“How did you go bankrupt?”
“Two ways. Gradually, then suddenly.”
― Ernest Hemingway, The Sun Also Rises
Dealing with principals and indemnitors filing for bankruptcy is something those in the surety world inevitably have to deal with. Most of the time, the bankruptcy process plays out as intended: assets are gathered and hopefully maximized, creditors get in line, and a distribution is made. However, occasionally a surety will be faced with a bankruptcy situation where something seems off. Maybe project funds or materials cannot be accounted for. Or maybe the indemnitors are suddenly saying they have no assets while somehow launching a new business enterprise and living a lavish lifestyle. Understanding how to sniff out and combat potential attempts to abuse the bankruptcy process can be an effective tool in your arsenal. This article explains and provides a few practical pointers for making use of two available methods to respond to bankruptcy abuses: objections to discharge and dischargeability.
One of the fundamental tenants of the bankruptcy process is the idea of a “fresh start” when emerging from bankruptcy. While this typically entails a discharge of the debtor’s prepetition obligations and liabilities, the Bankruptcy Code provides exceptions that may either preclude a discharge generally or that may preclude a discharge of a specific debt. As discussed in more detail below, objections to discharge under Section 727 of the Bankruptcy Code focus on the debtor’s bad faith actions relating to the bankruptcy process itself. On the other hand, objections to dischargeability under Section 523 focus on particular debts that arose through some kind of fraud, theft, or other bad act. If successful, an objection to discharge generally precludes any discharge of the debtor, while an objection to dischargeability will preclude a discharge for a particular debt.
Section 727 of the Bankruptcy Code sets forth circumstances where the debtor may not be eligible for a discharge. The relevant grounds for objecting to discharge typically address bad faith actions by the debtor during the bankruptcy or within a year before the bankruptcy that are designed to circumvent the bankruptcy process and give the debtor more than they are entitled to under the Bankruptcy Code. These generally include fraudulently transferring, misusing, or concealing property of the estate (or of the debtor within the last year); withholding or falsifying financial information or documents; making false statements in connection with the bankruptcy; making or receiving payments to influence actions relating to the bankruptcy; failing to explain a loss or deficiency of assets; or improperly failing to obey orders of the court.
Grounds for objecting to discharge in the surety context can arise in a number of ways. Most common is some attempt by a principal or indemnitor to hide assets from the bankruptcy process by failing to make full disclosures, whether through simply failing to disclose assets being held, or attempting to conceal assets through transfers or undisclosed arrangements. For an objection to discharge to be sustained on these grounds, the surety will typically need to show that a false statement was knowingly made with the intent to defraud and was material to the bankruptcy case.
As a practical matter, establishing that a debtor is hiding assets is often not an easy task. It will be important to carefully review and compare what is disclosed by the debtor voluntarily in the bankruptcy with the information that can be discerned from the records collected through investigation, underwriting, and discovery. Failure to disclose or be able to explain large bank transfers or disbursements—particularly in self-dealing situations—should be considered a red flag. Sureties should also be aware of whether equipment, machinery, materials, or facilities simply “disappear” either through an undisclosed sale or by being “acquired” by a new entity without any formalities or consideration. Other potential concerns include things like accumulation of large amounts of cash or spending that is lavish or inconsistent with reported income.
Section 523 of the Bankruptcy Code identifies certain types of debts that are non-dischargeable based on how the debt arose, including debt obtained by or resulting from: fraud or false pretenses (except as to the debtor’s financial condition) under part (a)(2); fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny under part (a)(4); and willful and malicious injury or property damage under part (a)(6).
Potential objections to dischargeability can also come up for sureties in a number of ways. For example, complaints of a principal absconding with project materials that are the property of the owner are not unheard of, and the surety is often required to foot the bill for the replacement. Depending on the situation, those costs may be nondischargeable to the extent that they are found to be a result of larceny or fraud. In a similar vein, after a contentious dispute, the principal may intentionally damage materials or work already in place while walking off a project. Again, the costs to repair or replace that damage may implicate the property damage exception to discharge.
Another common consideration for sureties is whether project funds have been misappropriated in some manner that could be construed as fraud or defalcation while acting as a fiduciary. The first question will be whether the principal was acting as a fiduciary for the surety. Bankruptcy courts have tended to require a formal fiduciary arrangement as opposed to quasi-fiduciary relationships that commonly occur when acting on behalf of another. In the surety context, the key to meeting the fiduciary requirement will typically be the trust provision language in the indemnity agreement which is relatively standard.
