Non-Dischargeability in Bankruptcy of Certain Claims Based on Intentional Wrongdoing

As discussed in detail in our article on Bankruptcy, the Constitutional Right to Start Over the right to start over after eliminating all debts is a cherished right in this nation, one devised to avoid the debtor’s prisons that plagued England at the time.

But the law provides limits as to what debts may be discharged in bankruptcy, with the Congress and the courts deciding that certain types of debts should survive bankruptcy. Much of the time the debts that survive bankruptcy are matters of public policy or the results of lobbying by various interest groups such as financial institutions.

One type of debt that is not discharged are those based on intentional wrongdoing of the party in bankruptcy. These include criminal actions or torts and often are based on fraud and misrepresentation.

This article shall outline the elements and criteria for nondischargeability of debts predicated on intentional wrongdoing. Clearly, good legal advice is required before relying on the basic law contained in this article.

 

The Basics of Intentional Acts Non Dischargeability:

11 U.S.C. § 523 – Elements Required to Provide Claim of Non-dichargeability Under Sections 523(a)(2)(A), 523(a)(4) and 523(a)(6)

The following provides an overview of the elements required to prove a claim of non-dischargability under Sections 523(a)(2)(4), 523(a)(4) and 523(a)(6) of the Bankruptcy Code.

 

I. Section 523(a) Generally

Section 523(a) sets forth certain types of debts that are excepted from discharge if the party in interest is able establish the necessary elements.

In an action for determination of dischargeability under Section 523(a), the plaintiff (creditor) has the burden of proving all elements of the claims for relief asserted by a preponderance of the evidence. In re Dakota, 284 B.R. 711, 721 (Bkrtcy. N.D. Cal., 2002) (citing to Grogan v. Garner, 498 U.S. 279 (1991)). The exceptions to discharge set forth in Section 523(a) are to be construed narrowly. Id.(citing to In re Risoi, 978 F.2d 1151 (9^th Cir. 1992)).

 

II. Section 523(a)(2)(A) – Fraud

Section 523(a)(2)(A) of the Bankruptcy Code provides an exception from the discharge of any debt for money, property or services, to the extent such debt was obtained by false pretenses, a false representation, or actual fraud. 11 U.S.C. § 523(a)(2)(A).

Section 523(a)(2)(A) requires a showing of actual fraud rather than constructive fraud or fraud implied in law. A claim of non-dischargeability under Section 523(a)(2)(A) requires the creditor establish each of the following elements:

1. the debtor made a representation;
2. the debtor knew at the time the representation was false;
3. the debtor made the representation with the intention and purpose of deceiving the creditor;
4. the creditor relied on the representation; and
5. the creditor sustained damage as the proximate result of the representation.

In re Apte, 96 F.3d 1319, 1322 (9^th Cir. 1996); In re Kirsh, 973 F.2d 1454, 1457 (9^th Cir. 1992).

a. Fraudulent Omission

The failure to disclose material facts constitutes a fraudulent omission under Section 523(a)(2)(A) if the debtor was under a duty to disclose and the debtor’s omission was motivated by an intent to deceive. In re Harmon, 250 F.3d 1240, 1246 (9^th Cir. 2001); In re Howarter, 95 B.R. 180, 187 (Bkrtcy. S.D. Cal., 1989).

b. Intent

Under Section 523(a)(2)(A), the creditor must show actual intent, not merely intent implied in law, or constructive intent. The requisite intent may, however, be inferred from the totality of the surrounding circumstances. In re Dakota, 284 B.R. at 721 (citing to In re Anastas, 94 F.3d 1280 (9^th Cir. 1996)).

c. Reliance

A creditor claiming non-dischargeability under Section 523(a)(2)(A) must also show the creditor was justified in relying on the debtor’s fraudulent conduct in obtaining the money, property or services. Field v. Mans, 516 U.S. 59, 73-76 (1995). Reliance must be justifiable, but need not reach the level of “reasonableness.” In re Dakota, 284 B.R. at 721.

Note that a person may justifiably rely on a representation “even if the falsity of the representation could have been ascertained upon investigation. In other words, negligence in failing to discover an intentional misrepresentation” does not defeat justifiable reliance. In re Eashai, 87 F.3d 1082, 1090 (9^th Cir. 1996); In re Apte, 180 B.R. at 229 (stating that “justifiable” reliance is a mixture of objective and subjective standards, which takes into account knowledge and relationship of the parties themselves). However, a person cannot justifiably rely on a representation if he or she knows it is false or its falsity is obvious.In re Kirsh, 973 F.2d at 1459 (stating that a “person cannot purport to rely on preposterous representations or close his eyes to avoid discovery of the truth”).

d. Causation

In addition, under Section 523(a)(2)(A), the creditor must show that the debtor’s fraud was a proximate cause of the damage to the creditor. Field v. Mans, 516 U.S. at 61, 64 (describing Section 523(a)(2)(A) as an exception to the discharge of debts “resulting from” or “traceable to” fraud).

