Settlement of Discharge Actions

February 15, 2008

By: Patrick J. Kearney

Creditors of bankrupt debtors are always looking for leverage in a bankruptcy proceeding.  Leverage is important in order to squeeze some form of payment out of a debtor who, absent the leverage, will be able to walk away without paying a penny.  The most potent weapon in a creditor’s arsenal, objecting to the discharge of a debtor under 11 U.S.C. § 727(a) (a “Discharge Action”), however, will not give an individual creditor leverage for payment of an individual claim, and could force an objecting creditor or Chapter 7 Trustee to pursue litigation regardless of the actual benefit.

Individuals file for relief under the Bankruptcy Code in order to be relieved of their debts:

Section 727 of the Bankruptcy Code allows debtors to receive a general discharge of their obligations in keeping with the primary purpose of bankruptcy law, to give honest debtors a fresh start “unhampered by the pressure and discouragement of preexisting debt.”  Lines v. Frederick, 400 U.S. 18, 19, 27 L.Ed.2d 124, 91 S.Ct. 113 (1970).  However, certain provisions of § 727 prohibit discharge for those who “play fast and loose with their assets or with the reality of their affairs.”

Farouki v. Emirates Bank International, Ltd., 14 F.3d 244, 249 (4^th Cir. 1994) (citation omitted).  Section 727(a) is founded on the premise that the law “will not ordinarily tolerate the debtor’s intentional departure from honest business practice when there is a reasonable likelihood of prejudice.”  First Union National Bank v. Golob (In re Golob), 252 B.R. 69, 75 (Bankr. E.D.Va. 2000).  Thus, the “‘solicitude of Congress . . . stops the debtor who does not measure up to the appealing image’ of the ‘honest but unfortunate debtor.’”  Hatton v. Spencer (In re Hatton), 204 B.R. 477, 482 (E.D. Va. 1997)(citation omitted).

Section 727(a) bars the granting of a discharge to a debtor who:  (1) fraudulently transfers or conceals his property in the year before filing a bankruptcy petition, (2) fraudulently transfers or conceals property of the estate after the filing of the bankruptcy petition, (3) conceals, destroys, falsifies or fails to preserve financial records, (4) makes a false oath in connection with the bankruptcy case, (5) presents or uses a false claim in connection with the bankruptcy case, (6) gives, offers or receives property or the promise of property for advantage for acting or forbearing to act, (7) withholds documents and financial records from an officer of the estate, (8) fails to explain satisfactorily the loss of assets or deficiency in assets to meet his liabilities, (9) refuses to obey any lawful order of the court, (10) fails to respond to a material question on the ground of privilege after being granted immunity, or (11) fails to respond to a question on a ground other than self incrimination.  A trustee, any creditor or the United States Trustee may object to the discharge of a debtor.  11 U.S.C. § 727(c)(1).

Section 727(a) differs from the dischargeability actions under § 523(a) in that the latter affects a specific debt between the debtor and a creditor.  Section 727(a), on the other hand, blocks the discharge of all debts owed by the debtor.  Thus, a successful objection to discharge under § 727(a) changes the nature of a bankruptcy from a “safe harbor” to a trap where a trustee can ferret out assets, strip the debtor of all non-exempt assets for the benefit of all creditors and then lay the debtor open to the normal collection actions.

Despite its power, § 727(a) should be used by a creditor only as a weapon of last resort.  Any party who objects to discharge under § 727(a) must understand the critical distinction between the “private” nature of a cause of action under 11 U.S.C. § 523(a) and the “public” nature of a cause of action under § 727(a).  A § 523(a) objection to discharge is “private” in that it must be brought by the creditor harmed by the debtor and it only avoids a discharge as to that creditor’s claim.  A Discharge Action, however, is “public” because:

