If a debtor files bankruptcy, it does not necessarily mean a creditor will be left holding the bag. Jocelyne A. Macelloni and Pavla Vitkova of Barakat + Bossa PLLC provide an in-depth guide of how creditors may be able to preclude a debtor’s debt from being discharged in bankruptcy.
BY JOCELYNE A. MACELLONI, PARTNER, BARAKAT + BOSSA PLLC and PAVLA VITKOVA, ATTORNEY, BARAKAT + BOSSA PLLC
Creditors may feel discouraged from pursuing debts owed to them when their debtor files for bankruptcy, in particular, Chapter 7 bankruptcy. However, creditors should not lose hope and should instead explore whether they can preclude their debt from being discharged by the debtor or otherwise preclude the debtor from receiving a bankruptcy discharge. A creditor can do this by asserting an objection to discharge-ability of their debt or an objection to the discharge of the debtor. These objections are completed through a process known as an “adversary proceeding” within the debtor’s bankruptcy case. This article will shed a little light on the primary pathways through which a creditor can persist in pursuing a claim even in the face of a debtor’s Chapter 7 bankruptcy filing and specifically addresses the application of Florida law, which may preclude the re-litigation of certain issues in bankruptcy.
Discharge in Bankruptcy
The very concept of Chapter 7 bankruptcy is to discharge all the debtor’s debts without the debtor being obligated to pay the full amounts due. In other words, when a debt is discharged, the debtor no longer has an obligation to pay the creditor. However, is it fair to discharge a debt that was obtained by fraud? Or in which the debtor is obviously hiding assets to avoid paying their debts to achieve a discharge in bankruptcy? The simple answer is no. The U.S. Bankruptcy Code addresses these situations and provides avenues for creditors under 11. U.S.C. § 523 and 11 U.S.C. § 727.
How to Avoid the Discharge of Your Debt
As a creditor, there are generally two ways to avoid your debt from being discharged.
The first way is found under 11. U.S.C. § 523, which is titled “Exceptions to Discharge.” This provision applies not only to Chapter 7 proceedings but to all bankruptcy proceedings.
The second way is found under 11. U.S.C. § 727, titled “Discharge.” This provision applies only to Chapter 7 bankruptcies.
Exceptions to Discharge-ability
The 11. U.S.C. § 523 provision provides for exceptions to the ability of a debtor to discharge a particular debt based upon the type of the underlying debt and the circumstances under which the debt arose. There are 19 categories of debts excepted from discharge under Chapters 7, 11 and 12. Chapter 13 has a more limited list of exceptions. Most of the exceptions to discharge apply automatically. However, the most important subsections for creditors, generally, are 11 U.S.C. § 523(a)(2), (4) and (6), which do not apply automatically. These sections require the creditor to ask the bankruptcy court to determine, upon notice and hearing, whether the debts are excepted, or exempt, from discharge. Unless a creditor makes a specific request in accordance with the timing set forth by the bankruptcy court, the debt will be discharged.[i] The procedure to make such a request is called an adversary proceeding. We have more about adversary proceedings later in this article.
Under section 523(a)(2), a discharge in bankruptcy does not discharge an individual debtor from any debt for money, property or services obtained by false pretenses, a false representation, actual fraud, or by using a written false statement regarding the debtor’s or insider’s financial condition on which the creditor relied, and which was made or published with the intent to deceive.
Section 523(a)(4) pertains to situations where the debt is for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.
Section 523(a)(6) excludes from discharge any debts for willful and malicious injury by the debtor to another entity or to the property of another entity. This is a particularly useful provision when the creditor is a company (e.g., a corporation or limited liability company).
Objections to Discharge
The 11. U.S.C. § 727 section of the bankruptcy code is specific to Chapter 7 bankruptcies and focuses on the debtor’s conduct during and immediately before the bankruptcy case.
There are 12 situations in which a discharge will not be granted in a Chapter 7 bankruptcy.[ii] For example, a discharge will not be granted if the debtor is not an individual or if the debtor has been granted a discharge in bankruptcy in the last eight years (counting from the date of filing the petition, not the date of discharge).[iii] For creditors, the most important provisions are sections 727(a)(2)-(6). If the debtor commits any of the acts listed in these sections within one year of the filing of the bankruptcy petition, the debtor cannot receive a bankruptcy discharge.
First, section 727(a)(2), which pertains to the hiding or transferring assets of the debtor or of the estate with the intent to hinder, delay or defraud a creditor or the officer of the estate, applies to any transfer or concealment of the debtor’s property within one year prior to the filing of the petition. Section 727(a)(3) states that a discharge will not be granted if the debtor has concealed, destroyed, or falsified any documents from which the debtor’s financial condition or business transactions could be ascertained.