 

III. Section 523(a)(4) – Fraud or Defalcation While Acting in a Fiduciary Capacity

The reader is first advised to read our article on Fiduciary Duty. Violation of that duty can result in nondischargeability of a debt.

Section 523(a)(4) provides an exception from discharge of a debt arising from fraud or defalcation by one acting in a fiduciary capacity, or of a debt arising from embezzlement or larceny.

Section 523(a)(4) provides, in part:

A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt

....

(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny . . .

11 U.S.C. § 523(a)(4).

Under Section 523(a)(4), the creditor must establish three elements for non-dischargeability:

1. an express trust;
2. that the debt was caused by fraud or defalcation; and
3. that the debtor was a fiduciary to the creditor at the time the debt was created.

In re Niles, 106 F.3d 1456, 1459 (9^th Cir. 1997).

a. Express Trust

Section 523(a)(4) requires an express or technical trust in existence before and independently of the defalcation. In re Lewis, 97 F.3d 1182, 1185 (9^th Cir. 1996) (citing Ragsdale v. Haller, 780 F.2d 794, 796 (9^th Cir. 1986)). A trust arising as a consequence of wrongdoing, such as a constructive, resulting, or implied trust, is outside Section 523(a)(4).In re Evans, 161 B.R. 474, 477 (9^th Cir. 1993).

The general characteristics of an express trust include each of the following:

1. sufficient words to create a trust;
2. a definite subject; and
3. a certain and ascertained object or res.

Banks v. Gill Distribution Centers, Inc., 263 F.3d 862, 871 (9^th Cir. 2001).

b. Fraud or Defalcation

Fraud within the meaning of Section 523(a)(4) means actual fraud. In re Roussos, 251 B.R. 86, 91 (9^th Cir. 2000). Fraud under Section 523(a)(4) must be fraud committed by a fiduciary, but does not otherwise differ from the actual fraud required for non-dischargeability under Section 523(a)(2)(A). In re Dakota, 284 B.R. at 723.

Defalcation is the misappropriation of trust funds or money held in any fiduciary capacity, or the failure properly to account for such funds. In re Lewis, 97 F.3d at 1186 (citing Black’s Law Dictionary 417 (6th ed. 1990)).

In the context of Section 523(a)(4), “the term ‘defalcation’ includes innocent, as well as intentional or negligent defaults so as to reach the conduct of all fiduciaries who were short in their accounts.” In re Lewis, 97 F.3d at 1186. Under California law, if a creditor establishes that a debtor occupied a fiduciary capacity, the burden shifts and it is the debtor’s burden to show that defalcation did not occur, by accounting for funds. In re Niles, 106 F.3d at 1456.

c. Fiduciary

While federal law governs the definition of “fiduciary capacity”, under the discharge exception for fiduciary fraud or defalcation, courts must look to state law to determine whether the requisite trust relationship exists. Under California law, a trust may be formed by express agreement, by statute, or by case law. In re Lewis, 97 F.3d at 1185.

The fiduciary capacity referred to in Section 523(a)(4) does not include the broad, general definition of fiduciary relationship as a relationship involving competence, trust and good faith. Rather, the relationship is one equivalent to the position occupied by the trustee of an express trust. Ragsdale v. Haller, 780 F.2d at 794.

In Ragsdale v. Haller, the court held that a general partner of a California partnership was a fiduciary to the partnership and its partners with respect to partnership assets for purposes of Section 523(a)(4) because California case law treated partners as trustees of express trusts. However, a corporation’s officer, director, or controlling shareholder has been held to lack fiduciary status toward the corporation for purpose of Section 523(a)(4) because California case law treats corporate principals as agents rather than as trustees. In re Cantrell, 269 B.R. 413 (9^th Cir. 2001). In re Cantrell states a possible exception to the general rule - when a creditor of an insolvent corporation claims a fiduciary duty. California’s Corporation Code provides a remedy for an insolvent corporation’s director’s violations of fiduciary duties to creditors, which could be actionable under Section 523(a)(4). In re Jacks, 266 B.R. 728 (9^th Cir. 2001). The court in In re Jacks also noted that “because a director’s fiduciary duties to creditors do not arise until the corporation is insolvent, the timing of the insolvency is critical.” Id. at 738. In this situation, it is the insolvency that creates the duty in the first place.

d. Embezzlement or Larceny

The elements of a claim based on embezzlement are:

1. property owned by another is rightfully in the possession of debtor;
2. debtor’s appropriation of such property to a use other than the use for which the property was entrusted to debtor; and
3. circumstances indicating fraud.

