CRASHING THROUGH THE DEBTOR’S BANKRUPTCY

Spring TRMG Conference April 16, 2012

Paul D. Keenan, Esq. and

Jeffrey D. Cohen, Esq.

Keenan Cohen & Howard PCjcohen@freightlaw.net

215-609-1104

Bankruptcy courts are units of the district court in the jurisdiction where the bankruptcy court sits. Bankruptcy judges are classified as “judicial officers” of the district court and are appointed by the United States Court of Appeals for each circuit.

Appointments are for a term of 14 years.

The Bankruptcy Code is silent on the issue of whether a litigant is entitled to a jury trial on matters litigated in bankruptcy court.

Courts have generally found that litigants are entitled to a jury trial when the matter at issue is legal in nature and is analogous, historically, to a suit seeking monetary compensation.

On the other hand, a litigant cannot obtain a jury trial for suits in bankruptcy court which are equitable in nature.

Courts have found the following types of cases to be equitable versus legal:

Disgorgement of excessive fees by counsel (equitable);

A trustee’s claim for turnover of property of the estate (equitable);

A fraudulent transfer action when asserted against a defendant that has not filed a proof of claim (legal); and

A preference action initiated by a trustee in response to a proof of claim filed by a creditor in a pending bankruptcy matter (equitable).

Bankruptcy courts apply a “preponderance of the evidence” standard when ruling upon whether an exception to discharge should be granted.

Following a bankruptcy court determination, the losing party can seek appellate review first at the district court level. On appeal, a district court or an appellate court reviews a bankruptcy court’s factual determinations under the clearly erroneous standard and its conclusions of law de novo (anew). In re: Fegley, 118 F.3d 979, 982 (3rd Cir. 1997).

When an issue arises in a bankruptcy case that can’t be resolved by negotiation or by motion, it becomes necessary to file an adversary complaint. The adversary complaint initiates a matter, (“adversary proceeding”), in bankruptcy court similar to the typical civil action brought in local district court.

Litigants will commonly initiate an adversary proceeding to address the following issues:

The debtor wishes to pursue a creditor for violating the bankruptcy automatic stay;

A creditor seeks an exception to discharge for his or her individual debt; and/or

The US trustee’s office objects to the debtor obtaining a discharge altogether.

Attorneys who specialize exclusively in bankruptcy matters many times, have limited actual trial experience. We have found that many times bankruptcy attorneys will avoid the formal adversary environment of an adversary proceeding. This can be detrimental to client goals particularly when a debtor is not playing by the rules and is perpetrating a fraud. Because many bankruptcy attorneys spend little if any time calling witnesses, conducting cross examination, ensuring the admissibility of documentary evidence and applying the rigid Federal Rules of Evidence they may not be accustomed to, and not comfortable with these proceedings.

This puts certain counsel at a disadvantage when faced with an experienced litigator. The question to be asked when determining which type of counsel to engage to recover assets when a debtor files for bankruptcy is whether or not fraud or self dealing of the debtor is likely, if it is – this will likely lead to an adversary proceeding in which a litigator is your better choice. If fraud is not likely and the technical mechanics of the bankruptcy process are primary – a bankruptcy attorney is more suited to this type of work.

A VERY BRIEF PICTORIAL HISTORY OF THEFT FROM CARRIERS OVER THE COURSE OF

HISTORY

A bankruptcy discharge releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order prohibiting the creditors of the debtor from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts.

Although a debtor is not personally liable for discharged debts, a valid lien (i.e., a charge upon specific property to secure payment of a debt) that has not been avoided (i.e., made unenforceable) in the bankruptcy case will remain after the bankruptcy case. Therefore, a secured creditor may enforce the lien to recover the property secured by the lien.

Certain exceptions to discharge apply automatically The most common types of nondischargeable debts are: certain types of tax claims, debts not set forth by the debtor on the lists and schedules the

debtor must file with the court, debts for spousal or child support or alimony, debts for willful and malicious injuries to person or property, debts to governmental units for fines and penalties, debts for

most government funded or guaranteed educational loans or benefit overpayments,

debts for personal injury caused by the debtor's operation of a motor vehicle while intoxicated,

debts owed to certain tax-advantaged retirement plans, and debts for certain condominium or cooperative housing

fees.

The types of debts described in sections 523(a)(2), (4), and (6), obligations affected by fraud or maliciousness are not automatically excepted from discharge.

Creditors must ask the court to determine that these debts are excepted from discharge. In the absence of an affirmative request by the creditor and the granting of the request by the court, the types of debts set out in sections 523(a)(2), (4), and (6) will be discharged.

Section 523(a) of the Code specifically excepts various categories of debts from the discharge granted to individual debtors. Therefore, the debtor must still repay those debts after bankruptcy.