The next section, 727(a)(4), precludes a discharge when the debtor knowingly and fraudulently, in connection with a bankruptcy case, makes a false oath; uses a false claim; offers or receives money, property or advantage for acting or forbearing to act; or withholds any financial documents from the officer of the estate.
Meanwhile, Section 727(a)(5) states that a discharge will not be granted if the debtor fails to satisfactorily explain, before determination of denial of discharge, the loss of assets to meet the debtor’s liabilities.
Lastly, Section 727(a)(6) provides for denial of discharge in situations which occur during the bankruptcy proceeding where the debtor refuses to comply with a court order, to answer a material question, or to testify. If the debtor raises the privilege against self-incrimination and the court grants immunity with respect to the matter, the question must be answered, otherwise discharge will not be granted.
Section 727 of the bankruptcy code permits a creditor to object to the granting of the discharge and, similarly to Section 523, such objection must be made via an adversary proceeding.
An adversary proceeding is a legal vehicle by which a creditor may request that a certain debt be excepted from discharge under 11 U.S.C. § 523 or object to the discharge of all debts of the debtor under U.S.C. 11 § 727. An adversary proceeding is essentially a lawsuit within a bankruptcy proceeding and is initiated by filing an adversary complaint.[iv] The creditor is identified as the plaintiff in the proceeding and the debtor is the defendant. The Adversary complaint should identify whether the action is being brought under Section 523 and/or 727 of the bankruptcy code, the specific subsection(s) and the basis for the objection.[v]
Once an adversary complaint has been filed, a deadline for the debtor to respond will be set and the proceeding will go forward like a lawsuit outside of bankruptcy court, including the conducting of discovery and a final trial.
The burden of proof in adversary proceedings is on the party seeking the declaration that its debt should be excepted from discharge.[vi] The non-discharge-ability must be proven by a preponderance of the evidence.[vii] However, “intertwined with this burden is the basic principle of bankruptcy that exceptions to discharge must be strictly construed against a creditor and liberally construed in favor of a debtor so that the debtor may be afforded a fresh start.”[viii]
Creditors who have already gone through the pains of litigation and successfully obtained a judgment against the debtor because of fraud can protect its judgment from discharge, but only if the creditor initiates a proper proceeding under 11 U.S.C. § 523.
A judgment creditor who has a judgment against the debtor in which there was a finding of fraud or some other clear ground for non-discharge-ability has an advantage thanks to the concept of collateral estoppel. “Under collateral estoppel, once a court decides an issue of fact or law necessary to its judgment, that decision precludes re-litigation of the same issue on a different cause of action between the same parties.”[ix] “Federal courts may apply collateral estoppel to issues decided by state courts.”[x] The elements of collateral estoppel vary state by state, and bankruptcy courts will use the law of the state in which the judgment was rendered.[xi]
In Florida, the elements of collateral estoppel are: (1) an identical issue must have been presented in the prior proceedings; (2) the issue must have been a critical and necessary part of the prior determination; (3) there must have been a full and fair opportunity to litigate that issue; (4) the parties in the two proceedings must be identical; and (5) the issues must have been actually litigated.[xii] These elements will be applied by any bankruptcy court in any state in the U.S. when a Florida judgment is at issue.[xiii] Lastly, the “bankruptcy court must find that the burden of persuasion in the discharge proceedings is not significantly heavier than the burden of persuasion in the initial proceeding.”[xiv]
What If You Have a Default Judgment?
In Florida, “pure” default judgments, where the defendant entirely failed to appear or defend an action premised on fraud, will satisfy the standard of collateral estoppel.[xv] A default judgment “can be sufficient to satisfy the ‘actually litigated’ element of collateral estoppel.” The phrase ‘actually litigated’ only contemplates that the defendant has been given a full opportunity to defend themselves. As a result, a default judgment obtained in state court should not be discounted because a defendant voluntarily chose not to participate in the case. The same rationale also applies to summary judgments entered in Florida’s state courts.[xvi]
Regarding the balance of burdens of persuasion of fraud under Florida law and fraud under federal bankruptcy law, “[t]he Eleventh Circuit has determined that the evidentiary burdens for fraud under Florida law and under § 523(a) are identical.”[xvii]
However, creditors should be careful when obtaining default judgments from debtors. Artful pleading is the key to obtaining a default judgment, which can be useful in bankruptcy court.
