Determining Congressional Intent Regarding Dischargeability of Imputed Fraud Debts in Bankruptcy - Theresa J. Pulley Radwan

• Publication year: 2003

Determining Congressional Intent

Regarding Dischargeability of

Imputed Fraud Debts in

Bankruptcy

Theresa J. Pulley Radwan*

[Congress's jurisdiction] extends to all cases where the law causes to be distributed, the property of the debtor among his creditors: this is its least limit. Its greatest, is a discharge of the debtor from his contracts. And all intermediate legislation, affecting substance and form, but tending to further the great end of the subject—distribution and discharge—are in the competency and discretion of Congress. With the policy of a law, letting in all classes, others as well as traders; and permitting the bankrupt to come in voluntarily, and be discharged without the consent of his creditors, the courts have no concern; it belongs to the lawmakers.¹

Bankruptcy allows for an orderly liquidation of a debtor's assets.² In exchange for participating (either voluntarily³ or involuntarily⁴ ) in this orderly distribution of one's assets, a debtor is given the ability to nullify all debts remaining after the distribution concludes, known as a discharge.⁵ But a discharge is not an absolute right granted to all debtors in bankruptcy.⁶ Indeed, the instances in which a debtor will not be given a discharge have increased dramatically over the past few decades.⁷ One example of such an exception is the rule that fraud debts cannot be discharged through a bankruptcy proceeding.⁸ A debtor who incurs a debt through fraud cannot use bankruptcy to escape liability for that debt, leaving a debtor forever responsible for his own fraud.⁹ Unfortunately, responsibility for perpetrating fraud does not always lead to compensation for the victim of fraud.¹⁰ The difficulty in collection against an insolvent debtor often forces the creditor to consider alternative means of recovering the debt.¹¹ In the case of fraud incurred by a partnership, the solution may lie with collection against the partners themselves pursuant to state law, which imputes partner- ship liability to its partners. If such a collection action against the partners forces some or all of those partners into bankruptcy, can each individual partner seek the benefit of bankruptcy discharge, or will each partner forever carry the burden of fraud liability? Should this determination of liability, or at least the permanence of this liability, depend upon the identity of the partners and each partner's respective involvement in perpetrating the fraud?

Consider, for example, a situation where John, Jeff, and Joyce become partners in a business they call "Triple J." A few years later, Triple J needs funds, and John arranges for a loan from a local bank, Sunshine Bank. The bank asks John about other liabilities of Triple J. John, being somewhat inept, inadvertently fails to mention a one-million dollar liability of Triple J to another lending institution. Sunshine Bank lends Triple J the money, but Triple J, saddled with the one-million dollar debt, defaults on its loan to Sunshine Bank. Sunshine Bank made a loan to Triple J that it would not have made but for the negligent misrepresentation, and for which Triple J is liable. If Triple J cannot pay all of that debt, Sunshine Bank will likely sue John, Jeff, and Joyce for the deficiency.¹² Will Sunshine Bank recover in full? The bank will only recover if John, Jeff, and Joyce do not declare bankruptcy individually. Because they are partners of Triple J, John, Jeff, and Joyce are personally liable for Triple J's debts. However, as the debt was incurred through John's mere negligence, the debt may be discharged in bankruptcy to the extent the debt was not paid through bankruptcy proceedings.

Instead, assume that when Sunshine Bank asked John about Triple J's obligations, John intentionally failed to mention the one-million dollar liability to the other bank, knowing that the size of that liability would probably cause Sunshine Bank to forego the loan to Triple J. Sunshine Bank again loans the money on the basis of the incorrect representation. Sunshine Bank now has a different position if Triple J defaults. Can Sunshine Bank collect more from Triple J? No. The company is insolvent, and even Sunshine Bank cannot force Triple J, as an entity, to pay money it simply does not have. However, Sunshine Bank still has the power to sue John, Jeff, and Joyce individually. If the partners declare individual bankruptcies, the situation changes. John, as the purveyor of fraud, cannot discharge his debt in bankruptcy. Because he acted fraudulently, John will remain liable for the entire debt regardless of his bankruptcy filing. The real issue is what should become of Jeff and Joyce. Jeff and Joyce did nothing (at least nothing with regard to Sunshine Bank) in either example. For that matter, Sunshine Bank's behavior and harm were unchanged in each example. Yet, though Jeff, Joyce, and Sunshine Bank each took the same actions in the alternative scenarios, John's behavior may have altered the relationships between Jeff, Joyce, and Sunshine Bank by allowing Sunshine Bank to continue to hold Jeff and Joyce liable indefinitely.

