A corporate financial penalty obligation of a Chapter 11 debtor owed to the Federal Communications Commission (“FCC”), resulting from “consumer fraud”, survived the discharge of the debtor’s reorganization plan, even when the FCC “was not the victim of the fraud,” the US District Court for the Southern District of New York ruled on September 2, 2021. In the case of Fusion Connect Inc., 2021 WL 3932346, * 1 (SDNY September 2, 2021). On appeal, the court overturned the bankruptcy court’s dismissal of the government’s non-discharge complaint, explaining that the discharge fraud exception relates to debts owed to “creditors who were not themselves. same defrauded, âlike the government here. Identifier., at 2 o’clock. According to the court, the bankruptcy court had upheld the debtor’s reorganization plan with a broad discharge (c. [the FCC Penalty] could attach to the new one [reorganized] entity â, when its terms made the exemption from this liabilityâ an open question â. Identifier., at 12.
The Fusion the decision is important. A debtor business seeking Chapter 11 relief typically wishes to clean up its balance sheet by eliminating unsecured liabilities with a discharge provision in a relief plan, permanently preventing creditors from asserting their pre-bankruptcy claims. When the bankruptcy court confirms the plan, discharge will be a key part of the confirmation order. As the Third Circuit recently pointed out in a similar context, âdebtors [must] know their liabilities [in order to] implement a viable plan to make a fresh start. Ellis v. Westinghouse Electric Co., LLC, 2021 WL 3852612, * 7 (3d Cir. August 30, 2021). According to the Third Circuit, however, “the debtor’s interest in a fresh start is not absolute, as the Bankruptcy Code tries to strike the” delicate balance between the competing interests of creditors pursuing their claims and those of debtors in securing a settlement. new beginning and finality â. ‘” Identifier., at * 4 (citation omitted).
The debtor’s predecessor (“B”) had committed to defrauding consumers “for years”. WL 3932346 to * 1. As a result, B entered into a consent decree with the FCC in 2016, acknowledging his fraud, agreeing to reimburse consumers and pay a “US $ 4.2 million civil fine (” FCC penalty ” ) in equal monthly installments over five yearsâ¦. By its terms, the decree of consent bound [Bâs] successors, assigns and assignees. Identifier. B then paid $ 1.2 million in refunds and consumer credits and began paying the FCC penalty. Identifier. * 2. In 2018, however, Fusion, the debtor here, had merged with B’s parent company, leaving âMerger as owner of [Bâs] company and responsible for the exceptional FCC penalty. Identifier.
Fusion filed a Chapter 11 claim in 2019 with â$ 2.1 million on the $ 4.2 million FCC penaltyâ unpaid. The FCC has filed proof of claim for this amount and the bankruptcy court upheld the Merger reorganization plan at the end of 2019. Upon confirmation of the plan, the bankruptcy court “declared that Merger’s continuing obligation for the outstanding civil penalty [to the FCC] âWill depend on whether these bonds are releasableâ – that is, whether they would survive the reorganization plan. Identifier.
Litigation in bankruptcy court
The government filed a non-release complaint in early 2020, alleging that the FCC penalty was not releasable under the Â§523 (a) (2) (A) code, made enforceable by the Â§1141 code. (d) (6). Although the government recognized that the discharge fraud exception in Â§523 (a) only applied to bankruptcy cases “involving individual debtors …, Congress, by enacting the abuse prevention and consumer protection in Code Â§1141 (d) (6), had extended [the fraud exception to discharge] to debtor companies in chapter 11 [cases]. ” Identifier.
The bankruptcy court granted Merger’s petition to dismiss the government’s complaint. It “has agreed with Fusion that the exception to discharge for liabilities resulting from fraud does not apply to the FCC penalty because this exception does not apply to debts owed to creditors who have not themselves been defrauded. Because the victims of [Bâs] the fraud consisted of consumers, not the government, [reasoned the bankruptcy court,] Section 523 (a) (2) (A), and therefore Section 1141 (d) (6) (A), does not reach the FCC penalty. ” Identifier. at 2 hours.
The Court of Appeal noted that âthe government’s appeal presents a pure question of law: whether a civil fine payable to the United States resulting from [a consumer fraud] constitutes a debt resulting from [fraud], so that the sentence is exempt from discharge in bankruptcy under [Code] Â§ 1141 (d) (6). Identifier. to 3.
Statutory framework and binding precedent. A Chapter 11 reorganization plan âreleases the debtor from any debt that arose before the date of this confirmationâ. Code Â§ 1141 (d) (1). âThe discharge of such debts serves the bankruptcy policy of providing debtors with a ‘fresh start’ to allow their operations to continue without pre-bankruptcy debts. ” DPWN Holdings (USA) Inc. v. United Airlines, 747 F.3d 145, 150 (2d Cir. 2014).
The Code Â§ 523 (a) (2) (A) âhas long prohibited debtors from fulfilling their obligations because of their fraud, embodying a basic policy animating the Code of granting relief only to “An honest but unhappy debtor”. Cohen v. by La Cruz, 523 US 213, 217-18 (1998). This generally applies in Chapter 7 cases involving individual debtors. Congress thus intended to ensure that “all debts resulting from fraud are exempt from discharge, whatever their form”. Archer vs. Warner, 538 US 314, 321 (2003).
