Out of 19 kinds of debt that bankruptcy doesn’t wipe out, three are radically different.
Three exceptions to discharge look, not at the kind of debt such as taxes, or support or student loans. Rather the exceptions look at how the debt arose.
These exceptions prevent bad actors, who have incurred debts by forms of dishonesty or intentional bad behavior, from escaping the consequences in bankruptcy.
But unlike the other exceptions to the scope of the discharge, the creditor has the burden of filing a timely challenge to the discharge of its debt.
The creditor also has the burden of proving the facts that make the debt non dischargeable under the federal bankruptcy standard. The presumption is that the debt is dischargeable.
So, what kind of bad behavior may keep a debt from being discharged.
Fraud is first
Debts that are created as a result of fraud, misrepresentation or false pretenses aren’t subject to being wiped out. That’s §523(a)(2).
Note that the exception looks at the transaction at the being. The debtor may have behaved badly, resisting payment, after a debt was created and still get it discharged. The statute focuses on money, property, services to the extent obtained by fraud.
If the false statement is one about the debtor’s financial condition when the transaction is going down, that statement must be in writing to preclude discharge.
Breach of fiduciary duty survives
The second clutch of bad behaviors that can’t be discharged involve breach of fiduciary duty, embezzlement and larceny. §523(a)(4).
Embezzlement and larceny, which is a kind of theft, are easy to understand. But bankruptcy law has a narrow definition of who is a fiduciary for these purposes.
For breach of fiduciary duty to be nondischargeable, the duty must arise under an express trust. So trusts that are created by law to further equity or prevent undue enrichment don’t fall under this subsection.
One of the first judges I practiced before used to say that under California law, everyone is a fiduciary for everyone else. But not in his federal court.
Willful and malicious injury gets no discharge
Debts that are grounded in intentional injury to person or property live on after bankruptcy. That’s §523(a)(6).
There’s a huge body of law tussling with the meaning of “willful” and “malicious”. And the plot thickens when you realize that the protections for creditors created by this subsection is greater in Chapter 13 than in Chapter 7.
In Chapter 13 a debt for damages for personal injury is non dischargeable if it results from either willfulness or malice! Damage property willfully or maliciously and you’re OK in Chapter 13.
Timing is everything
There’s a timing issue for both creditors and debtors in these three discharge exception cases.
Debtors facing state court litigation may want to file bankruptcy before trial of the matter. Findings of fact made in a state court trial will be entitled to finality in a subsequent bankruptcy trial on the issue of dischargeability. So, suffer an adverse finding in state court and you’re stuck with that finding.
But since the standards of what is fraud or false representations is slightly different in federal law than in state law, you may have a dispute about whether the finding is really on the same issue that the bankruptcy court is focused on.
It may be cheaper to try the issue once, in bankruptcy court, than risk having to defend yourself twice in state court, then bankruptcy court.
Creditors must be diligent once a bankruptcy case is filed, to meet the filing deadline for challenging the discharge of their debt. Generally, the bankruptcy court sets a deadline 60 days after the date set for the first meeting of creditors by which challenges to dischargeability must be filed.
Miss that deadline for one of these kinds of debts and you’re out of luck. The debt will be discharged regardless of the merits of the challenge you could have brought to exclude it from discharge.