Creditors receive a notice shortly after the case is filed that sets forth much important information, including the deadline for objecting to the discharge. To object to the debtor's discharge, a creditor must file a complaint in the bankruptcy court before the deadline set out in the notice. Filing a complaint starts a lawsuit referred to in bankruptcy as an "adversary proceeding."

Code Provisions That Permit Survival of Debt After

Bankruptcy

The types of debts described in sections 523(a)(2), (4), and (6) (obligations affected by fraud or maliciousness) are not automatically excepted from discharge. Creditors must ask the court to determine that these debts are excepted from discharge. In the absence of an affirmative request by the creditor and the granting of the request by the court, the types of debts set out in sections 523(a)(2), (4), and (6) will be discharged.

(A) - Misrepresentations or Fraud Used to Obtain Money or Services

(a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title [11 USCS § 727, 1141, 1228(a), 1228(b), or 1328(b)] does not discharge an individual debtor from any debt--

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained, by—

(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's or an insider's financial condition.

◦To prove an exception to discharge under this Code section, a creditor must establish the following:

◦ (1) The debtor made a false representation of fact;

◦ (2) The debtor knew the representation to be false;

◦ (3) The debtor made the representation with the intent and purpose of deceiving the creditor;

◦ (4) The creditor justifiably relied on the debtor’s representation; and

◦ (5) The creditor sustained the alleged injury as the proximate result of the representation.

The debtor made a false representation of fact◦ Direct Evidence

The debtor knew the representation to be false◦ Circumstantial Evidence

The debtor made the representation with the intent and purpose of deceiving the creditor◦ Circumstantial Evidence

Because actual intent is difficult to decipher, courts have adopted a multiple-factor test used to prove actual intent to defraud through circumstantial evidence, including the following factors:

(1) Number of charges made;

(2) The amount of charges;

(3) The financial condition of the debtor at the time the charges were made;

(4) Whether the debtor made multiple charges on the same day; and

(5) The financial sophistication of the debtor

The creditor justifiably relied on the debtor’s representation

A creditor must establish that the falsity of the debtor’s representation would not be patent upon cursory examination.

Justifiably relied Reasonably relied

The creditor sustained the alleged injury as the proximate result of the representation

Not as a result of other factors (business operations)

(B) Written Misrepresentations about Financial Condition

A debtor is not entitled to a discharge of a debt incurred because of false statements made about the debtor’s financial condition in writing. 11 U.S.C. § 523(a)(2)(B). To establish this exception to discharge, a creditor must prove:

(1) The use of a written statement; (2) That is materially false; (3) Respecting the debtor's or an insider's

financial condition; (4) On which the creditor reasonably relied;

and (5) That the debtor caused to be made or

published with the intent to deceive.

11 U.S.C. § 523(a)(2)(B) differs from 11 U.S.C. § 523(a)(2)(A) because a creditor must establish “reasonable reliance.”

In other words, a creditor must establish that its conduct in extending credit to the debtor was objectively reasonable.

Additionally, this exception is limited to statements about financial condition, which must be in writing. Oral misrepresentations about financial condition are not excepted from discharge.

A debt will be excepted from discharge if the debtor fails to schedule that debt on his or her bankruptcy petition in sufficient time for the creditor to file a proof of claim.

The only exception to this rule is that a debt will be discharged if the creditor had notice or actual knowledge of the case in time to file a proof of claim, even though the debtor failed to list that creditor on his or her schedules. 11 U.S.C. § 523(a)(3)(A).

In applying this Code section, courts typically rely upon the plain language of this statutory section and hold that, if there is a claims bar date, a creditor must have notice of the bankruptcy before that date for the creditor’s debt to be discharged.

(a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title [11 USCS § 727, 1141, 1228(a), 1228(b), or 1328(b)] does not discharge an individual debtor from any debt—

(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.

In order for a creditor to prevail under this section, he or she must prove that a debtor committed:

(1) Fraud or defalcation while acting as a fiduciary; or

(2) Embezzlement; or (3) Larceny.

Step One – Fiduciary Relationship

Step Two – Fraud or Defalcation

◦ "Fraud" for purposes of this exception has generally been interpreted as involving intentional deceit, rather than implied or constructive fraud.

◦ Most courts agree that "Defalcation" requires something more than mere negligence or mistake.

the act or an instance of embezzling

a failure to meet a promise or an expectation

Embezzlement, under § 523(a)(4), has been defined as the "'fraudulent appropriation of property by a person to whom such property has been entrusted or into whose hands it has lawfully come.'" In re Weber, 892 F.2d 534, 538 (7th Cir. 1989).

To prove embezzlement, the creditor must establish that:

◦ (1) The debtor appropriated the subject funds for his own benefit; and

◦ (2) The debtor did so with fraudulent intent or deceit.

