When an individual files for bankruptcy, the typical result is that the individual’s debts to all of its creditors—including its bank creditors—are discharged. As a practical matter, this means that those obligations are essentially uncollectable as personal obligations of the bankrupt debtor. (The creditors may retain lien rights, but that is a subject for another day.) However, under certain circumstances, and provided that the proper hoops are jumped through within the required time deadlines, some or all of the debtor’s debts may be excepted from the discharge. When only one or more particular debts are excepted from the discharge, this is called “nondischargeability.” The bankruptcy statute specifies the types of debts that are subject to nondischargeability, and the hoops that must be jumped through in order for such debts to be nondischargeable.
There are two statutory provisions regarding non dischargeability that are of particular interest to bankers: these two nondischargeability provisions are generally referred to as the “false financial statement” exception and the “actual fraud” exception.
In two recent bankruptcy decisions of interest to bankers, the Supreme Court has weighed in on each of those two exceptions. In one(1), the Supreme Court issued what amounted to a warning to bankers to make sure to take certain steps; in the other(2), the Supreme Court appears to broaden the exception, in a way that may well turn out to be helpful to bankers.
False Financial Statements
If a bank reasonably relies on a borrower’s false financial statement in making a loan, and if the borrower then files for bankruptcy, the bank—if it acts quickly and jumps through the right hoops—may be able to get a judgment denying the borrower’s discharge of that particular debt. Under the right facts, this can save the bank from a massive loss. (In many instances, this will mean that the borrower is still obligated to the bank, but has been discharged of all of its other debt.) One of those hoops is that the false financial statement must be in writing. In a recently announced decision, the Supreme Court clarified that the “writing” hoop applies to any statement about the debtor’s financial condition, even if the statement is an informal reference, and even if the reference is to a single asset.
Get it in writing! If the bank is relying on a representation by its customer as to any matter or thing relating to the customer’s financial condition, whether as to the making of a loan, the renewal of a loan, or forbearance as to enforcing a loan, find a way to get that representation in writing. If the customer tells you, “My ship is coming in,” in any way, and if you are relying on what’s on that ship, you need to get the customer to tell you about the ship in writing.
If, in making a loan, a bank reasonably relies on a representation about anything other than the borrower’s financial condition, and if the borrower then files for bankruptcy, the bank—again, if it acts quickly and jumps through the right hoops—may be able to obtain a judgment denying the discharge of that particular debt. Until now, many courts have interpreted the “hoops” to include the requirement that a specific misrepresentation must have been made. As we all know, some fraudulent schemes don’t necessarily involve the making of a specific misrepresentation to every victim. In a decision that under the right facts could be extremely helpful to banks, the Supreme Court held that this “actual fraud” exception to discharge does not require a specific misrepresentation.
If a borrower goes bankrupt and the bank suspects that it has been the victim of a fraudulent scheme, the bank should investigate—and likely consult with competent counsel—the pros and cons of commencing a legal action in the bankruptcy court to deny the discharge of that debt. As with legal actions involving false financial statements, there are strict deadlines for commencing legal actions alleging “actual fraud” as the basis for denying the discharge of that particular debt. Accordingly, it is important to act quickly. Under the right facts and circumstances, the bank may end up avoiding, or at least mitigating, what might otherwise have been a massive loss.
This information is general in nature and should not be construed as tax or legal advice.
(1) Husky International Electronics, Inc. v. Ritz, 136 S.Ct 1581, 194 L.Ed.2d 655 (2016).
(2) Lamar, Archer & Coffrin, LLP v. Appling, 138 S.Ct. 1752 (2018).