To complicate matters further, assume that Joyce had been given the sole responsibility in the partnership to ensure that no fraud was committed and she indeed could have uncovered John's fraud had she been more diligent in performing this task. This highlights the potential need to treat partners who did not perpetrate fraud differently on the basis of whether each partner was completely without fault in creating the fraud, or was simply involved indirectly.

The real benefit in not discharging fraudulently incurred debt is a social one. From a public policy standpoint, fraud causes more concern than mere negligence—even if each causes the same damage—because the harm done results from an intentional action. Further, because fraud is an intentional tort, a fraud victim deserves a greater recovery than a victim of negligence. Yet, this rationale creates a difficult situation. Even if one agrees that a fraud victim deserves more protection than a victim of negligence because fraud can be prevented more easily than negligence, this presents a significant problem when considering imputed liability. Do we continue to protect fraud victims by making someone liable whose only mistake was an unintentional failure to prevent the fraud? Assuming that we do hold such a person liable, should that liability last indefinitely? The answer to the first question requires an inspection of state law,¹³ the second, bankruptcy law.

Refusing discharge under 11 U.S.C. Sec. 523(a)(2)(A)¹⁴ to a debtor who did not actually perpetrate fraud and who had no actual ability to prevent that fraud violates Congress's intent in enacting Sec. 523(a)(2)(A), is inconsistent with early caselaw under Sec. 523(a)(2)(A)'s predecessors,¹⁵ and fails to further an accepted goal of the Bankruptcy Code—the fresh start. Though amending Sec. 523(a)(2)(A) to specify that imputed fraud debts will be dischargeable would be ideal, the statute, even as currently written, supports this idea because the clear expressions of Congressional intent and the policies underlying the Bankruptcy Code are sufficient to allow courts to find that imputed fraud debts should be discharged in bankruptcy.

I. Congressional Intent

A. Language of the Statute

The Bankruptcy Code discharges a debtor who has completed his bankruptcy plan pursuant to the Code.¹⁶ In essence, this discharge means that a debtor will no longer face responsibility for pre-filing debt, even if the debtor has not repaid the debt in full during the bankrupt-cy.¹⁷ However, exceptions to this discharge occur in two ways. First, the bankruptcy court may deny a debtor's discharge altogether.¹⁸ Second, the court may grant a debtor's discharge, but except specific debts from discharge.¹⁹

Discharge under the Bankruptcy Code provides a debtor with breathing room, commonly referred to as a "fresh start."²⁰ This fresh start provides the primary incentive to file for bankruptcy protection by providing the debtor with the ability to escape the burdens of debt. Exceptions from discharge protect a creditor by maintaining the debtor's liability to the creditor after bankruptcy.²¹ Courts do not take the decision to make exceptions to the fresh start, and thus to burden the debtor even after the conclusion of bankruptcy proceedings, lightly; rather, courts create exceptions only in situations where fairness to the parties warrants a deviation from accepted bankruptcy policies.²² When doubt exists about the dischargeability of a debt, the debtor should receive the benefit of the doubt, and the court should grant the discharge.²³

Fraudulently-incurred debts provide just one example of a situation in which the courts may tip the scales in favor of a creditor thus denying the debtor's complete fresh start in order to promote fairness between the parties. Section 523 specifically limits the dischargeability of a debtor for a debt incurred fraudulently:

(a) A discharge . . . does not discharge an individual debtor²⁴ from any debt . . .

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by —

(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's or an insider's financial condition;

(b) use of a statement in writing —

(i) that is materially false;

(ii) respecting the debtor's or an insider's financial condition;

(iii) on which the creditor to whom the debtor is liable for such money, property, services, or credit reasonably relied; and

(iv) that the debtor caused to be made or published with intent to deceive . . . .²⁵

The above statute indicates that dischargeability rests on how the indebtedness was created; however, the statute fails to mention the debtor as the party perpetrating the fraud, except in subsection 2(a)(2)(B)²⁶ regarding use of a written statement to perpetuate fraud.²⁷ Thus, a literal...