The Supreme Court affirmed in Cohen that a Chapter 7 debtor’s actual fraud made his liability non-dischargeable under Â§ 523 (a) (2) (A). He also ruled “that an award of ‘triple damages assessed for fraud'” was not releasable because it “fell within the scope of” any debt “concerning” money, property. , services or credit âthat the debtor has fraudulently obtained. Identifier., at * 4, citing Cohen, 523 US to 218 and Code Â§ 523 (a) (2) (A). The Court noted that because “the award of triple damages” in Cohen fell under the fraud exception to be discharged, “the creditor ha[d] a corresponding “right to payment” for such damage. Identifier., at * 5, citing Cohen, 523 United States at 218-19.
Section 1141 (d) (6) (A). Congress “imported [in 2005] the relevant content of the Code Â§ 523 (a) (2) (A) in chapter 11 [cases] via Â§ 1141 (d) (6)â¦. “ Identifier. “Article 1141 (d) (6) (A) extends Â§ 523 (a) (2) (A) to [chapter 11 cases], by exempting from “discharging a debtor which is a corporation from any debt … of a type specified in paragraph (2) (A) or (2) (B) of section 523 (a) which is owed to a unit national government. ” Identifier. at 5. By extending Â§ 523 (a) (A) to corporate debtors in Chapter 11 cases, reasoned the court in Fusion, Congress was “presumed … [have] adopt[ed]âThe interpretation of the Supreme Court in Cohen. Identifier. The district court therefore dealt with the Cohen analysis as “governing the question presented” here. Identifier., to 6.
FCC penalty not releasable under code 1141 (d) (6) (A). The District Court thus ruled that the âFCC penalty falls within the scope of the Â§ 523 (a) (2) (A) exception to the exemption, as discussed in Cohen, and as extended to Chapter 11 debtors through 1141 (d) (6) (A). ” Identifier., at 7 O’clock. He first stressed the “breadth” of the Supreme Court’s decision Cohen reasoning: “Â§ 523 (a) (2) (A) prohibits the exemption from any liability arising from fraud”. Identifier. (emphasis in text), citing Cohen, 523 US at 222. The district court also relied on other appeal decisions. See, for example Pleasant, 219 F.3d 372, 375 (4th Cir. 2000) (a non-dischargeable debt âneed not necessarily be owed, in whole or in part, to a victim of the fraud, nor represent compensationâ for the victim); Hatfield v. Thompson, 555 BR 1, 12 (10th Cir. BAP 2016) (â[T]there is no requirement that the debt be for something the debtor gets from the creditor. “).
Reject merge arguments. Rejecting Merger’s argument that the fraud in question “must have been directed against the creditor holding the debt”, the district court relied on “decisions of the Eleventh and Third Circuits holding that the requirement of Â§ 523 (a) (2) (A) fraud consistent with the common law elements of fraud is satisfied where the defrauded party or parties were persons other than the bankruptcy creditor [case]. “2021 WL 3932, 346, at * 9. For example, the Securities and Exchange Commission (” SEC “) had obtained a judgment of non-discharging civil fraud against the debtor because of its fraudulent investors”[e]even though the fraud was not directed against the SEC. Identifier., citing In re Bilzerian, 153 F.3d 1278, 1280 (11th Cir. 1998). And the Third Circuit ruled that the SEC’s civil fraud judgments against the debtor were “non-dischargeable because evidence of fraud had been gathered as to [the debtorâs] customersâ¦ even though the fraud was not directed at the SEC. In re Bocchino, 194 F.3d 376, 382-83 (3d Cir. 2015).
The district court also dismissed as “unusually unconvincing” Merger’s argument that the overthrow of the bankruptcy court “would place the burden of responsibility on the stakeholders of the reorganized entity. [Bâs] wrongdoing that occurred even before the acquisition of the company by Fusion. Identifier., at 12. Not only were the “stakeholders” knowingly assuming B’s pre-existing liability to the United States, but the bankruptcy court had also warned them that the FCC penalty could survive any discharge that Fusion allegedly obtained in the order. confirmation of the plan. âA shareholder of the new company had his eyes open that [this] the liability, like other ongoing liabilities or business costs and risks, could endure. Identifier.
Political implications. More importantly, allowing Fusion “to get rid of a regulatory fraud penalty in this way could invite mischief.” Identifier. For example, this could encourage “the strategic offloading of such liability onto a successor entity ready to file a Chapter 11 reorganization in the near future”, particularly where the entity “had a recent history of fraud”. Identifier. “…[C]our courts have warned against interpreting the Code in a way that would create perverse incentives for debtors who do not meet the objectives of the Code. Identifier., citing In re Murphy, 282 F.3d 828, 874 (5th Cir. 2002); KeyBank Nat’l Ass’n v. Franklin Advisers Inc., Co., 600 BR 214, 231 (SDNY 2019) (rejecting a “rule that … would create perverse incentives for parties to engage in deadlines and maneuvers in both bankruptcy reorganization and related litigation”).
Fusion can probably use the second circuit. But the district court’s thorough, carefully reasoned and sensible opinion will stand up to scrutiny. Chapter 11 should not be a safe haven for debtor companies with a fraudulent past.