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Most experienced litigators have suffered the frustration of successfully chasing a judgment against people that harmed a client's business, only to be hit with a notice that one of the defendants has filed bankruptcy. In cases involving fraud by individuals, tactical decisions concerning proof at trial can make all the difference in limiting the likelihood of a bankruptcy filing, or at least avoiding being forced to retry the case in bankruptcy court.
HOW THE PROBLEM PLAYS OUT
In commercial disputes, it is common to sue not only a company, but also one or more individuals. When individuals are named as defendants, it is often for fraud. Many times, the decision to sue individuals for fraud is born of a desire to open a multi-front campaign against the defendants. The thought is that suing a business and individuals for multiple causes of action will maximize the likelihood of recovering damages.
In this context, plaintiffs at trial sometimes make tactical decisions to push one theory harder than another. And, since fraud requires an intent element that can be hard to prove, fraud claims can become less important during trials. While this can make sense tactically, it can be counterproductive if the individual files for bankruptcy protection after the trial. In fact, a strategic decision to downgrade a fraud claim in favor of focusing on an easier to prove breach of contract or interference with business relationship claim may create an unpleasant decision if a bankruptcy case is filed later. That is, your client may have to decide whether it is willing to re-litigate the case in bankruptcy court in an effort to prevent the debt from being discharged. The alternative is for your client to allow the debt to be discharged without a fight on the theory that it should not throw good money after bad. Aggressively pushing a fraud claim at trial can be the best way to avoid having a client stuck with this bad set of options.
NONDISCHARGEABILITY BASICS
Once a bankruptcy case is filed, a judgment creditor must take steps to protect its rights. Otherwise, all of the debtor's obligations are likely to be discharged to some degree. Whether they are discharged in full, or there is a plan that requires payments over time, will depend on the assets and liabilities of the particular debtor. However, it is safe to say that the typical individual debtor is likely to exit bankruptcy having received a full discharge, or paying pennies on the dollar.
Certain debts cannot be discharged in bankruptcy and do not require the creditor to take steps to protect its rights. These include many tax obligations and claims for alimony, maintenance and support. Other types of debts, including those based on fraud, may be excepted from discharge, but only if the creditor files an adversary proceeding in bankruptcy court no later than 60 days after the first setting of the meeting of creditors. If the creditor obtains an order holding that the debt is "nondischargeable," the debt will remain an obligation of the debtor notwithstanding the bankruptcy.
In connection with judgments against individual debtors, the most commonly litigated nondischargeable debts are those arising under §§ 523(a)(2), (4) and (6) of the Bankruptcy Code. In summary, these Code sections state that debts may not be discharged if they arise from actual fraud, embezzlement, larceny, misrepresentation, or willful and malicious injury.
COLLATERAL ESTOPPEL APPLIES IN SUBSEQUENT BANKRUPTCY PROCEEDINGS
The principle of collateral estoppel applies in bankruptcy court to bar re-litigation of factual or legal issues determined in a prior action. Four elements must exist for collateral estoppel to apply: (1) the issue sought to be precluded must be the same as that involved in the prior action; (2) the issue must have been litigated in the prior action; (3) the issue must have been determined by a valid final judgment; and (4) the determination must have been essential to the prior judgment. The party asserting collateral estoppel has the burden of proving that all four elements apply.
To determine whether an issue was actually litigated and was necessary to the decision in the prior action, courts examine the entire record of the earlier proceeding. Collateral estoppel may only be applied if the party against whom the earlier decision is being asserted had a "full and fair" opportunity to litigate the issue. In other words, a default judgment is not sufficient.
BACK TO OUR TACTICAL TRIAL DECISIONS
When you consider the Bankruptcy Code provisions regarding nondischargeability and the willingness of bankruptcy courts to apply collateral estoppel, your strategy decisions may change somewhat regarding what claims to pursue aggressively at trial. Now, you need to consider the extent to which the elements of the causes of action that you have alleged overlap with the elements of proving nondischargeability in the event of a future bankruptcy filing. The chance of using collateral estoppel to avoid protracted nondischargeability litigation provides an incentive to focus on claims whose elements would satisfy the Bankruptcy Code's definition of nondischargeability.
In the context of a trial court judgment for fraud, if there is a written opinion that makes it clear that the debtor committed fraud, and the factual basis for the finding is clearly set forth, bankruptcy courts will almost always invoke collateral estoppel in holding that the obligation is nondischargeable. If you obtain such a judgment, your client has probably side-stepped the trap of having to re-litigate in bankruptcy court in order to prove fraud.
NONDISCHARGEABILITY ISSUES IN SETTLEMENT AGREEMENTS
Litigators should also think about the possibility of a bankruptcy filing in connection with settlement agreements. Frequently, parties attempt to deal with this issue by requiring security or collateral in the event of a structured settlement. While this strategy may provide some comfort, it is a partial solution at best. One of the best ways to protect a settlement agreement from a future bankruptcy filing is to include language in the agreement that recites the reasons for the settlement. To the extent that there is language that recites from §§ 523(a)(2), (4) or (6), and to the extent that the reasons cited in the agreement are true, bankruptcy courts are likely to find the debt arising from the settlement agreement nondischargeable.
Since most defendants will balk at the idea of including recitals like this in a settlement agreement, a fallback position can be to simply have the agreement expressly reserve the issue of nondischargeability in the event of a bankruptcy. This should be adequate to convince the bankruptcy court that the parties did not intend to leave the settlement agreement as the sole remedy available to the plaintiff. Otherwise, the debtor is likely to argue that the obligation is based on breach of the settlement agreement and not fraud.
CONCLUSION
Where there are claims of fraud against individuals, trial strategy should take into account the possibility of a future bankruptcy filing and nondischargeability litigation. For a losing defendant, if there are not any findings of fact or conclusions of law that also demonstrate nondischargeability, bankruptcy may be a tempting option to deal with the judgment. By carefully applying bankruptcy considerations to proof elements at trial, one can severely limit the likelihood of a bankruptcy filing, or at least avoid re-litigating the case in bankruptcy court.
For more information about this topic, please contact Robert Gonzales (rjg@mglaw.net) or one of our other Insolvency or Litigation attorneys. |
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