Debts Incurred in Bad Faith Aren’t Dischargeable in Bankruptcy
Section 523(a)(2)(A) of the bankruptcy code provides that a debtor may not discharge debts incurred as a result of fraud. The statute defines fraud broadly and includes debt incurred under false pretenses, false representations and actual fraud. Examples of debts that fall under the fraud exception include, but are not limited to, credit card debt or loans obtained through false representations on an application, the sale of goods based upon fraudulent warranties or false promises. This rule reflects the bankruptcy code’s basic policy of affording a fresh start only to an honest, but unfortunate debtor.
In Re Livingston
Questions about whether a particular debt was incurred through fraud often lead to adversary proceedings, challenges to discharge, and sometimes bankruptcy appeals. This is what occurred in Livingston v Transnation Title Insurance (In re Livingston), where the debtors owned two properties, each of them was encumbered by a first mortgage. On March 2, 1999, the debtors granted a second mortgage on both properties to Standard Federal Bank to secure a loan in the amount of $ 166,000. On November 23, 1999, the debtors sold the Northville property and conveyed title by warranty deed. The first mortgage was paid but the Standard Federal Bank mortgage was not paid. On April 6, 2000, the Debtors sold one property and conveyed title by warranty deed. Again, the first mortgage was paid, but the Standard Federal Bank mortgage was not. On January 24, 2001, Standard Federal Bank foreclosed its second mortgage on the two properties. Transnation issued owner’s title insurance policies to the purchasers of both of these two properties. Ultimately, Transnation paid the Standard Federal Bank mortgages and became subrogated to the rights of the purchasers with respect to the two properties.
The record established certain misrepresentations by the Livingstons as part of the refinancing transactions. First, they provided an owner’s affidavit and affidavit of no-encumbrance, both of which were required by Transnation before it would insure the title to the purchasers. The owner’s affidavits clearly stated: “The undersigned have no knowledge of any restrictions other than shown of record, or easements or claims of easements against said property nor does the undersigned have any notice of claims or disputes as to boundary lines on said property.” Even though the second mortgages from Standard Federal Bank were never fully satisfied, the affidavits of no-encumbrance declared that the Livingstons’ mortgages had been discharged. Relying on these statements, Transnation then issued title insurance policies to the purchasers.
In June 2001, Transnation filed suit in Wayne County Circuit Court against the Livingstons, alleging breach of contract, innocent misrepresentation, fraud, and unjust enrichment. In May 2002, Transnation prevailed in that suit, and in 2004 Transnation’s state court victory was affirmed on appeal.
About a year later, the Livingstons filed a Chapter 7 bankruptcy petition. Soon thereafter, Transnation filed an adversary proceeding seeking a determination that the judgment in its favor was non-dischargeable under 11 U.S.C. § 523(a)(2)(A). At the close of discovery, Transnation filed for summary judgment, arguing that the state court judgment was preclusive on the issue of fraud. The bankruptcy court agreed and held that because the elements of a state common law fraud claim are virtually identical to those necessary to determine non-dischargeability, the Livingstons were collaterally estopped (a legal term which basically means courts will not review issues decided previously by other courts when the same parties are involved) from re-litigating the issue of fraud. The Livingstons then timely appealed to the district court, which affirmed the bankruptcy court opinion in full.
The U.S. Court of Appeals for the Sixth Circuit affirmed, finding that the debt could not be discharged. The appellate court “was not persuaded that the Livingstons were unaware of the encumbrances they placed upon the properties they sold.” The appellate court also found that the lower courts properly applied the doctrine of collateral estoppel; “[o]n the strength of the state court rulings and factual findings, we conclude that the Livingstons’ conduct evinced the “bad faith” and “actual or positive fraud” required … for a finding of “gross recklessness.” Thus, the parties actually litigated the issue of fraud before the state courts, and the Michigan Court of Appeals adjudicated it consistently with the standard of “gross recklessness” required for a finding of non-dischargeability on grounds of fraud under 11 U.S.C. § 523(a)(2)(A).
If you are considering bankruptcy, and have concerns about whether a particular debt can be discharged, talk to a bankruptcy attorney in your jurisdiction.