(1) A discharge action under § 727(a) functions to protect “the integrity of the bankruptcy system by denying a discharge to debtors who engage in objectionable conduct that is of a magnitude and effect broader and more pervasive than fraud on, or indurate to a single creditor.”  In re Taylor, 190 B.R. 413, 416 (Bankr. D.Colo. 1995); In re Harrison, 71 B.R. 457, 459 (Bankr. D.Minn. 1987).  Thus, protecting the integrity of the bankruptcy system is a matter which passes “beyond the creditors and is one of public policy.”  Wolinsky v. Maynard (In re Maynard), 258 B.R. 91, 93 (Bankr. D.Vt. 2001), rev’d on other grounds,  -296  B.R. 535 (D. Vt. 2001) (quoting, In re Hammerstein, 189 F. 37, 38 (2^nd Cir. 1911)); and

(2)  A successful Discharge Action benefits all creditors since each creditor is then able to pursue its claims against the debtor.  Bankruptcy Receivables Management v. de Armond (In re de Armond), 240 B.R. 51, 54 (Bankr. C.D.Cal. 1999).

Thus, the “public” nature of a Discharge Action puts the plaintiff in the shoes of  a fiduciary for all creditors.  Id., 240 B.R. at 57.^[2]  As a fiduciary, the plaintiff in a Discharge Action must be guided by the long recognized standard enunciated by Justice Cardozo that a fiduciary is held to “‘something stricter than the morals of the market place.  Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior.”  Id., quoting Meinhard v. Salmon, 249 N.Y. 458, 464, 164 N.E. 545, (1928).  Put in slightly less prosaic terms:

[B]y initiating litigation which, if successfully prosecuted, will benefit all creditors, a creditor assumes an obligation to the general creditor body.  Having done so, it may not abdicate that responsibility or use that position to its own advantage by settling litigation on terms which will allow it to receive a private benefit solely for itself.

Bank One Crawfordsville, N.A. v. Smith (In re Smith), 207 B.R. 177, 178 (Bankr. N.D. Ind. 1997)(citations omitted).

The special nature of a Discharge Action is recognized by the Federal Rules of Bankruptcy Procedure.  F.R.Bankr.P. 7041 provides that

Rule 41 F.R.Civ.P. applies in adversary proceedings, except that a complaint objecting to the debtor’s discharge shall not be dismissed at the plaintiff’s instance without notice to the trustee, the United States trustee, and such other person as the court may direct, and only on order of the court containing terms and conditions which the court deems proper.

Thus, it has been held, “Rule 7041 allows the [bankruptcy] court to ensure that the dismissal was not obtained improperly, and also allows the trustee and creditors to oppose dismissal.”  State Bank of India v. Chalasani (In re Chalasani), 92 F.3d 1300, 1310 (2^nd Cir. 1996).

The first rule to be learned from the fact that a creditor who brings a Discharge Action is treated like a fiduciary for all creditors is the majority rule of reported decisions and the local rule in several jurisdictions, is that no Discharge Action can be settled on terms which either pays the objecting creditor money or allows only the debt to that creditor to be declared non-dischargeable. Pennwell Printing Co. v. Stout (In re Stout), 262 B.R. 862 (Bankr. D.Colo. 2001); Hage v. Joseph, (In re Joseph), 121 B.R. 679 (Bankr. N.D. N.Y. 1990); In re Armond, supra; In re Bates, 211 B.R. 338 (Bankr. D.Minn. 1997)(citing Minn. Local Rule 7041-1 which requires the plaintiff to certify that nothing has been received in consideration of the dismissal of a § 727 case); Migoscha, S.A. v. Meffert (In re Meffert), 232 B.R. 71(Bankr. S.D.N.Y. 1998)(citing Local Rule 4007-2(a) which requires the debtor and his attorney to certify that the “debtor has not promised or paid consideration for the withdrawal of the complaint”); In re Smith, supra.

