Friday, November 21, 2008

Ninth Circuit Overturns BAP in Preserving Creditor's Non-Dischargeability Claim Against Embezzling Debtor After Creditor's Payment of Preference

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

Busseto Foods, Inc. v. Laizure (In re Laizure)
Ninth Circuit Court of Appeals, Case No. 06-16857
November 17, 2008

In this opinion released on Monday, the Ninth Circuit overturned both the bankruptcy court and the BAP (Bankruptcy Appellate Panel) in holding that a creditor which paid the trustee a preference preserved its right to pursue the debtor on its nondischargeability claims. The lower courts had ruled that the creditor could not pursue the debtor for nondischargeability because at the time the debtor filed the bankruptcy case he owed nothing to the creditor; having paid off the creditor during the preferential period, the debt only arising again post-petition after that creditor paid back the preferential payment to the trustee. This was strictly a case of statutory construction, focusing on the meaning of § 502(h) of the Bankruptcy Code, apparently the first time this issue has been addressed by any Circuit Court.

The Crucial Facts
Debtor embezzled from his employer while he was its controller and CFO, and after leaving employment arranged to repay the employer. Within 90 days after his final payment of about $39,000, debtor and his wife filed a Chapter 7 bankruptcy, and trustee demanded employer pay the $39,000 to the estate. While in negotiations with trustee about this and just before the filing deadline, employer filed an adversary proceeding alleging the nondischargeability of the debt under § 523(a)(4) of the Code. Employer then paid trustee $34,000 in settlement of the preference matter. It filed a proof of claim for that amount, but all of the Chapter 7 estate assets went to pay debtor's priority tax claims and the trustee's fees so employer received nothing through the estate. On debtor's motion, the bankruptcy court dismissed the employer's nondischargeability complaint on the basis that the debtor owed employer nothing on the date of the bankruptcy filing. The BAP affirmed; employer appealed.

The Statute
"Generally, § 502(h) allows claims arising from recovery of property by the trustee under § 550 the same as if the claim had arisen before the filing date of the bankruptcy petition."

§ 502(h) states in full:
A claim arising from the recovery of property under section 522, 550, or 553 of this title shall be determined, and shall be allowed under subsection (a), (b), or (c) of this section, or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition.
Primarily at issue was whether the "claim" which "shall be allowed" was a claim against the estate or against debtor personally.

The Ninth Circuit's Rationale
The Court couched the issue as follows: "whether the trustee's action in requiring [employer] to pay to the bankruptcy estate the amount it received from [the debtor] deprived [the employer] of its nondischargeability claim."

Its statutory analysis focused on the word "determined," stating that "[t]here would be no reason to require a § 502(h) determination if it were subsumed by allowability, so the plain language of § 502 demonstrates that the determination is an independent inquiry." Also, "the statute's use of the word 'and' shows Congress' intent to reinstate both determined and allowed claims."

Then the Court noted that the "phrase 'determination of dischargeability' appears twice in § 523" (regarding exceptions to discharge). The Court found this important because § 523(a) introduces the list of exceptions to discharge by speaking of not discharging "an individual debtor from any debt," and this term "any debt" the Court found to be "certainly broad enough to apply to personal claims," so "if a § 550 claim is determined to be nondischargeable under § 502(h), § 523 permits that reinstated claim to be brought against the debtor personally."

The Ninth Circuit concluded with a public policy argument. "Here, allowing [the debtor] to avoid repaying the funds he embezzled from [the employer] would only encourage debtors to pay outstanding debts that are nondischargeable and later file for bankruptcy protection, thus avoiding the nondischargeability of their debt under the veil of our bankruptcy laws." The Court remanded the case back to the bankruptcy court to resolve the employer's nondischargeability complaint against the debtor.

The Bottom Line
Creditors who are paid in full before debtor files a bankruptcy case, and so are not owed anything by the debtor as of the date of filing, may nevertheless pursue the debtor on a nondischargeability complaint if the creditor ends up returning some of the payments to the trustee on a preference claim. Therefore, if a creditor has reason to believe it will be pursued on a preference claim, that creditor should file a nondischargeability complaint against the debtor if it has grounds to do so, even if the creditor was owed nothing on the date of filing the case. The seeming lack of a debt at the date of filing of the petition will no longer preclude creditor from pursuing debtor on nondischargeability as to any preference funds it pays to the trustee.

by: Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

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