First, as to multi-count default judgments, Florida courts are split on whether each count of the complaint must independently satisfy the grounds for non-discharge-ability. In the Middle District of Florida, the court ruled that the elements of collateral estoppel were not met when a default judgment resulted in fraudulent misrepresentation, or alternatively, breaches of contract.[xviii] In the Southern District of Florida, the court has expressed that a default judgment on a multi-count complaint, where at least one count sounds in fraud, will give preclusive effect because every allegation in the complaint was “conclusively established as true by entry of the default judgment”.[xix] It is better to err on the side of caution, and if possible, either only include claims which support the non-discharge-ability under § 523 (a) or otherwise seek a final judgment that in form clearly articulates the difference in the damages awarded under each individual claim.
Another wrinkle that creditors must beware of is the way in which the counts are pled. In short, each count must contain the factual allegations that meet the element of actual fraud as bankruptcy courts interpret it.[xx] For example, in a claim for fraudulent misrepresentation in Florida, one may plead that the defendant knew or should have known about the falsity of their claims, as that still satisfies the elements of fraudulent misrepresentation in Florida.[xxi] However, in order to show actual fraud and have the debt categorized as non-dischargeable in federal bankruptcy court, one must show that the defendant knew about the falsity.[xxii] If the complaint says that the defendant knew or should have known about the falsity, it will satisfy the state court, but the federal courts will have no way to determine which fact served as basis for the judgment.[xxiii] Therefore, pleading alternative facts is not a good idea when a default is anticipated. An amendment can always be made to the pleading if the defendant appears in the case and a judgment by default is no longer possible. But, simply stated, each count must be pled with such facts that would satisfy the “fraud” requirement under § 523(a).
Interestingly, if the default judgment is from federal court, federal law on collateral estoppel applies. Under federal law, a default judgment does not satisfy the federal elements of collateral estoppel, therefore, the claims must be relitigated anew in the adversary proceeding.[xxiv]
Lastly, as the bankruptcy code does not give much explanation as to what it means by “fraud” and other terms, the courts will turn to statutory construction, legislative history and the common law in determining the meaning of the words in the statute.[xxv] For example, the Eleventh Circuit has held that the elements for common law fraud in Florida closely mirror the requirements of §523(a)(2)(A).[xxvi]
Often, creditors will find a debtor that fails to appear in litigation, permitting a default to be entered against them, will subsequently file for bankruptcy. Therefore, if a creditor believes that they were defrauded, it is important to raise the issue of fraud in the initial litigation so that if a default final judgment is entered, it will encompass the fraud and collateral estoppel will preclude re-litigating the fraud in the adversary proceeding.
If a creditor can establish the relevant elements under section 523 or 727 of the bankruptcy code at the final hearing in the adversary proceeding, the creditor will successfully preclude the debt due to it by the debtor from being discharged and/or the debtor receiving a discharge, allowing the debt to live another day.
There are many ways in which a creditor may pursue their claims even if a debtor files for Chapter 7 bankruptcy. First, a creditor may ask the court to except their debt from discharge based on the specific debt arising from actual fraud or other fraudulent conduct. Second, a creditor may object to the discharge of all debts of the debtor if the debtor’s conduct in the bankruptcy proceedings shows that the bankruptcy is being used to hinder creditors, either by the debtor transferring out or hiding assets, or by not providing information on the debtor’s financials. Both avenues require a creditor to file an objection by way of an Adversary proceeding. If the creditor takes no action, their debt will be discharged when the creditor receives a discharge.
Florida judgment creditors who have a judgment for fraud or another ground for non-discharge-ability have an immense advantage in such an adversary proceeding because of the doctrine of collateral estoppel. Even if the creditor has a default judgment where the defendant entirely failed to respond to the lawsuit, collateral estoppel precludes the issues from being relitigated, and a favorable outcome in the adversary proceeding without the need of a trial is guaranteed.
Creditors should not shy away from bankruptcy proceeding but should consult with legal counsel and determine whether they have the ability to exclude their claim from the discharge or to object to the debtor’s ability to obtain a discharge.
Jocelyne A. Macelloni is a partner and director of education at Barakat + Bossa PLLC, located in Miami. Board-certified by the Florida Bar in business litigation, Macelloni has spent more than a decade representing businesses and business owners in courts and arbitrations around the U.S., including in cross-border transactions and disputes that involve enforcing factoring companies’ and secured creditors’ rights. Macelloni can be reached at firstname.lastname@example.org.
Pavla Vitkova is an attorney at Barakat + Bossa PLLC, located in Miami. Vitkova commenced her legal career in the Czech Republic, where she earned her first law degree. Subsequently, she transitioned to the U.S. She graduated summa cum laude from Nova Southeastern University and now specializes in business litigation. Vitkova can be reached at email@example.com.
