for the discharge to be excepted.

Speaking to the “willful” element, the Supreme Court specifically rejected a broad interpretation of the exception by narrowly holding that “non-dischargeability takes a deliberate or intentional injury, not merely a deliberate act that leads to injury.” Kawaaukau v. Geiger, 523 U.S. 57 (1998). The injury itself must be desired and in fact anticipated by the debtor in order or for the debt to be excepted from discharge. Thus, debts arising from recklessly or negligently inflicted injuries do not fall within the compass of §523(a)(6).

The term “malicious” refers to the debtor’s motivation in committing the act and has been defined by the court to mean wrongful and without just cause or excuse, even in the absence of personal hatred, spite, or ill-will. Actual or constructive malice will suffice and may be imputed to the debtor in cases where a debtor seeks profit or some other benefit only upon a finding of aggravated circumstances. See In re Ormsby, 591 F.3d 1199 (9th Cir. 2010).

Section 727(a)(3): Failure to Produce Financial Records

Section 727(a)(3) states that the court shall grant the debtor a discharge unless the debtor has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor’s financial condition or business transactions might be ascertained, unless the failure to act was justified under all of the circumstances of the case.

The purpose of §727(a)(3) is to give a creditor and the court complete and accurate information concerning the status of the debtor’s financial affairs and to test the completeness of the disclosure requisite of a discharge. The policy served by debtor’s disclosure obligations is to give unsecured and undersecured creditors the ability to trace a debtor’s financial history to determine whether they are being treated fairly.

The elements of a §727(a)(3) claim that must be proved by a preponderance of the evidence are as follow: (1) the creditor must prove that the debtor failed to keep or preserve records; and (2) such failure was not reasonably under the circumstances and this failure makes it impossible to ascertain the debtor’s true financial condition or business transactions. All records that are necessary to understand a debtor’s financial condition are within the scope of this section. All books and materials which shed light on what was done with a debtor’s bankruptcy estate and the factors which led to the filing for relief are material to a §727(a)(3) analysis.

Section 727(a)(4)(A): False Oath or Account

Section 727(a)(4)(A) provides that the court shall grant the debtor a discharge, unless the debtor knowingly and fraudulently, in or in connection with the case, made a false oath or account. Examples of these false oaths relating to the bankruptcy schedules include: understating income, over stating expenses, intentionally omitting assets, intentionally omitting debts owed to creditors, or failing to identity fraudulent conveyances or preferential transfers.

A party objecting to a debtor’s discharge must allege and prove the following: (1) the debtor made a statement under oath; the statement was false; (3) the debtor knew the statement was false; (4) the statement was made with fraudulent intent; and (5) the statement related materially to the bankruptcy case.

Section 727(a)(4)(B): False Claim

Section 727(a)(4)(B) prohibits the granting of a discharge to a debtor who knowingly and fraudulently presented or used a false claim in or in connection with a bankruptcy case.

This provision of the code is utilized infrequently. The courts that have considered objections to discharge for presenting a false claim have required the objecting party to prove that the debtor presented or used an inflated or fictitious claim. Such cases generally involve the scheduling of non-existent debts, the scheduling of inflated debts, or the filing by the debtor of a false proof of claim.

A §727(a)(4)(B) violation requires both intentionality and materiality to be actionable. At least one bankruptcy court has denied a debtor’s discharge where the court found that the overstatement of a secured claim was a material falsity because it created a mistaken belief that the liens against the debtor’s residence exceeded it fair market value.

Section 727(a)(6)(A): Failure to obey a court order

Section 727(a)(6)(A) provides that the court shall grant the debtor a discharge, unless the debtor has refused to obey any lawful order of the court, other than an order to respond to a material question or to testify. Given the plain language of the statute that debtor “refuse” to obey a court order, it appears that “mere failure” to obey is insufficient to justify the harsh sanction of denial of a discharge imposed by §727. Consequently, discharge should only be denied where the debtor’s noncompliance with a court order was a result of willful, intentional disobedience or dereliction rather than mere inadvertence or mistake.

Burden of proof in an Adversarial Proceeding.

The party seeking to bar a debtor from discharge under Section 727 and concomitant “fresh start” has the burden of proof. That party must articulate well-pleaded allegations establishing the required elements for the denial of discharge under one or more provision of the U.S. Bankruptcy Code. The creditor or trustee objecting to a debtor’s discharge carries the burden of proof because of the draconian relief sought. The courts strictly construe against objecting creditors and liberally construe in favor of the debtor.

Exceptions to discharge under Section 523 must be similarly construed so as to give maximum effect to the Code’s policy of providing honest but unfortunate debtors with a “fresh start.” To sustain a cause of action under either §727 or §523, the creditor must establish each element of the statue by a preponderance of the evidence. Grogan v. Garner, 498 U.S. 279 (1991).

Discharge of Debts in a Divorce and Adversarial Proceedings

The Bankruptcy Code has several specific provisions that relate to family law and divorce issues. As with all things related to bankruptcy since 2005, the past laws were significantly affected by the enactment of the Bankruptcy Abuse Prevention and Consumer Protection Act (“BAPCPA”). These broad changes expanded the law in some very important ways.  As part of the BAPCPA and the recognition by Congress that “the economic protection of dependent spouses and children under state law is no longer accomplished solely through the traditional mechanism of support and alimony payments,” §523(a)(15) was revamped. The law was significantly changed to further the underlying public policy of §523, favoring the enforcement of familial obligations over the Bankruptcy Code’s “fresh start policy.” The law applies to all bankruptcy cases filed on or after October 17, 2005.

