If you represent corporate creditors pursuing actions for non-dischargeability in bankruptcy court, there are some important considerations to weigh before moving forward. Typically, creditors will file for non-dischargeability under Section 523(a)(2) of the Bankruptcy Code. While most debts can be discharged in bankruptcy, this code section creates an exception for debts that were procured by "false pretenses, a false representation, or actual fraud," which are not dischargeable. Often times, however, a creditor may file an adversary complaint for non-dischargeability solely to force a settlement with the debtor. Creditors with that goal in mind need to be cautious as they could end up facing sanctions. Read on to learn more about sanctions for non-dischargeability actions under Section 523 and how you can protect your clients.
Substantial Justification Required
In order to discourage frivolous non-dischargeability actions, Section 523(d) allows for costs of suit and attorney's fees where a creditor's action is not "substantially justified" and where imposition of sanctions would be unjust. The Supreme Court has weighed in on the meaning of "substantially justified" in a related case, noting that "a position can be justified even though it is not correct, and [. . .] it can be substantially (i.e. for the most part) justified if a reasonable person could think it correct, that is, if it has a reasonable basis in law and fact."
A great example of this is seen in a case from the Bankruptcy Appellate Panel (BAP) for the Tenth Circuit, Household Bank, N.A. v. Sales (1999). In that case, two credit card issuers filed a non-dischargeability action against a debtor under Section 523(a)(2). The debtor sought to dismiss the non-dischargeability complaint based on the plaintiffs’ failures: (1) to investigate alleged fraud prior to commencing the action; and (2) to allege or produce any facts or evidence to establish debtor's fraud. Absent any allegations or evidence of fraud, the bankruptcy court granted the debtor a default judgment, but denied the debtor's request for relief under Section 523(d) because there were no findings indicating bad faith or an absence of substantial justification.
The BAP reversed on appeal and held that merely granting a default judgment in favor of the debtor defendant was not a sufficient sanction against the creditor plaintiffs. It determined that if a debtor succeeds in discharging a debt that is the subject of a nondischargeability lawsuit, then the burden is on the creditor plaintiff to prove that its lawsuit is substantially justified (or that circumstances would render an award of fees unjust). If the creditor cannot meet its burden, the court must award sanctions as a matter of law in the form of fees and costs.
In another Bankruptcy Court case addressing substantial justification and sanctions under Section 523, the Court noted that the test for substantial justification centered on objective criteria and not the subjective motives of the creditor (e.g. whether it intended to file a nondischargeability action only to pressure a debtor into settlement).
What Does This Mean For Your Clients?
The Sales case is consistent with a line of cases designed to curtail abusive nondischargeability litigation by creditors. Courts are growing less tolerant of litigation aimed at forcing consumer debtors into onerous settlement agreements to avoid additional legal costs. Section 523(d) is designed to limit these "unfair collection tactics," and Sales sends a clear message to the bankruptcy courts to employ Section 523(d) as mandated.
That being said, your clients cannot be penalized if one motivation for filing their nondischargeability action is to induce a settlement. However, they must have a reasonable basis for their claims and be willing to prosecute them with the court. It's incumbent upon you to ensure that your clients are advised of the possibility of sanctions and, if they move forward with an action under Section 523(a)(2), that they properly allege fraud and meet the burden of substantial justification.
Additional Resources
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