[i] See 11. U.S.C. § 523 (c)(1)(“…the debtor shall be discharged from a debt of a kind specified in paragraph (2), (4), or (6) of subsection (a) of this section, unless, on request of the creditor to whom such debt is owed, and after notice and a hearing, the court determines such debt to be excepted from discharge under paragraph (2), (4), or (6), as the case may be, of subsection (a) of this section.”).
[ii] 11 U.S.C. § 727(a).
[iii] 11 U.S.C. § 727(a)(8).
[iv] USCS Bankr. R 7003; FRCP R 3.
[v] USCS Bankr. R. 7008; FRCP R 8.
[vi] Warren v. Warren (In re Warren), 2022 Bankr. LEXIS 3440, *11, 2022 WL 17481431.
[ix] Howard Ave. Station, LLC v. Kane (In re Howard Ave. Station, LLC), 2022 U.S. Dist. LEXIS 171912 *22 (M.D. Fla. 2022) (citing to Montana v. United States, 440 U.S. 147, 153, 99 S. Ct. 970, 59 L. Ed. 2d 210 (1979)).
[x] Id. (citing to Kremer v. Chem. Constr. Corp., 456 U.S. 461, 467 n. 6, 102 S. Ct. 1883, 72 L. Ed. 2d 262 (1982)).
[xi] Wharton v. Shiver (In re Shiver), 396 B.R. 110, 120 (S.D.N.Y. 2008) (“Congress specifically required all federal courts give preclusive effect to state court judgments whenever the courts of the state from which the judgments emerged would do so…”) (quoting Allen v. McCurry, 449 U.S. 90, 96, 101 S. Ct. 411, 66 L. Ed. 2d 308 (1980) (internal citations omitted)).
[xii] Howard Ave, 2022 U.S. Dist. LEXIS 171912 at *23-24 (citing to Diagnostic Leasing, Inc. v. Associated Indem. Corp., 8:16-CV-958-T-36TGW, 2019 U.S. Dist. LEXIS 242665, 2019 WL 13192055, *13 (M.D. Fla. Jan. 25, 2019) (Honeywell, J.) (collecting cases)); see also Winn—Dixie Stores, Inc. v. Dolgencorp, LLC, 746 F.3d 1008, 1036 (11th Cir. 2014) (listing the elements as: (1) an identical issue (2) has been fully litigated (3) by the same parties or their privies, and (4) a final decision has been rendered by a court of competent jurisdiction).
[xiii] Wharton, 396 B.R. at 120.
[xiv] Manucy v. Hartman (In re Hartman), 274 B.R. 911, 914 (M.D. Fla. 2002).
[xv] Lasky v. Itzler (In re Itzler), 247 B.R. 546, 551 (S.D. Fla. 2000)(“[U]nder Florida law, pure default judgments have preclusive effect.”); Manucy, 274 B.R. at 916; see also, Masciarelli v. Maco Supply Corp., 224 So. 2d 329 (Fla. 1969); Avant v. Hammond Jones, Inc., 79 So. 2d 423 (Fla. 1955).
[xvi] See Manucy v. Hartman (In re Hartman), 274 B.R. 911, 914 (M.D. Fla. 2002); Lasky v. Itzler (In re Itzler), 247 B.R. 546, 551 (S.D. Fla. 2000); Masciarelli v. Maco Supply Corp., 224 So. 2d 329 (Fla. 1969); Avant v. Hammond Jones, Inc., 79 So. 2d 423 (Fla. 1955).
[xvii] See St. Laurent, II v. Ambrose (In re St. Laurent, II), 991 F.2d 672, 677 (11th Cir. 1993).
[xviii] In re Green, 262 B.R. 557 (Bankr. M.D. Fla. 2001).
[xix] See, Howard Alternatives, Inc. v. Bentov (In re Bentov), 514 B.R. 907, 914 (S.D. Fla. 2014).
[xx] See Harris v. Jayo (In re Harris), 3 F.4th 1339 (11th Cir.2021).
[xxi] Id. at 1349 (citing to Joiner v. McCullers, 158 Fla. 562, 28 So.2d 823, 824 (Fla. 1947)).
[xxii] Id. at 1349 (citing to In re Bogdanovich, 292 F.3d 104, 112 (2d Cir. 2002)).
[xxiv] See Bush v. Balfour Beatty Bahamas, Ltd., 62 F.3d 1319, 1323 (11th Cir. 1995) (general federal rule is that a default judgment will not ordinarily support the application of collateral estoppel).
[xxv] See City Bank & Trust Co. v. Vann (In re Vann), 67 F.3d 277 (11th Cir. 1995).
[xxvi] Manucy, 274 B.R. at 915 (citing to In re St. Laurent, II, 991 F.2d at 676).