Focus is on the dischargeability of various divorce related debts in bankruptcy, including attorney fees, as well as the timing of filing a petition in bankruptcy for divorcing (or divorced) couples.

However, certain debts are not dischargeable under the Bankruptcy Code. With respect to divorce related debt, there are two specific provisions that apply. Under 11 U.S.C. Section 523(a)(5) certain “support” debts (payments) are non-dischargeable.

11 U.S.C. § 1328 (a) provides, as here relevant:

(a) … the court shall grant the debtor a discharge of all debts provided for by the plan …except any debt– … (2) of the kind specified in section 507(a)(8)(C) or in paragraph (1)(B), (1)(C) , (2) , (3) , (4) , (5) , (8) , or (9) of section 523(a) ; …

Exceptions to discharge orders— that is debts or obligations that must be paid despite the discharge order– are in 11 U.S.C. § section 523 “Exceptions to Discharge”

11 U.S.C. § 523(a)(5) and (15) “(a) A discharge under section 727… or 1328(b) of this title does not discharge an individual debtor from any debt – . . . (5) for a domestic support obligation; . . . (15) to a spouse, former spouse, or child of the debtor and not of the kind described in paragraph (5) that is incurred by the debtor in the course of a divorce or separation or in connection with a separation agreement, divorce decree, or other order of a court of record, or a determination made in accordance with State or territorial law by a governmental unit;”

§523(15) applies to all discharge orders entered under a chapter 7 discharge order under §727: the debtor must still pay those obligations.

However, a chapter 13 discharge granted pursuant to 1328 (a) does discharge theobligations of § 523(a)(15).

Broader in scope and more comprehensive, 11 U.S.C., Section 523(a)(15) applies to debts incurred through the course of a divorce case.

Discharge of “Support” Payments

Simplicity is not often synonymous with the Bankruptcy Code. However, 11 U.S.C. Section 523(a)(5) perhaps is an exception.

The section provides in pertinent part, that:

“(a) A discharge under section 727, 1141, 1228 (a), 1228 (b), or 1328 (b) of this title does not discharge an individual debtor from any debt . . . .(5) for a domestic support obligation;”

The Bankruptcy Code defines Domestic Support Obligation at 11 U.S.C. 101(14A).

Hold Harmless and Indemnification Provisions

In marital settlement agreements or final judgments, when one spouse is obligated to pay a joint debt or debt of the other spouse, a family law practitioner includes a clause directing the obligated spouse to indemnify and hold the other spouse harmless therefrom. Such a provision is clearly preferable for bankruptcy purposes.

Before the BAPCPA, courts were divided on whether debts owed to a third party related to a separation or divorce agreement required such a clause to be within §523(a)(15). Some courts required an indemnification and hold harmless proviso to create a direct liability from the debtor to the former spouse, while other courts did not, reasoning that the obligation there under to pay such debts ran from the debtor to the ex-spouse without an express indemnification or hold harmless clause.

Post-BAPCPA cases evince a clear indication that indemnification and hold harmless clauses are not necessary to a finding of nondischargeability. As one court concluded:

Despite the fact that the Marital Settlement Agreement did not alter either parties’ personal liability to third party creditors, it did create, or at least declare, an enforceable obligation running from Debtor [former wife] to Plaintiff [former husband]. Plaintiff’s right to an enforceable obligation arising out of the Marital Settlement Agreement created new legal rights that are clearly within the exception to discharge in §523(a)(15). This conclusion is not dependent on the presence of a hold harmless clause, but is bolstered by such language.  See In re Shepard, Case No. 7-07-10497 SA, Adv. Pro. No. 07-1177S at 7 (Bankr. N.M. June 30, 2008).

Debts No Longer Dischargeable

As a result of the BAPCPA, debts and obligations that have been held to no longer be dischargeable simply by virtue of the debts arising out of a divorce proceeding include, but are certainly not limited to, property equalization and equitable distribution payments, lump sum distributions and payments, credit card and charge account obligations, mortgage and HELOC payments, homeowner’s association dues, income tax obligations, automobile loan payments, indemnification and hold harmless obligations, medical bills, attorneys’ fee obligations between the spouses incurred in matters unrelated to the divorce, and sanctions awarded for contemptuous conduct.

Robert Rodriguez has represented both debtors and creditors in dozens of bankruptcy proceedings under chapters 7, 13, and 11.

If a debtor spouse is attempting to discharge a marital dissolution obligation; it may be attacked by Adversarial Proceeding.

Robert Rodriguez has  litigated well over 100 family law cases and civil litigation matters including personal injury motor vehicle cases, dog bite and slip & fall cases, breach of contract, defamation & invasion of privacy, fraud, unfair business practice, malicious prosecution, workplace and employment matters including sexual harassment, wrongful termination, wage & hour violations, discrimination pursuant to the FEHA, Gov’t Code §§ 12940 et seq., violations of the FMLA & Pregnancy Leave, Civil Rights  discrimination pursuant to 42 U.S.C. § 1983 and Title VII of the 1964 Civil Rights Act in the State of California and California federal district courts.

* Disclaimer – Robert Rodriguez is licensed to practice only in the State of California & this analysis is applied only under State of California law.  Robert D. Rodriguez is also admitted to practice in the U.S. District Courts, Central, Northern & Eastern Districts of California.  Robert Rodriguez has practiced in the State of California Court of Appeal.

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