Making Sense of Bankruptcy: Fraud-Based Debts Which Can Be Challenged by Creditors

Although most debts are legally written off when you file bankruptcy, creditors can object by alleging you incurred the debt fraudulently.

 

Here’s the sentence that we’re explaining in this blog post today:

Bankruptcy law presumes debts are dischargeable (eligible for being written off) unless fitting a specific exception to discharge, with the fraud exception based on not rewarding dishonest behavior, an exception which must be raised on time by the creditor or the debt is still discharged.

The Presumption that Debts are Discharged

The Bankruptcy Code—the federal statutes governing bankruptcy that Congress has written under the authority of the U. S. Constitution—gives a list of the kinds of debts that are not discharged, and the conditions in which they are not discharged. Federal courts, which are empowered under the Constitution to interpret federal statutes, have made clear that debts are presumed to be discharged unless they fit within the Bankruptcy Code’s list of discharge exceptions.

The Fraud Exception

One of the most important exceptions to discharge is the one which says that debts, “to the extent obtained, by… false pretenses, false representation, or actual fraud” may be not dischargeable. Many of the other exceptions to discharge pertain to very particular kinds of debts, such as child and spousal support, various taxes, and student loans. But the fraud exception could apply to just about any kind of debt if it was incurred in a fraudulent way.

For a creditor to establish that a debt should not be discharged because it arose out of the debtor’s fraudulent behavior, the creditor would have to bring evidence and prove the following elements:

1. the debtor made a representation;  
2. the debtor knew at the time that this representation was false;  
3. the debtor made the representation with the intention and purpose of deceiving the creditor;       
4. the creditor relied on the representation; and
5. the creditor sustained damage directly because of the representation.

In other words, a creditor would have to show that you got a loan or some other form of credit by providing to the creditor certain false information, which you knew was false and provided it with the intent to cheat the creditor into letting you get the credit. In addition the creditor relied on that false information and was directly harmed in giving you the credit and then having the debt be discharged in bankruptcy.

Proving these elements may sometimes be easier than it sounds because a “representation” can be implied. For example the act of writing a check implies the “representation” that you have money in the account to cover the check. So in some circumstances a bounced check can be challenged as “fraud” for bankruptcy purposes. Similarly, the other elements of fraud may be able to be proved by a creditor easier than you might expect.

Still, a creditor must present convincing evidence to the bankruptcy court meeting all 5 of these elements in order to win. Otherwise its debt will be discharged, and you will not have to pay it. Proving these elements can be difficult and expensive, and so creditors tend not to object unless they believe they have a strong argument establishing fraud. In the vast majority of bankruptcy cases no creditors raise any fraud-based challenges.

And when creditors do raise this kind of challenge, they almost always gets settled. The challenge is raised in a specialized lawsuit in the bankruptcy court, focusing usually exclusively on the question whether the creditor can prove the elements of fraud. But these legal proceedings very seldom get as far as a trial where the judge would have to decide the matter. These get settled before that because there’s usually not that much money at issue compared to the amount of attorney fees that can accrue quickly for both sides. But this assumes both sides are acting rationally—these dispute can drag out when brought by personally vindictive creditors, such as ex-spouses and ex-business partners.

The Purpose of the “Fraud” Exception

Bankruptcy is designed to give a fresh financial start to the honest debtor. Among other things this generally means that you must have been honest in how you incurred your debts in order to be able to discharge them later in bankruptcy. So if you lied to get a loan or other debt and your intent was to cheat the creditor at the time you got the credit, you are considered to be not entitled to the discharge of that debt.

Be aware that this is not referring to what happened AFTER you incurred the debt, including during the collection process. Being evasive during that process, or not paying when you told a debt collector that you’d pay–these are NOT the kind of behavior that would jeopardize the discharge of a debt.  It’s your actions and intent in getting the debt in the first place that counts.

The Creditor Must Timely Complain or You Win

The fraud exception to discharge requires objection by the creditor or else the debt at issue is still discharged. Some kinds of debts are not discharged simply because of the type of debt they are, without the creditor needing to challenge the discharge in bankruptcy court. Examples are child and spousal support, most student loans, and various categories of taxes. But allegedly fraud-originated debts ARE discharged if the creditor fails to object, and does so on time.

But this assumes that the creditor knows about your bankruptcy filing and so indeed has the opportunity to raise an objection by the deadline given. That is one reason why it is very important that all your creditors be included on the documents filed at the bankruptcy court by your attorney.

Assuming the creditor is given appropriate notice, it has a very short time to raise its objection by formally filing a complaint with the bankruptcy court laying out its allegations. Its deadline to do this is 60 days after your “meeting of creditors,” so usually about three months after your case is filed. (This applies to both Chapter 7 and 13). If the creditor fails to file a complaint on time, it loses its chance to do so forever.