A voluntary Chapter 11 bankruptcy filing ordinarily leaves the bankruptcy debtor in possession of the assets (as the “debtor-in-possession”). Needless to say, the debtor-in-possession has an inherent conflict of interest in being directed to manage the bankruptcy estate assets for the benefit of bankruptcy creditors. The question is if the debtor couldn’t be trusted to pay creditors before filing for bankruptcy, can he be trusted after filing for bankruptcy to preserve the interests of creditors?

The Bankruptcy Code gives the debtor-in-possession the early benefit of the doubt. In the worst-case scenario involving a dishonest debtor, a creditor or interested party can petition the Court for appointment of a Chapter 11 Trustee or Examiner. If a Chapter 11 Trustee is appointed, the debtor is dispossessed of the bankruptcy estate assets, and the Trustee manages the bankruptcy estate for the benefit of creditors.

Without a provision in the bankruptcy laws for dispossessing a debtor of the bankruptcy estate assets, any dishonest debtor could make a mockery of the bankruptcy system by acting in his own interest at the expense of creditors (and, in the case of individuals who file for bankruptcy, obtain a full discharge of his debts). In a dishonest debtor case, leaving the debtor in possession of the bankruptcy estate is akin to leaving the wolf in charge of the sheep. One would like to think that dishonest debtors are few and far between, but in many cases the evidence of dishonesty is simply never brought to the Court’s attention, because creditors are disinclined to pursue their claims in bankruptcy court due to the uncertainty of recovery.

There are some safeguards against dishonest debtors: The U.S. Trustee’s Office maintains oversight of bankruptcy filings, and can prosecute Complaints Objecting to Discharge. However, the U.S. Trustee often lacks access to the evidence of a debtor’s dishonesty or gross mismanagement. Creditors and interested parties who interacted with the dishonest debtor and who often know him well remain the most reliable source of evidence about the true state of a debtor’s financial affairs.

The Bankruptcy Code denies a debtor a discharge of his debts if, in connection with the bankruptcy case, he “made a false oath or account.” False oaths include actions as diverse as committing perjury, or submitting monthly reports containing falsified information. The operative fact is that the debtor must have acted deliberately and knowingly, with intent to deceive. 

In cases involving serial bankruptcy filings, the related bankruptcy filings could provide a wealth of admissible evidence relevant to a potential denial of discharge. Related cases often involve “insiders” (directors or shareholders) whose misconduct in other bankruptcy cases could be used to deny them a discharge in their own bankruptcy filing. 

Other grounds for denial of discharge include fraudulent conveyance (transferring or hiding assets to hinder and defraud creditors), whether the debtor committed the act in his own bankruptcy case, or in another case in which he is an “insider.” 

A discharge of debts in bankruptcy erases all debts that were incurred pre-petition (before the bankruptcy filing). Therefore creditor attorneys must be diligent to file Complaints Objecting to Discharge (or Complaints for Non-Dischargeability) by the deadlines set by the Court. Bankruptcy is a debtor’s forum and the burden of proof is on the proponent of the Complaint Objecting to Discharge. Therefore it behooves the creditor attorney to go to Court with their strongest evidence of the debtor’s fraud and misconduct.

Hot Off The Press: In a unanimous recent decision, United Student Aid Funds v. Espinosa, 130 S. Ct. 1367 (2010), the U.S. Supreme Court held that, despite legal error by the bankruptcy judge in confirming a plan that discharged Student Loan Debt Interest, the discharge was enforceable and binding on the creditor (the student loan lender). The creditor failed to object to confirmation of the plan, failed to file a timely appeal, and only years later sought a ruling from the High Court that the bankruptcy judge’s legal error made the discharge “void.”

Chapter 13 bankruptcy protection can provide for adjustment of an individual’s debts. Individual debtors develop a plan to repay all or a portion of their debts over a period of time. If the plan is confirmed by the bankruptcy court, the debtor is discharged of the debts listed in the plan, once the payments are completed.

Student loan debt, however, is dischargeable only if denial of discharge “would impose an undue hardship on the debtor and the debtor’s dependents.” 11 U.S.C. section 523(a)(8). An independent determination of undue hardship must be made by the bankruptcy judge, before such student loan debt is discharged. The Federal Rules of Bankruptcy Procedure permit the creditor to file a Complaint Objecting to Discharge, and the debtor should not propose a plan to discharge student loan debt without obtaining a determination by the bankruptcy judge of “undue hardship.” The debtor can obtain a determination by filing an adversary proceeding against the student loan lender. 

Espinosa presents the rare case where neither the creditor nor the debtor filed an adversary proceeding to determine “undue hardship.” The debtor in Espinosa filed a proposed plan to pay off the student loan principal, and to discharge the interest. The creditor filed no Complaint Objecting to Discharge, and the bankruptcy judge confirmed the plan.

In Espinosa, the U.S. Supreme Court places the blame squarely upon the creditor—for failing to file a Complaint Objecting to Discharge, and for failing to file a timely appeal to confirmation of the plan, despite having notice of the debtor’s intent. The U.S. Supreme Court also chastized the bankruptcy judge in Espinosa, for failing to make an independent inquiry into undue hardship, and further chastized the debtor’s attorney, for failing to file an adversary proceeding to obtain a determination of undue hardship prior to filing a proposed plan to discharge the student loan debt. Ultimately, however, the Court rejected the student loan lender’s argument that the bankruptcy judge was without jurisdiction to confirm the plan. 

And what lesson for creditors? The lesson is not new. Espinosa is consistent with bankruptcy case law precedent and the overall theme of the bankruptcy rules. Creditors must press and prosecute their claims in the bankruptcy system, or risk losing benefits to which the law may entitle them.