In a Bankruptcy, some debts are non-dischargeable. This means that even though all of the other debts are no longer owed (discharged), the non-dischargeable debts are still owed even after the Bankruptcy is concluded. A complete list of the types of debt are found in the Bankruptcy Code Section 523. These debts are general thing like student loans, taxes, fines owed the government, child support, and debts incurred through bad acts by the debtor. These bad acts are generally one of the following:
- False Pretenses
- Willful or Malicious Injury
If a creditor wants to be allowed to collect a debt from a debtor after the bankruptcy, they generally need to file a lawsuit in Bankruptcy Court known as an Adversary Proceeding. To win this suit, the creditor will need to prove that the debt was incurred in one of the non-dischargeable manners listed in Section 523. For that reason, the suit is known as a 523 action.
Types of Creditors in 523 Actions
Credit Card Companies
Credit Card companies often file a 523 action if a debtor has run up a large amount of debt just prior to filing. The reasoning is this: If you knew you were going to file bankruptcy then you had no intention to pay the debt when you borrowed the money. Therefore, you committed fraud when you signed the credit card slip agreeing to be bound by the terms of the cardholder agreement. Under a theory of fraud or false pretense, the debt may be non-dischargeable. As you can imagine, it can be fairly difficult for a credit card company to prove what you were thinking when you borrowed the money. Often a bankruptcy can occur after an unexpected job loss, divorce, or death in the family. If those unexpected circumstances happened AFTER you incurred the debt, then it will be difficult to show that the debt was incurred through fraud or false pretenses.
Friends or Family
Friends or Family that are involved in business ventures or co-own an asset (like a boat or ATV’s) may end up being listed as a creditor on bankruptcy schedules. Sometimes they will feel the need to sue to make the debt non-dischargeable. If they can prove one of the theories of injury listed in 523, then they will prevail. Each reason listed in 523 requires proof of very specific facts (for example see our article on FRAUD). If the facts exist the friend or family member will likely prevail. The problem with a friend or family member 523 suit is that it most often is driven by emotion rather than facts that can be proven. This leads to mutually expensive litigation that could be solved with a written agreement between the parties reaffirming the debt rather than discharging the debt. This sort of solution should be sought rather than litigating the issue.
If someone sued you and you lost, they may try to use a 523 action to prevent you from discharging the judgment debt. In this sort of 523 suit, the facts that were proven in the initial lawsuit become the determinative facts. For example, if there was no proof of fraud or malicious injury in the original suit, then the judgment debtor will have a very difficult time proving enough facts to prevail in a 523 suit.
If any creditor is surprised or upset about the fact you are attempting to discharge your obligation to them in Bankruptcy, they may choose to file a 523 action. This will result in their need to prove that the debt was incurred in a manner listed in Section 523. The facts that can be proven matter more than the fact that they are surprised.
Risks as a Creditor in a 523 Action
The first significant risk is the inability to prove sufficient facts to prevail in the 523 action. If a Creditor hires an attorney to file the suit and they lose, they will have lost the money they spent hiring the attorney in addition to the amount of money that will be discharged in the Bankruptcy. Further, Section 523 (d) allows a defendant/debtor’s attorney to recovery their reasonable attorney fees to defend the 523 Action. If the court awards fees under Section 523(d), then the creditor will have lost even more money in the suit.
Even if a creditor wins a 523 action, there is significant case law that makes it very difficult for a the creditor to receive an award of fees. This is even true if the underlying contract that formed the basis of the dispute allowed a creditor to be awarded fees. When Section 523 was initially enacted, the legislature made it clear that 523 was designed to not give a creditor undue influence in a settlement that would lead to a debt being classified as non-dischargeable. For that reason, a creditor needs to weigh the cost of litigation with the possible outcomes.
Risk as a Debtor in a 523 Action
The first important point—you have to answer the complaint. If there is no answer then you will default on the adversary proceeding and the creditor will receive everything they are requesting.
If you answer, and have competent representation, your ultimate risk will be that the creditor will prove their case and the debt will be non-dischargeable. Without extreme circumstances, you likely will not be liable for the creditor’s attorney fees.
Catalyst will take some 523 defense actions on a modified contingency basis. Contact us to see if your circumstances qualify and to learn more.