Treatment of Fraudulent Debts in Bankruptcy
We have written in a previous article about the risk of revocation of a bankruptcy discharge if the debtor is found to have committed bankruptcy fraud. The most frequent type involves the debtor’s deliberate hiding of assets or filing bankruptcy forms that contain willfully false information or are intentionally incomplete. In such cases, the debtor may also be charged with a crime.
But what about debts affected by the debtor’s fraud outside of the bankruptcy? Can they be discharged in bankruptcy? The answer is “it depends”.
The Bankruptcy Code provides that certain types of debts obtained through “actual fraud” cannot be discharged in bankruptcy. The reason is simple – it is thought that a misbehaving debtor should not be able to both nullify the fraudulent debt and keep the proceeds of his scheme by filing bankruptcy.
Much like impeachable “high crimes and misdemeanors” in Article 2 of the U.S. Constitution, the Code does not define “actual fraud”. Most often, it involves a deliberate oral or written and material untrue statement to a creditor regarding assets, income or some other aspect of the debtor’s financial condition, on which the creditor reasonably relied. In recent years, however, the courts have defined the term more broadly to include any debt affected by deliberate misconduct, even if the debtor did not make any explicit false statements.
In a 2016 case, management of the corporate debtor transferred assets to another subsidiary before filing a petition. The Supreme Court held that the related debt of approximately $150,000 debt was not dischargeable, even though neither the debtor company nor its principals had made any false statements when obtaining credit. The concealment of assets was sufficient to establish “actual fraud”.
Fraud in Selling Cars “Out of Trust”
Earlier this year, a federal court jury in Dallas awarded a Ford Motor Company subsidiary more than $53 million in fraud-related damages against a local car dealership and its principals. Because of the fraud, the awards will not be discharged in the dealership’s pending bankruptcy or in any case later filed by the owners.
Virtually all car dealers have ongoing “floor plan” financing agreements with vehicle makers. In these arrangements, the dealer receives financing to purchase inventory, on which the manufacturer holds a lien. When a vehicle is sold, part of the loan is repaid and the lien is released. With the dealership facing financial difficulty, it sold vehicles without making millions of dollars in repayments and misled Ford regarding their status. This is known as “selling out of trust”; it usually leads only to cancellation of the floor plan contract and a civil action to recover the required loan repayments. Because of the nature and the scale of the misconduct in this case, however, the jury found that the scheme was fraudulent. Criminal charges were also filed against several dealership employees.
With the finding of fraud, the dealership and the employees implicated in the crime will likely not be able to discharge these debts in bankruptcy court.
If you or your business are considering bankruptcy and you have concerns about a whether one or more debts can be discharged, we would be happy to consult with you free of charge. You can schedule a free, in-person consultation by clicking here.