Debtors as Predators: the Proper Interpretation of "a Statement Respecting the Debtor's . . . Financial Condition" in 11 U.s.c. § 523(a)(2)(a) and (b)

• Publication year: 2014

Debtors as Predators: The Proper Interpretation of "a statement respecting the debtor's . . . financial condition" in 11 U.S.C. § 523(a)(2)(A) and (B)

Mallory Velten

DEBTORS AS PREDATORS: THE PROPER INTERPRETATION OF "A STATEMENT RESPECTING THE DEBTOR'S . . . FINANCIAL CONDITION" IN 11 U.S.C. § 523(A)(2)(A) AND (B)

Abstract

U.S. Courts of Appeals disagree on the correct interpretation of the phrase "statement respecting the debtor's . . . financial condition" as it appears in the exceptions to discharge in 11 U.S.C. § 523(a)(2)(A), the fraud provision, and § 523(a)(2)(B), the false written statement provision. Two major viewpoints have emerged—the strict and the relaxed. Under the strict interpretation, for the fraud provisions to apply, the statement must comprise the overall financial condition of the debtor. According to the relaxed interpretation, the debtor's fraudulent assertion of ownership of only a single item of property constitutes a statement respecting the debtor's financial condition.

The Fifth, Eighth, and Tenth Circuits have adopted the strict interpretation, while the Fourth Circuit has followed the relaxed interpretation since 1984. Lower courts in other circuits have gone both ways. The divergence of opinion has resulted in some courts allowing debtors who acquired money through fraud or misrepresentation to walk away from those debts by discharging them in bankruptcy, while others hold such debtors accountable and refuse discharge.

This Comment interprets § 523(a)(2) and concludes that the correct reading of "financial condition" is the debtor's overall financial health—the view of the courts that have adopted the strict interpretation. This Comment further proposes adding a definition of "financial condition" to 11 U.S.C. § 101 to resolve the circuit split.

This split jeopardizes the dual purposes of bankruptcy—to provide relief to honest debtors and to ensure the fair treatment of creditors. As it is, in some jurisdictions debtors who commit fraud are allowed to abandon their debts, leaving creditors in a lurch. Burning creditors in this way may result in negative repercussions for other debtors, such as decreased borrowing ability. Providing a clear definition of "financial condition" will help promote better bankruptcy policy for debtors and creditors.

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INTRODUCTION

Although the Bankruptcy Code (Code) provides the standard legal framework for bankruptcy for the entire nation, the laws are not always interpreted consistently. This disparity is particularly significant in the fraud exceptions to discharge in 11 U.S.C. § 523(a)(2). As a result of differing interpretations, debtors in some jurisdictions are prevented from discharging debts acquired through fraud, false pretenses, or misrepresentation,¹ while debtors in other jurisdictions might walk away from debts they obtained by dishonest means.² Preventing debts acquired by fraud from being discharged is of such importance that the principle was included in the earliest American bankruptcy laws.³ This longstanding commitment to prohibiting debtors from shedding fraudulent debts through bankruptcy makes this disparate treatment of similar situations in different circuits especially alarming.

Consider the following situation: businessman Damien Debtor approaches Creditor Company and asks for a loan. He assures the company president that he can repay the company, telling her about the swanky office building in which he has an interest. The company agrees to the loan. Months later, Damien files for bankruptcy and seeks to discharge the debt he owes to Creditor Co. The worried president discovers, to her dismay, that Damien was dishonest about the office building. In fact, he has no significant assets and scores of liabilities. Now that Damien has filed for bankruptcy, however, he can discharge the debt owed to Creditor Co. and walk away, leaving Creditor Co. with the loss—or can he?