Courts and commentators have gone so far as to hold that settlements of Discharge Actions which benefit an individual creditor are criminal violations under 18 U.S.C. § 152.^[3]  Russo v. Nicolosi (In re Nicolosi), 86 B.R. 882, 888 (Bankr. W.D.La. 1988)(citing 9 Collier on Bankruptcy ¶ 7041.03 (15^th ed. 1988)).  Another court suggested that negotiations of a settlement which benefit a single creditor might run afoul of ethical rules which prohibit the threat of criminal prosecution to obtain advantage in a civil matter.  In re Maynard, supra, 258 B.R. at 94 fn.3 (citing Vt. Rules of Professional Conduct, Rule 4.5), rev’d,  -296  B.R. 535 (D. Vt. 2001). .^[4]

It should be noted that certain courts will not allow the settlement of a Discharge Action under any circumstances, even if payment is being brought into the estate for the benefit of all creditors.  The reason for such per se rule is simple; the use of a quid pro quo in return for a discharge gives the appearance of the sale of discharges.  Such appearance harms the integrity of the bankruptcy system and is contrary to the purpose of a Discharge Action which is to protect the system’s integrity.  In re Wilson, 196 B.R. 777, 778-79 (Bankr. N.D.Ohio 1996); Moister v. Vickers (In re Vickers), 176 B.R. 287 (Bankr. N.D. Ga. 1994); In re Moore, 50 B.R. 661 (Bankr. E.D.Tenn. 1985).     The majority of cases, however, will allow the settlement of a Discharge Action which benefits the estate if  the settlement is “fair and equitable and in the best interests of the estate.” In re de Armond, supra, 240 B.R.  at 56.

The distinction between the cases which allow a settlement and those which do not allow settlements is based upon two premises:  (1)  discharges are not being sold because there is no judicial determination that the debtor is not entitled to a discharge and (2) as a matter of public policy, settlements between parties are encouraged. Wolinsky v. Maynard (In re Maynard), 269 B.R. 535 (D. Vt. 2001); In re Bates, supra, 211 B.R. at 347-348.

In re Mavrode, 205 B.R. 716 (Bankr. D.N.J. 1997) is noteworthy because:  (1) it is in the distinct minority of allowing payment to a creditor in settlement of a Discharge Action and (2) it used a traditional analysis for that settlement.  In that case, creditors instituted a Discharge Action against the debtor alleging, inter alia, failure to schedule equipment which was property of the estate.  The debtor’s son offered to pay plaintiffs $15,000 over nine months to settle the case.  The Bankruptcy Court in Mavrode examined the settlement using the standards set by Fed.R.Bankr.P. 9019: (1) the probability of success in litigation, (2) the difficulties in collection, (3) the complexity, expense, inconvenience and delay attendant to the continued litigation and (4) the interests of the creditors.  Id., at  722.  The Bankruptcy Court approved the settlement, noting that the payment (a) was from non-estate property, (b) benefited the estate because the settling plaintiffs were releasing their claims against the estate, thus enlarging any potential dividend to remaining creditors, and (c)  no party objected to the settlement or sought to be substituted as plaintiff after notice and hearing.  Id.  Thus, while Mavrode is in a distinct minority that allows payment to an objecting creditor, the analysis of the settlement is clearly in the mainstream of bankruptcy jurisprudence.  Further, Mavrode can be reconciled with other cases allowing settlement in that the Bankruptcy Court found that there was a benefit to other creditors.  See, Lindauer v. Traxler (In re Traxler), 277 B.R. 699 (Bankr. E.D.Tex. 2002)(rejecting a per se rule against settlements of Discharge Actions but requiring that some benefit inure to the estate or its creditors as a whole). 

