Two birds with one stone

Obtaining bankruptcy-proof judgments:

Two birds with one stone.

By James B. Angell

A bankruptcy will discharge individuals of most judgments, but not all. Certain claims may be excepted from a debtor’s bankruptcy discharge based on how the claim arose. For example, claims “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny”, claims for a “domestic support obligation” or claims for “willful and malicious injury by the debtor to another entity or to the property of another entity” may survive the discharge. To have one of these exceptions apply, you will need to file an adversary proceeding (a law suit within the bankruptcy), conduct a trial, and obtain a court order that the debt is not subject to the discharge and is “nondischargeable”. You may avoid having to present witnesses and evidence at trial in the Bankruptcy Court if the state court has already determined the issues necessary to determine that a claim is nondischargeable.

If the debtor has any prospect of financial rehabilitation, a nondischargeability order may put you in a better position than you were before the bankruptcy, because other claims will have been discharged and there is less competition for assets.

Case in Point.  As shown in the recent case of Lecann v. Cobham (In re Cobham), Case No. 13-06340-8-SWH (E.D.N.C.), a state court judgment that includes appropriate language may determine whether the claim is discharged in Bankruptcy Court if the claim was actually litigated in state court. In the Cobham case, the creditor obtained a judgment in North Carolina state court against the debtor prior to the bankruptcy. The judgment contained specific findings that the debtor, a director of jointly-owned companies, caused harm by making improper transfers from the companies, that the debtor was aware of the probable consequences of her wrongful conduct, and that punitive damages were appropriate. Based on these findings and a finding that the claim was actually litigated in state court, the Bankruptcy Court found that the claim was nondischargeable as a “willful and malicious injury” without conducting a trial.

Lessons Learned. Two lessons are to be learned from the Cobham opinion:

1. An attorney pursuing a state court judgment may obtain a “bankruptcy-proof” judgment by making claims that parallel the nondischargeability provisions of the Bankruptcy Code and seeking to have specific findings made in the order granting the judgment. If the state court’s findings on the claims align with the grounds for nondischargeability, then the Bankruptcy Court can rely on the state court judgment to except the claim from the discharge and avoid a full trial on the issue of whether the standards needed to show dischargeability have been met.

2. If you have a judgment against a bankrupt debtor, you may wish to have the judgment reviewed by a bankruptcy attorney to determine whether it evidences any basis for denying dischargeability of the judgment and whether it may avoid the need for a second trial in the bankruptcy court.

Other issues in Cobham. The Cobham decision has an interesting appellate history, having been appealed to both the District Court and the Fourth Circuit.  The District Court opinion suggests that creditors with claims against a corporation may have nondischargeable claims against a director of the corporation for improper management of corporate assets. On appeal to the District Court, the District Court held that, as a director, the debtor voluntarily assumed trust-like obligations under North Carolina law to the corporation’s stockholders and creditors. A director who misapplies corporate assets may be found to have committed “fraud or defalcation while acting in a fiduciary capacity” resulting in denial of the dischargeability of the creditors’ claims. Although this holding was found unnecessary by the Fourth Circuit on appeal, the District Court’s ruling on this matter remains of some significance in the Eastern District of North Carolina and may lead to dischargeability litigation of claims against directors of corporations by creditors.

If you have questions, or need assistance in evaluating the dischargeability of a claim, please contact James B. Angell at (919) 821-7700 or at jangell@hsfh.com.