This hypothetical illustrates the importance of exceptions to discharge granted under the Code. In an ideal world, all debtors would be honest, hardworking folks with every intention of paying their debts, who just fell on hard times and need some help—though to be fair, in an ideal world no one would need to file for bankruptcy. The policy behind the Code was to aid such honest debtors by giving them an opportunity for a fresh start⁴ while providing

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fair treatment to their creditors.⁵ Unfortunately, the world not being ideal, there are dishonest debtors like Damien who file for bankruptcy to avoid repaying debts they acquired through false representations, false pretenses, or other fraudulent means. To prevent this occurrence and protect creditors like Creditor Co., Congress enacted § 523(a)(2).⁶

Section 523 lists nineteen exceptions to discharge for individual debtors.⁷ Subsection 523(a)(2) deals with fraud and misrepresentation.⁸ More specifically, § 523(a)(2)(A), the fraud provision, prohibits individual debtors from discharging debts acquired through fraud or false pretenses.⁹ Under this section an individual debtor may not discharge any debt acquired under "false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's . . . financial condition."¹⁰ The fraud provision does not specify whether statements of financial condition must be oral or written. Additionally, § 523(a)(2)(B), the false written statement provision, prohibits debtors from discharging debts obtained through materially false written statements "respecting the debtor's . . . financial condition" that were used with the intent to deceive.¹¹ The result of these provisions is that a debtor who acquires a debt through a false representation of his or her financial condition to a creditor may still discharge the debt through bankruptcy under certain circumstances.¹² However, what exactly constitutes a "statement respecting the debtor's or an insider's financial condition" is not clarified by the statute.¹³

The U.S. Courts of Appeals for the Fourth, Fifth, Eighth, and Tenth Circuits are divided on the proper interpretation of a "statement respecting the debtor's . . . financial condition" in the fraud provision and the false written statement provision.¹⁴ There are two major viewpoints: the relaxed or broad

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interpretation and the strict or narrow interpretation.¹⁵ Under the relaxed interpretation, a debtor's assertion that he owns specific properties free and clear constitutes a statement respecting the debtor's financial condition.¹⁶ Courts that follow this interpretation hold that "a statement of the financial condition of even one asset qualifies under the statute and therefore the statement may not be used in a [§] 523(a)(2)(A) claim as evidence of false pretense, false representation or actual fraud."¹⁷ The relaxed interpretation has the effect of making the fraud provision inapplicable in more situations—the more statements by a debtor are considered to be about his or her financial condition, the more a debtor can avoid the fraud exception to discharge.¹⁸ Accordingly, a relaxed interpretation works in favor of the debtor and against the creditor. Under this standard, Damien's statement about his interest in the office building would qualify as a statement about his financial condition, and he would be able to discharge his debt to Creditor Co.¹⁹

Under the creditor-friendly strict interpretation, a statement respecting a debtor's financial condition must comprise the overall financial condition of the debtor for it to fall under the exception to discharge.²⁰ Under this viewpoint, the statement respecting the debtor's financial condition must pertain to the complete picture of the debtor's financial health—that is, to qualify for discharge under § 523(a)(2) (the fraud and the false written statement provisions—together, the fraud exception to discharge), the debtor must have falsely represented his or her complete financial situation to the creditor in order to receive the loan.²¹ Because Damien only told the president of Creditor Co. about his ownership of a single asset—his interest in a specific office building—his declaration would not qualify as a statement about his

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financial condition, and Creditor Co. could prevent him from discharging the debt.

Part I of this Comment provides an overview of the fraud provision and the history of the circuit split. Part II conducts statutory interpretation of the fraud and the false written statement provisions to discern the proper meaning of "statement respecting the debtor's . . . financial condition."²² Part III will discuss why, based on statutory interpretation and public policy, the correct reading of "a statement respecting the debtor's . . . financial condition" is a statement that concerns the debtor's overall financial health, as opposed to a statement concerning the debtor's ownership of certain items of property.²³ This Comment recommends that courts should abandon the broad interpretation because it results in poor bankruptcy policy. It proposes adding a definition of "financial condition" to § 101 to clarify that the meaning of "financial condition" is the overall financial health of the debtor.

I. Background

The bankruptcy laws of the United States have a long history of preventing the discharge of debts acquired through fraud or deceit.²⁴ Section A describes the background and history of the fraud and false written statement provisions in § 523(a)(2). Section B explains the history and progression of the circuit split that exists today over the proper meaning of "statement respecting the debtor's . . . financial condition."²⁵

A. The History of the Fraud Provision

Section 523 of the Code, "Exceptions to discharge," lists nineteen categories of debts that individual debtors may not discharge in bankruptcy.²⁶

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The categories make up four distinct groups: "(i) governmental liabilities, (ii) liabilities incurred through fault, (iii)...