Debtors behaving badly: non-payment of the debt on the basis of the “bad acts” of the debtor

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It is said that the word bankruptcy originated in the Middle Ages from the term “breaking the bench”. At that time, breaking a craftsman’s workbench was the punishment for default. Later, the debtors were punished for their non-payment of their debts by imprisonment. Neither approach helped the creditor. Rather, he punished those who depended on the debtor for maintenance. At the end of the 19e Century the American bankruptcy system was created to break with these policies and give debtors a fresh start.

This “new start” is written into the Bankruptcy Code (hereinafter, the “Code”). It can allow debtors to recover some or all of their debts.

In a previous customer alert, we discussed debt default: Non-dischargeable debt – Cullen and Dykman LLP (cullenllp.com). Section 523 of the Code creates exceptions to the discharge of certain types of debt. Section 727 of the Code allows the bankruptcy court to refuse the discharge of a debtor. Creditors can either oppose the overall payment of the debtor or the payment of a specific debt.

Creditors can ask the court to declare a debt non-dischargeable. Examples include debts resulting from (i) money, goods or services provided to the debtor obtained under false pretenses, misrepresentation or actual fraud (Section 523 (a) (2) (A)); (ii) fraud or embezzlement by the debtor acting in a fiduciary capacity, embezzlement or theft (section 523 (a) (4)); or (iii) intentional and malicious harm by the debtor to another entity or to the property of another entity (section 523 (a) (6)).

Our recent legal alerts deal with student loan debt, which is another type of debt that may be non-dischargeable under section 523 (a) (8) of the Code: Student Loan Debt Released in Recent Bankruptcy Court Notice – Cullen and Dykman LLP (cullenllp.com); Student loan debt canceled in recent Illinois Bankruptcy Court notice – Cullen and Dykman LLP (cullenllp.com); Another bankruptcy court rules in favor of paying off the student loan debt. – Cullen and Dykman LLP (cullenllp.com)]; An Update on Student Debt: Interpreting the Law is Key – Cullen and Dykman LLP (cullenllp.com).

A recent case in Illinois, McGee v. Reed (In re Reed), No. 18bk19801, 2021 WL 4028730 (Bankr. ND Ill. 3 Sept. 2021), illustrates the ability of the court to refuse the release of a debt due to wrongdoing. Here, the debtor falsely modified a power of attorney by using it to deceptively withdraw funds from a bank account without the authorization of the holders. The court determined that Section 523 (a) (2) (A) precluded the release of the debt as actual fraud. The court concluded that the creditor had established that (1) fraud had occurred; (2) with the debtor’s intention to defraud; and (3) the fraud created the debt. The debtor was required to reimburse the money she had obtained fraudulently.

In another case, the Court of Appeal of the Second Circuit of In re Snyder, 939 F.3d 92 (2d Cir. 2019) held that the wrongdoing of a debtor was significant enough to deny him discharge. The debtor here has agreed to invest his friend’s money in a construction project. Instead, the debtor used these funds for his own personal and business expenses. In view of the embezzlement exception, the court concluded that there was a fiduciary relationship between the parties and that the debtor had acted with flagrant recklessness by improperly using his friend’s money for himself. As a result of these wrongdoing, debts have not been discharged under Sections 523 (a) (4) and (6) of the Code.

Creditors facing the bankruptcy of their debtor should be aware that while a fresh start is available for most debts, some debts may not be dischargeable. As such, creditors may hold the power to oppose the discharge or discharge of the debtor from his particular debt.

However, a debt falling under one of the exceptions does not automatically exclude it from release. It is up to the creditor to act. It is advisable to consult an insolvency counselor to assess whether a debt can be exempt from discharge.


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