In 2013 the U.S. Supreme Court handed down an opinion that shed light on the meaning of the word “defalcation” as it is used in the Bankruptcy Code’s list of nondischargeable debts.  The opinion disabuses of their error those who thought the word had something to do with a bathroom bodily function.  In this post we will look at the Supremes’ decision in the larger context of nondischargeability under 11 U.S.C. § 523(a)(4).

I.  Nondischargeable Debts In A Personal Bankruptcy:  Section 523(a)(4)

As readers of this blog know, 11 U.S.C. § 523(a) contains the exceptions to discharge in Chapter 7, 11, 12, and 11 U.S.C. § 1328(b) hardship discharge Chapter 13 bankruptcies.  Included in that list is the following:

A discharge under section 727, 1141, 1228 (a), 1228 (b), or 1328 (b) of this title does not discharge an individual debtor from any debt— . . . for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.

11 U.S.C. § 523(a)(4).

The list of debts that are nondischargeable in a completed Chapter 13 plan discharge ― found in 11 U.S.C. § 1328(a) ― is shorter than the list of exceptions to discharge found in 11 U.S.C. § 523(a).  However, § 1328(a) includes § 523(a)(4) by reference, so a debt incurred through “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny” is never dischargeable in any personal bankruptcy.

However, § 523(a)(4) is not self-executing.  According to 11 U.S.C. § 523(c)(1):

[T]he 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.

Thus, the creditor can only make the debt survive the bankruptcy discharge by successfully prosecuting a special kind of lawsuit in the Bankruptcy Court.  That kind of lawsuit is called an adversary proceeding.
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This post is the fourth in a series in which I will discuss fraudulent transfers.  The second post discussed the sources for a trustee’s authority to avoid a fraudulent transfer.  This one deals with the mechanics of fraudulent transfer avoidance. 

            D.        Avoiding Fraudulent Conveyances

            1.        The Power To Avoid

The Bankruptcy Code’s fraudulent transfer avoidance power is found in beginning of 11 U.S.C. § 548(a):  “. . . the trustee may avoid any transfer . . . of an interest of the debtor in property . . .” and in 11 U.S.C. § 548(b):

The trustee of a partnership debtor may avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within 2 years before the date of the filing of the petition, to a general partner in the debtor, if the debtor was insolvent on the date such transfer was made or such obligation was incurred, or became insolvent as a result of such transfer or obligation.

The first avoidance passage — from § 548(a) — is quite general and encompasses any sort of fraudulent conveyance, whether or not the debtor was insolvent.  The second provision is much more narrowly tailored, and applies only to a debtor that is a partnership that was insolvent at the time of transfer, or immediately after the transfer.

The trustee will learn of the transfer because the debtor is required to report it in item 10 of the Statement of Financial Affairs.  Failure to report the transfer is perjury, which can be redeemed for free room and board at government expense.

The vehicle for avoiding a fraudulent transfer is an adversary proceeding pursuant to Fed. R. Bankr. Proc. 7001(1): 

The following are adversary proceedings:  a proceeding to recover money or property, other than a proceeding to compel the debtor to deliver property to the trustee, or a proceeding under §554(b) or §725 of the Code, Rule 2017, or Rule 6002.

An adversary proceeding is a full-blown lawsuit, so it’s a big deal.

Why does the Bankruptcy Code provide for the avoidance of fraudulent transfers?  When a debtor files bankruptcy papers an estate is created that consists of all of the debtor’s assets (except those the debtor can exempt).  In theory, the debtor ceases to be liable for those debts (this ultimately happens when the debtor receives a discharge, though some types of debts may not be dischargeable), and the debtor’s debts become claims against the estate.  The estate is the pot from which creditors are to be repaid.  A fraudulent transfer diminishes that pot.  
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The answer differs depending on the nature of the debt and under which chapter the bankruptcy case was filed.

I.          The Key Exception To Discharge

The key provision of the Bankruptcy Code that we use to answer the question is 11 U.S.C. § 523(a)(3), which states (with emphasis added):

A dischargeunder section 727, 1141, 1228 (a), 1228 (b), or 1328 (b) of this title does not discharge an individual debtor from any debt— . . . neither listed nor scheduled under section 521 (a)(1) of this title, with the name, if known to the debtor, of the creditor to whom such debt is owed, in time to permit

(A) if such debt is not of a kind specified in paragraph (2), (4), or (6) of this subsection, timely filing of a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing; or

(B) if such debt is of a kind specified in paragraph (2), (4), or (6) of this subsection, timely filing of a proof of claim and timely request for a determination of dischargeability of such debt under one of such paragraphs, unless such creditor had notice or actual knowledge of the case in time for such timely filing and request;

If you’re not used to reading statutory language you may naturally ask:  What does all of this mean?  One thing is clear:  this statutory provision concerns debts that were “neither listed nor scheduled” in the bankruptcy papers “in time to permit . . .”  But to permit what?  There are two things that the creditor would have been able to do in a timely fashion if the debt had been properly scheduled, but cannot because of the oversight.
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