Client Q&A: The Person Who Cheated Me Just Filed For Bankruptcy. Is This Legal? What Can I Do?

The Person Who Cheated Me Just Filed For Bankruptcy. Is This Legal? What Can I Do?

Nothing adds insult to injury like getting the news that someone who cheated you in a business transaction, or otherwise did you wrong, has filed for bankruptcy in order to get out of paying you your money back.

The Automatic Stay

As an initial matter, an "automatic stay" goes into effect immediately upon a bankruptcy filing, with the effect that the filing prevents you from suing the person who filed (known in bankruptcy law as the "debtor"), continuing an existing lawsuit against them, settling any claims against them, continuing any judgment collection efforts against them, or really doing anything at all to get your money back. The automatic stay is intended to simplify and rationalize the debtor's affairs by forcing all creditors into one court so that the debtor’s assets can be collected, pooled, and divided fairly among legitimate creditors. This system works fairly well when the debtor is a legitimate business with transparent financial records and realizable assets and accounts receivable that can be collected by the creditors, or when the debtor is an "honest but unfortunate" individual who has been overwhelmed by medical expenses or loss of a job and can simply no longer pay all of their bills in full. But sometimes, the debtor is not "honest but unfortunate" but instead has either been playing fast and loose, or even engaging in outright fraud or other wrongdoing. And unfortunately, dishonest debtors can use the ordinary bankruptcy court procedures to obtain significant advantages over their creditors.

So what is a creditor to do?

The first step is to try and persuade the Bankruptcy Trustee, if one is appointed, to act. The Trustee is an officer appointed by the Bankruptcy Court to supervise the process of identifying and notifying creditors, collecting assets, and paying creditors out of the assets. One of the first things a Trustee does is to convene a Creditor's Meeting, and a creditor can attend this meeting, explain the circumstances, and ask the Trustee to take further action by investigating the debtor’s assets and prior actions. In theory, if the Trustee finds that the debtor has lied in the Bankruptcy Petition, has hidden assets, or has destroyed or falsified financial records, the Trustee can apply to the Court for a denial of discharge. If the application is approved by the Court, the entire bankruptcy proceeding ends, the bankruptcy petition is thrown out, and all of the debtor’s creditors can go back to suing, or settling, or pursuing any judgment enforcement remedies that might be available to them. (An individual creditor may also pursue this remedy, but an application by the Trustee is far more likely to succeed.) However, this is an extreme remedy, and a Trustee will inevitably demand strong evidence of fraud against creditors generally—rather than just against one creditor—to object to discharge. Trustees also tend to be unwilling to do much in no-asset bankruptcies—Trustees often have many cases pending, and may not put much effort into a small case where the debtor, regardless of how sleazy their behavior, does not appear to have any money to pay creditors regardless of what happens in the bankruptcy proceeding.

The second option requires creditors to take action on their own. In every bankruptcy proceeding, the Trustee sets a date by which Objections to Discharge must be filed. Up to that date, creditors can object to the discharge of a particular debt owed to them. The kinds of particular debt that can be denied discharge are set forth in section 523 of the Bankruptcy Code (11 U.S.C. § 523), and they include:

Debts for money, services etc. obtained by fraud;
Consumer debts incurred within 90 days of the bankruptcy filing;
Debts arising from fraud by a fiduciary, or from embezzlement or larceny;
Debts for domestic support obligations;
ebts for willful and malicious injury to another person or entity or to their property;
Debts for violation of federal or state securities laws.

If creditors believe that a debt they are owed (which includes an unliquidated claim, an unpaid settlement, or a judgment) can fit into one of these categories, they can commence an Adversary Proceeding, which is a separate lawsuit within the bankruptcy proceeding. An adversary proceeding goes through all the phases of a standard lawsuit: complaint, answer, motions to dismiss, discovery, motions for summary judgment, trial, etc. If the creditor can show clear and convincing evidence (a higher standard than the “more likely than not” standard applicable in most civil actions) that their debt fits into one of the § 523 categories, that particular debt will be denied discharge. This means that, although the remainder of the debtor’s debts will be discharged, the particular debt that was the subject of the adversary proceeding will not be, so the creditor can continue its collection efforts.

It is no easy matter to begin and prosecute a § 523 adversary proceeding. For example, the default position of the Bankruptcy Courts is that discharge should be granted, so the Bankruptcy Court's instinct will be to deny the objection and grant discharge. The general language of the statute—terms like "willful and malicious injury," "embezzlement or larceny," "obtained by fraud," etc.—may seem simple, but have been interpreted and refined over the years by countless judicial rulings, up to and including Supreme Court decisions. And the type of dishonest debtor that might be the subject of a § 523 objection is not likely to cooperate by complying fully with their discovery obligations. The services of a competent and experienced lawyer are therefore essential, and creditors proceeding pro se are wasting their time.

Conclusion

Schlam Stone & Dolan has substantial experience in litigating objection to discharge cases, both in § 523 proceedings and also in the less frequent creditor applications to prohibit a general discharge. For example, Schlam Stone & Dolan lawyers had a bankruptcy filing made by the World Boxing Council dismissed in its entirety, allowing collection of a client’s $28 million judgment to proceed. We also have a great deal of experience with § 523 actions. If you are faced with a dishonest debtor trying to avoid paying you by filing bankruptcy, you should contact the firm and ask our advice.