Adversary proceedings are litigated matters within a bankruptcy case. They are not common, but can arise in certain special circumstances. They are serious matters that deserve your attention. Some of these situations will be discussed in this post.
When a bankruptcy case is filed, all of the creditors receive notice of the filing. By law they are provided with a opportunity to file a complaint objecting to the discharge of a debt, or the discharge of the entire case. A creditor can object to the discharge of its debt if it believes the debt was incurred in certain fraudulent circumstances (fraud, malice, defalcation in a fiduciary capacity, and a few other rare scenarios.).
There are also rare situations where a Trustee initiates an adversary action to recover property or attempt to revoke or deny someone a discharge.
These types of suits are not common. It is a strict, high standard that a creditor would have to meet in order to prove fraud, malice, or violation of a fiduciary duty, so you should not get the impression that creditors do this regularly. The vast majority of people who file bankruptcy cases never have to deal with adversary actions. But they do happen, and you need to have an attorney experienced in defending against these types of allegations.
In addition, a debtor himself or herself can file an adversary proceeding against another party in a bankruptcy case if he or she wishes to get a judicial ruling on some legal matter that is pertinent to the case: trying to avoid a lien or undersecured loan, seeking a determination on the dischargeability of a debt, seeking to get a ruling on discharging a student loan, an attempt to resolve a controversy that has arisen as part of the case, and many other types of situations. These types of adversary actions can arise in corporate or business bankruptcy situations.
The bottom line is that adversary proceedings, while not something to worry about for the average debtor, can arise on occasion. When they do arise, it is important to act quickly. You will have a limited time to file an answer or response, and a failure to do so can have serious consequences. It is critical to have an attorney who is experienced in litigating these types of cases. At Phillips & Thomas LLC, we have litigated many of these cases over the years (representing both plaintiffs and defendants) and are experienced in getting results for our clients.
Adversary Proceedings Seeking Objections To Discharge Under Section 523
We will now discuss briefly some types of adversary proceedings that can be filed by a creditor in a bankruptcy case. Again, understand that these types of situations are not common.
Among the adversary proceedings that are the most commonly encountered are actions
alleging that a debt was obtained due to some sort of fraud, breach of fiduciary duty, or
malicious conduct by the debtor under 11 U.S.C. § 523(a)(2), (4), or (6). Section
523(a)(2) lays out the types of debts that may be discharged where a debtor obtained the
debt by false pretenses, fraud, or false financial statements; Section 523(a)(4) relates to
fraudulent acts by the debtor while acting in a fiduciary capacity; and Section 523(a)(6)
provides that a debtor is not discharged from a debt due to willful and malicious injury by
the debtor to some other party.
It must be said at the outset here that the occurrence of these types of adversary proceedings is not common. In other words, only a very tiny fraction of bankruptcy cases are faced with this type of an allegation. Creditors do not file these as a matter of course. So, the vast majority of debtors filing cases have absolutely no need to fear being faced with this type of litigation.
It is also very important to appreciate the fact that in bankruptcy court, there is a strong presumption that debts should be discharged unless some special circumstances exist. In other words, the presumptions are generally in favor of a debtor. This can be quite different from civil actions in state or federal court, where triers of fact may be inclined to favor creditors. But these kinds of adversary actions do happen sometimes, and it is important to point out the differences between the different types of actions.
Section 523(a)(2)(A) states that debts obtained by false pretenses, false representations or actual fraud are nondischargeable. However, it does not define those terms nor does it indicate what standard of reliance a creditor must establish to show that the subject debt should be nondischargeable. Every judicial circuit has established its own “test” as a means of evaluating if the standard has been met. Kansas is in the Tenth Circuit, and Missouri is in the Eighth Circuit, and each of these circuits have tests that are slightly different, or weigh different factors differently. In general, however, the basic elements of fraud a creditor must establish to prevail in a Section 523(a)(2)(A) action are:
(1) That the debtor made a representation;
(2) That at the time the representation was made, the debtor knew the
representation was false;
(3) That the debtor made the false representation with the intention of
deceiving the creditor;
(4) That the creditor relied on such representation; and
(5) That the creditor sustained the alleged loss and damages as the proximate
result of the false representation.
One of the key factors in these types of actions is what level of reliance the creditor had. In other words, did the creditor “reasonably” rely on the representations made to him? Did the creditor “justifiably” rely on the representations made to him? Courts have found that a creditor cannot just close his eyes to certain obvious information available to him at the time, and then try to claim later that he was deceived.
Actions under Section 523(a)(2)(B)
The elements a creditor must establish to prevail in a nondischargeability action
under Section 523(a)(2)(B) are clearly set forth in the Code itself. Section 523(a)(2)(B)
provides that the materially false statement must be in writing and, as referenced above,
the creditor must show that its reliance upon the writing was reasonable. One of the key
issues in determining dischargeability under Section 523(a)(2)(B) is whether the written
statement is one relating to the debtor’s “financial condition.” These cases often come about when a creditor has been given some sort of financing statement or affidavit from a debtor before the bankruptcy, which the creditor will claim was not accurate or truthful.
Actions Under 11 U.S.C. § 523(a)(4)
Debts arising from fraud or defalcation while the debtor was acting in a fiduciary capacity.
The main issue under Section 523(a)(4) is whether the debtor was acting in his
“fiduciary capacity” as that term is defined for purposes of nondischargeability actions. Here again the burden of proof for a creditor is going to be high. He would have to show the existence of an actual trust (not a constructive or resulting trust) and the existence of a true fiduciary duty. There are other elements that must be shown, but these are the basic contours of this type of action.
Actions Under 11 U.S.C. §523(a)(6)
Debts arising from a willful or malicious injury to another party. Here again, the burden of proof for a creditor is very high. An objecting creditor would have to show the infliction here of an actual tort: that is, a willful, malicious injury that the debtor actually targeted specifically against the creditor. Each of these terms has a specific legal meaning in the context of this type of action, and the bankruptcy court will interpret them narrowly in favor of a debtor.
If you are facing any type of adversary proceeding, need a bankruptcy attorney who is experienced in successfully litigating these types of cases. Only a bankruptcy litigation attorney will have the experience and knowledge of local rules and conditions to see these issues through to successful outcomes.
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