The second element is establishing that the debt arose from fraud or defalcation. “Defalcation” is not defined by the bankruptcy code, but in this context generally means misuse or misappropriation of funds by someone who has a legal financial duty, such as a trustee. Generally, the term defalcation is broader than fraud and can include misuse resulting from negligence, which resulted in a longtime split among the circuit courts on whether negligent defalcation by itself was sufficient for nondischargeability. However, the Supreme Court has now clarified that a showing of wrongful intent, reckless conduct, or gross deviation from the ordinary standard of conduct is required for all of the wrongful acts set out in 523(a)(4).
In the surety context, a number of courts have found that misuse of project funds amounts to defalcation of while acting as a fiduciary when there is express trust agreement language in the indemnity agreement. A surety or its counsel should also check to see if the jurisdiction has a trust fund statute which provides that contractors receiving contract balances hold those funds in trust for its suppliers or subcontractors. However, given the Supreme Court’s clarification that defalcation requires a showing of wrongful intent, it will be important for a surety intending to assert this objection to gather sufficient evidence to establish that the principal’s misuse of funds was performed knowingly or that there was some element of recklessness or gross deviation from the standard of care involved.
Armed with a better idea of the types of information to look for, the next question is how to obtain the evidence needed to support these objections. In the surety context, the investigation often begins before a bankruptcy is even filed. Information about the principal and indemnitors can and should come from thorough underwriting and regular requests for updated financials. Also, when a surety gets involved with a project over concerns about a potential default, gathering project records and financials is an important step to both identify potential issues that may already be occurring and to establish a baseline of the financial scenario. If the indemnity agreement in place has a books and records clause, this is a good time to consider making a formal request, particularly if the surety is being asked to facilitate completion in some manner.
Once the bankruptcy process begins, additional tools for investigation become available. Debtors are required to file bankruptcy schedules and a statement of financial affairs that are designed to elicit a relatively complete snapshot of the debtor’s financial situation at the time bankruptcy was filed. The 341(a) meeting of the creditors is also helpful for gathering initial information and is typically scheduled three to seven weeks after the petition date. The meeting will be led by the trustee or the trustee’s counsel, but creditors or their counsel are also given an opportunity to ask the debtor questions directly.
Additional information can be also gathered under Rule 2004 of the Federal Rules of Bankruptcy Procedure, which provides that, on a motion from any party in interest, the court may order an examination of the debtor or any other entity relating “to the acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor's estate, or to the debtor's right to a discharge.” When relevant, “the examination may also relate to the operation of any business and the desirability of its continuance, the source of any money or property acquired or to be acquired by the debtor for purposes of consummating a plan and the consideration given or offered therefor, and any other matter relevant to the case or to the formulation of a plan.” The bankruptcy court may decide the motion ex parte or may require a hearing. If the court approves and orders the examination, the procedure for compelling attendance is similar to the standard federal subpoena procedures.
Objections to discharge and dischargeability may be brought by a creditor or the trustee and are made through the filing of a complaint to initiate an adversary proceeding in the court where the bankruptcy is pending. For the relevant objections to dischargeability, a complaint must be filed no later than sixty days after the first date set for the meeting of creditors under 341(a). A motion to extend this deadline can be filed before the deadline runs, but requires a showing of cause by the party seeking an extension. One point to note is that once an adversary proceeding is commenced, the Bankruptcy Code allows for use of standard discovery requests without prior approval from the Court.
The process and deadline to file a complaint to object to discharge will depend on the type of bankruptcy case. In a Chapter 11, the deadline is the first date set for the hearing on confirmation. In a Chapter 7 or 13 case, the deadline is sixty days after the first date set for the meeting of creditors under 341(a). Motions to extend should again be brought before the deadline has passed; however, in contrast to the procedures for objecting to dischargeability, Bankruptcy Rule 4004 expressly provides that a creditor may seek an extension to object to discharge after the deadline has passed based upon the discovery of new facts that provide a basis for denying discharge.
Objections to discharge and dischargeability are useful tools to address situations where a principal or indemnitor is attempting to abuse the bankruptcy process. However, raising these objections successfully often requires a detailed investigation that preferably begins long before the bankruptcy petition is filed. In situations where fraud or misappropriation might be a concern, retaining counsel early in the process may prove helpful.