To demonstrate fraudulent intent, the creditor must show intent on the debtor's part to deprive him of his property. A fiduciary relationship or trust relationship need not be established in order to find a debt non-dischargeable by an act of embezzlement.

Larceny under § 523(a)(4) necessitates a showing that a debtor wrongfully took property from its rightful owner with fraudulent intent to convert such property to his own use without the owner's consent.

a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title [11 USCS § 727, 1141, 1228(a), 1228(b), or 1328(b)] does not discharge an individual debtor from any debt—

(6) for willful and malicious injury by the debtor to another entity or to the property of another entity.

Willful Intentional Knowing Malicious Purposeful Recklessly Negligently Deliberate

In this context, “Willful” means intentional or deliberate (actual intent) or acts which have a substantial certainty of causing harm.

“Malicious” means wrongful and without just cause or excuse. Lee v. Ikner (In re: Ikner), 883 F.2d 986, 989 (11th Cir. 1989).

(a)(1) - Corporation Does not Get Discharge in a Chapter 7 (Liquidation)

A bankrupt corporation, unlike a bankrupt natural person, has virtually no prospect of future property accumulation. For that reason, a determination whether the corporation should be discharged is a purely academic exercise with no practical or economic purpose. It is for this reason that the Bankruptcy Code provides a discharge only for individuals in Chapter 7 cases. 11 U.S.C. § 727(a)(1); In re: Gulfstream Marina, Restaurant & Motel, Inc., 2 B.R. 26 (Bankr. S.D. Fla. 1979).

Creditors may find it beneficial to pursue a denial of discharge, under 11 U.S.C. § 727, in addition to, or instead of, an exception to discharge, under 11 U.S.C. § 523, for two significant reasons.

First, a creditor may pursue a denial of discharge under 11 U.S.C. § 727 because that Code section is its only option. The Bankruptcy Code specifically limits the exceptions to discharge contained in 11 U.S.C. § 523(a) to “individual” debtors, not corporations. Thus, for those creditors who are pursuing a corporate debtor involved in a Chapter 11 (reorganization), Section 727 may be the only method available to prevent a discharge of its debt in a liquidation context.

Second, a creditor, asserting a cause of action under 11 U.S.C. § 727, may find that it has additional negotiating leverage and the potential threat of maintaining the complete status quo as powerful bargaining tools. Naturally, a debtor filing a bankruptcy petition is seeking a “fresh start.” To the extent that an individual creditor can “scare” the debtor into thinking that this “fresh start” will be denied, the creditor may force the debtor to forgo efforts defending discharge or dischargeability litigation and seek a resolution of that particular creditor’s claim as quietly as possible.

Wheels Unlimited, Inc. v. Sharp (In re Sharp), 2009 Bankr. LEXIS 481, 2-3 (Bankr. D. Idaho Jan. 14, 2009).

 

Defendant/Debtor Sharp was a motor carrier which brokered loads to Wheels, another motor carrier, to transport a number of trailers from locations out West to Hurricane Katrina relief sites in Mississippi and Louisiana. 

Sharp, retained Wheels to transport its freight through its agent Tompkins.

Tompkins on behalf of Sharp made and oral agreement with Wheels for Wheels to transport the trailers for a rate of $1 per mile

After moving 35 trailers Sharp and Thompkins did not pay Wheels the 75K it determined was due

Wheels learned that Sharp was identified as the carrier on bills of lading.

Wheels called Sharp and demanded payment Sharp confirmed Thompkins was their

representative and said not sure of payment terms.

Sharp sent check for about 18K – indicating rate that there was an agreement for a flat rate per load

Wheels sued Sharp for the difference and received a default judgment

Sharp, an individual, filed for Chapter 7 Bankruptcy and included the Wheels debt on his schedules.

Wheels initiated an adversary complaint to have the debt declared non-dischargeable eventually proceeding under 523(a)(2) and 523(a)(6).

SHIPPER >SHARPE > THOMPKINS > WHEELS

The Court first conducted an analysis of whether or not the representations of Tompkins could be attributable to Sharp – and determined that they could be under an agency theory.

Next the court analyzed if the elements of Section 523(a)(2) were met◦ Representations– yes◦ Knew was false – no◦ Made with intent to deceive – no◦ Justifiable reliance of creditor – barely◦ Loss as a result of the representation

(proximate result of fraud) – no

Next the court analyzed if the elements of Section 523(a)(6) were met◦ “willful and malicious” injury – no◦ Lower court default was for breach of contract◦ No state court fraud established – clear and

convincing◦ In fact fraud not established for lesser

preponderance level of proof

LESSONS: ◦ Have a Written Contract, ◦ Conduct Due Diligence, ◦ Cap Credit and ◦ Monitor

A prior judgment may have preclusive effect in bankruptcy court under the doctrine of issue preclusion. Issue preclusion prevents the relitigation of a particular issue that was necessarily adjudicated in rendering a prior judgment. The United States Supreme Court has recognized that issue preclusion applies in dischargeability litigation. Grogan v. Garner, 498 U.S. 279 (1991).