No reported case in the Fourth Circuit has reviewed such settlements.  Bankruptcy Courts in Virginia have traditionally analyzed all settlements using a standard like the one enunciated in Mavrode.  Shaia v. Three Rivers Woods, Inc. (In re Three Rivers Woods, Inc.), 2001 WL 720620 (Bankr. E.D.Va. March 20, 2001)(Tice, C.J.); In re Frye, 216 B.R. 166 (Bankr. E.D.Va. 1997).  Accordingly, it would seem appropriate to review settlements of Discharge Actions using traditional Rule 9019 standards.^[5]  Further, there is a possibility that the courts in the Eastern District of Virginia might follow Mavrode and allow payments to objecting creditors.  Local Rule 7041-1 in the Eastern District of Virginia provides that any party wishing to dismiss a Discharge Action must give at least ten days written notice to the United States Trustee, parties-in-interest requesting notice and the creditors’ committee or 20 largest unsecured creditors in a Chapter 11 proceeding.  “The notice shall fully and clearly state any consideration paid or promised to be paid by the debtor to the plaintiff in connection with such dismissal.  Whether an actual hearing will be required if no objectionsare filed is within the discretion of the judge.”^[6]  Thus, in the absence of objection, it can be argued that the Local Rules of the Eastern District of Virginia do not prohibit the settlement of a Discharge Action which contemplates payment to the objecting creditor.  There are, however, no reported cases which in any Bankruptcy Court in Virginia which give guidance as to whether such settlements will actually pass muster.  It is, however, probable, that Bankruptcy Judges will give any settlement which solely benefits an objecting creditor very strict scrutiny.

Finally, it should be noted that the strategy of filing both a Discharge Action and a § 523 action with the expectation that the settlement of a § 523 action will allow the plaintiff to dismiss the Discharge Action is of limited value.  The proposed dismissal of a Discharge Action which is tied to a § 523 action will be scrutinized to ensure that the Discharge Action is not being improperly dismissed. In In re Nicolosi, supra, plaintiff sought to settle her § 523 action and dismiss her Discharge Action (which was then before the Court of Appeals on debtor’s appeal).  The Bankruptcy Court undertook a detailed examination of the § 523 claims and concluded that those claims did not have sufficient merit to warrant a settlement.  The court, however, did not express any opinion as to whether the case could have been settled if the § 523 action did have merit.  Id., 86 B.R. at 888.  In Palmer v. Hayden (In re Hayden), 246 B.R. 795 (Bankr. D.S.C. 1999), the Bankruptcy Court allowed a settlement of a § 523 action which involved the dismissal of a § 727 action, but only after notice of the settlement to all creditors, the absence of another party offering to substitute as plaintiff, and, most importantly, after the United States Trustee commented that the Discharge Action did not have any merit. ^[7]  In Hass v. Hass (In re Hass), 273 B.R. 45 (Bankr. S.D.N.Y. 2002), the Bankruptcy Court approved a settlement which dismissed a Discharge Action and exempted from discharge specific debts owed by the debtor to his former wife.  The Bankruptcy Court approved the settlement because (i) notice of the terms of the settlement had been sent to all parties in interest, (ii) there was no objection, (iii) no payment was being made by the debtor to his former wife, and (iv) there was no evidence of wrong doing in the settlement. It is reasonable to conclude, therefore, that any settlement which benefits an individual creditor under the guise of settling a § 523 action and dismissing a Discharge Action will be allowed only if there is no hint of self-dealing by the plaintiff and if there is notice to all parties in interest which fully disclose the terms of the settlement.^[8]

CONCLUSION

No attorney should bring a Discharge Action against a debtor with the expectation that it will generate a settlement resulting in the direct payment of a client’s personal claims.  While it remains possible that the Bankruptcy Courts in the Eastern and Western Districts of Virginia will allow an individual creditor to receive a benefit in the settlement in the absence of an objection, it is more likely that a Discharge Action will either result in a judgment barring discharge for the benefit of all creditors or that a settlement will be struck that will allow the Estate to realize a monetary benefit which, in turn, will be distributed to creditors in the order of priority set by 11 U.S.C. § 507.

---

Related Practice Areas

Bankruptcy/Creditors Rights