In re Littleton, 942 F.2d 551, 555 (9^th Cir. 1991).

The elements of a claim based on larceny differ from those of a claim based on embezzlement only in that in a claim based on larceny, thus by definition, the debtor must have come into possession of the property wrongfully rather than voluntarily transferred by the creditor relying on the debtor’s representations (which is embezzlement.).

A debt can be non-dischargeable for embezzlement under Section 523(a)(4) without the existence of a fiduciary relationship. In re Littleton, 942 F.2d at 555.

 

IV. Section 523(a)(6) - Willful and Malicious Injury

 

Section 523 also excepts from discharge debts “for willful and malicious injury by the debtor to another entity or to the property of another entity…” 11 U.S.C. § 523(a)(6). A willful and malicious injury under Section 523(a)(6) requires proof of a “deliberate or intentional injury, not merely a deliberate or intentional act that leads to injury.” Kawaauhau v. Geiger, 523 U.S. 57, 61 (1998).

a. Willful

Under Section 523(a)(6), to meet the willful injury requirement, the plaintiff must show either that the debtor had a subjective motive to inflict the injury or that the debtor believed that injury was substantially certain to occur as a result of his conduct. In re Su, 290 F.3d 1140, 1143 (9^th Cir. 2002).

In In re Su, the Ninth Circuit noted that willfulness and malice are two separate requirements that are not to be “conflated” into a single inquiry, and made it clear that each alternative prong of the willfulness showing must be based on a subjective standard. The subjective standard focuses on the debtor’s state of mind and precludes application of Section 523(a)(6)’s non-dischargeability provision short of the debtor’s actual knowledge that harm to the creditor was substantially certain. In re Su, 290 F.3d at 1146.

While bankruptcy law governs whether a claim is non-dischargeable under Section 523(a)(6), the court looks to state law to determine whether an act falls within the underlying tort. In re Bailey, 197 F.3d 997, 1000 (9^th Cir. 1999); See also Lockerby v. Sierra, 535 F.3d 1038, 1041 (9^th Cir. 2008) (holding that a breach of contract is not “willful and malicious” under Section 523(a)(6) unless accompanied by conduct that constitutes a tort under state law).

It is vital to note that debts arising from recklessly or negligently inflicted injuries arenot within the scope of Section 523(a)(6). Kawaauhau v. Geiger, 523 U.S. at 64; see In re Quari, 357 B.R. 793, 798 (Bkrtcy. N.D. Cal., 2006).

Non-dischargeability under Section 523(a)(6) is limited “to those situations in which the debtor possesses subjective intent to cause harm or knowledge that harm is substantially certain to result from his actions.” In re Su, 290 F.3d at 1145.

b. Malicious Injury

 

A “malicious injury” under Section 523(a)(6) involves:

1. a wrongful act;
2. done intentionally;
3. which necessarily causes injury; and
4. is done without just cause or excuse.

“Maliciousness” may be implied from circumstances surrounding the debtor’s conduct, even without proof that the debtor acted with spite, hatred or ill will toward the victim. In re Ormsby, 591 F.3d 1207 (9^th Cir. 2010).

 

Conclusion:

The common theme with the obligations that are not discharged above is the element of intentional wrongdoing. That is why reckless negligence does not fall within the exceptions to discharge described herein. Thus, debts arising from assault and battery or other crimes cannot be discharged but speeding, however reckless, can be.

It also means that victims of fraud, embezzlement, and other financial crimes are often those seeking to prevail despite a bankruptcy proceeding. The typical method is commencement of an “adversarial proceeding” in the bankruptcy court which is, essentially, a trial before the bankruptcy judge seeking to prove the elements above and avoid the bar of recovery. Alternatively, some creditors seek to maintain their state actions predicated on the above, seeking to petition the court to remove the stay on the underlying proceedings. Assuming they are successful, the creditor can find itself in a much better position in that all the other creditors basing their claims on nonintentional wrongdoing are discharged, leaving the creditor free to collect without competition from the other creditors.