The application of issue preclusion in dischargeability litigation requires the existence of three elements, including:

1) The issue at stake must be identical to the one involved in the prior litigation;

2) The issue must have been actually litigated in the prior litigation;

3) The determination of the issue in the prior litigation must have been a critical and necessary part of the judgment in the earlier action.

Thus, for the prior judgment to have preclusive effect, the facts and elements necessary to satisfy the prior judgment must match those necessary to satisfy the showing to be made in bankruptcy court, otherwise the prior judgment will have limited preclusive effect.

In District Court the Defendant Debtor Entered into a Consent Judgment agreeing to the following:

(1) that Mr. Crook was the principal actor, principal corporate officer, and sole director and shareholder of Steal Your Money Collection Agency (“Steal”) and that they provided collection services to Carrier (¶ 3(a));

(2) that he was Carrier’s collection agent and fiduciary with the obligation to collect monies on Carrier’s behalf and remit them to Carrier on a timely basis (¶ 3(b));

(3) that Mr. Crook and Steal, while acting as Carrier’s collection agent, collected, retained, and never remitted at least $1,000,000.00 in Carrier’s funds (¶ 3(c));

(4) that final judgment was entered against Steal on Carrier’s claims for breach of contract, breach of obligation of good faith and fair dealing, breach of fiduciary duty, common law and statutory conversion, statutory attorney’s fees, constructive trust, and accounting (¶ 3(d));

(5) that Mr. Crook exercised complete dominion and control over Steal, commingled Steal’s funds with his own on a systematic and regular basis, did not hold regular corporate meetings of Steal or observe other corporate formalities, utilized Steal to collect and retain the Carrier funds, and thereafter never remitted the Carrier funds to Carrier and expended them for his own personal uses (¶ 3(e));

(6) that Mr. Crook wrongfully and knowingly converted and misappropriated the CSX funds in violation of common law and O.C.G.A. § 51-10-6 (¶ 3(f)); and

(7) that Mr. Crook systematically and regularly exercised complete dominion and control and abused the corporate forms of Steal with respect to wrongfully retaining the Carrier funds such that the veil between him and Steal is pierced (¶ 3(g)).

These facts do not establish that Mr. Crook acted “willfully and maliciously” within the meaning of § 523(a)(6). The factual finding in paragraph 3(f) is that Mr. Crook “wrongfully and knowingly converted and misappropriated the Carrier Funds in violation of common law and O.C.G.A. § 51-10-6.” “Wrongfully and knowingly” is not the same as “willful and malicious” within the meaning of 11 U.S.C. § 523(a)(6). As noted above, an essential element for a determination that a debtor acted willfully and maliciously is that he acted without just cause or excuse. E.g., Hope v. Walker (In re Walker), 48 F.3d 1161, 1164 (11th Cir. 1995); Miller v. Held (In re Held), 734 F.2d 628 (11th Cir. 1984); see Britt’s Home Furnishing, Inc. v. Hollowell (In re Hollowell), 242 B.R. 541 (Bankr. N.D. Ga. 1999). The Consent Judgment does not include factual findings that Mr. Crook acted without just cause or excuse.

To establish the willful and malicious injury exception to discharge mentioned above, a creditor often times will attempt to utilize a prior determination that the debtor converted its property to support a finding of an exception to discharge under 11 U.S.C. § 523(a)(6). Creditors may find difficulty to with this strategy depending upon the language contained in the prior judgment, because the standards for common law conversion and a willful and malicious exception to discharge may differ.

Therefore, a finding that a debtor "wrongfully and knowingly converted” another’s property may not be the same as a finding of a "willful and malicious" because an essential element for a determination that a debtor acted willfully and maliciously is that he acted without just cause or excuse, which is often not an element of a conversion cause of action.

Accordingly, unless a prior judgment specifically states that the debtor converted the creditor’s property without a just excuse, a creditor may be required to litigate a dischargeability issue in bankruptcy court, even though it obtained a prior judgment establishing that the debtor engaged in wrongful conduct.

JEFFREY D. COHENKEENAN COHEN & HOWARD P.C.ONE PITCAIRN PLACESUITE 2400165 TOWNSHIP LINE ROADJENKINTOWN, PA 19046(DIRECT) 215-609-1104(FAX) 215-609-1117JCOHEN@FREIGHTLAW.NET