Law Offices of Nicholas Gebelt

Are Fraud Debts Dischargeable In A Bankruptcy?

  1. The Discharge Of The Debt Must Be Successfully Challenged In An Adversary Proceeding

    Fraud debts are dischargeable in bankruptcy, unless the creditor successfully challenges their discharge. The same holds for debts that are the result of a breach of fiduciary duty and debts that are the result of doing willful and malicious harm to a person or property. (However, a debt for willful and malicious harm to property can be discharged in a Chapter 13 bankruptcy, and only in a Chapter 13.)

    If a creditor wishes to challenge the discharge of a fraud debt (or a breach of fiduciary debt, or a willful and malicious harm debt — for simplicity, I’ll just refer to fraud, with the understanding that the principles apply to the other two categories of debt, mutatis mutandis), it must do so by initiating a special kind of lawsuit, called an adversary proceeding, in the Bankruptcy Court.

  2. There Is No Mercy If The Creditor Misses The Filing Deadline
  3. The creditor must initiate the adversary proceeding by filing an adversary complaint no later than 60 days after the date first set for the meeting of creditors; or the next business day after the expiration of the 60 days if day sixty lies on a weekend or holiday. There is no wiggle room on the one minute before midnight deadline. This is illustrated by a case from a few years ago, Anwar v. Johnson, 720 F. 3d 1183 (9th Cir. 2013). The attorney in that case filed one of two complaints 26 minutes late, and the other 38 minutes late, due to a computer malfunction. The Ninth Circuit held that the actions were time-barred. Ouch!

    Of course, just filing the adversary complaint does not guarantee that the creditor will win. It must convince the judge that the debt really was incurred through fraud. If it succeeds, the debt will be not be discharged — ever. However, if the creditor doesn’t initiate the lawsuit timely, or loses the lawsuit, then the debt will be discharged.

  4. The Losing Creditor May Have To Cover The Debtor’s Court Costs And Attorney Fees
  5. There is a twist in the Bankruptcy Code that is specific to fraud debt. If a creditor seeks a nondischargeability determination under a theory of fraud and the creditor loses, the debtor can be awarded costs and attorney’s fees by the court, if the court determines that the creditor wasn’t substantially justified in initiating the lawsuit. That should give a creditor pause in filing such a lawsuit because it can be an expensive mistake.

  6. What Is A Fraud Debt?

There are two informal definitions of fraud in bankruptcy.

  1. Inducement Through Material Misrepresentation

The first definition is: A debt is incurred through fraud if the debtor made a material misrepresentation that induced the creditor to extend credit or lend the money, and that entity would not have done so but for the lie.

  1. No Intention Of Ever Repaying The Debt
    The second definition is: A debt is incurred through fraud if the debtor incurred it without intending to repay it. This second definition is a bit problematic because of the difficulty of knowing what another person intends. Since we cannot read people’s minds, the creditor must point to certain types of behavior that establishes the debtor’s intention. The analysis goes down two basic paths.

    1. A Reasonable Expectation Of Ability To Repay
    2. The first path — the road less traveled — asks, “Based on the debtor’s financial circumstances at the time of debt incurrence, did the debtor have a reasonable expectation that eventually the debtor would be able to repay the debt? A couple of simple examples illustrate possible answers to the question.

      Suppose you make $500,000 per year, and you incur a debt for $150,000. Do you have a reasonable expectation that eventually you will be able to repay it? Sure (unless you are already heavily burdened by other debt). Three months later you lose your job. Is it now a fraud debt? No, because the bad intention is measured at the time of debt incurrence. The subsequent catastrophic intervening event of a job loss is not evidence of fraud.

      Suppose you make minimum wage, and you incur a debt for $150,000. Do you have a reasonable expectation that eventually you will be able to repay it? Not so much.

      I admit that these examples are a bit simplistic. They were designed to illustrate possible fact patterns without including additional facts that may color the analysis. Ultimately, the outcome will depend heavily on the facts.

    3. Relatively Recent Debts
      1. Aging Recent Debts
      2. As I previously stated, the reasonable expectation analysis is the road less traveled. Most of the action is on relatively recent debt. A debtor who runs up a lot of debt shortly before filing for bankruptcy protection will probably face a fraud nondischargeability action. How recent is too recent? In other words, how much aging of the debt is necessary prior to filing a bankruptcy petition? The answer depends on three factors.

        The first factor is the identity of the creditor. Some creditors are more aggressive than others. If the creditor in question is very aggressive, then a longer aging period is necessary than with a less aggressive creditor. Knowing which creditors are aggressive and which aren’t, takes years of experience.

        The second factor is what the money was used for. A necessity of life is generally viewed more sympathetically than a luxury good or service. If the money was used for a luxury good or service, more time is necessary than if it was used for a necessity.

        The third factor is how the debt was incurred. A gradual accretion of over time is usually not a problem; but surges require more time.

      3. Making Minimum Payments
      4. While letting water pass under the bridge before filing is necessary with recent debts, it isn’t the whole story. A failure to make any payments on a debt after it was incurred is certainly evidence a creditor will use in challenging the dischargeability of the debt. Therefore, the debtor will probably need to make a few minimum payments prior to filing as well. How many depends on the factors I just discussed.

        Aging the debt and making some minimum payments will reduce the likelihood of an adversary proceeding. In sum, careful prebankruptcy planning helps to avoid post-filing problems.

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