by Scott Schuster

Typically, the central purpose of filing a bankruptcy is to “discharge” all or most of the debtors’ debts. A bankruptcy “discharge” releases the debtor from personal liability for certain specified types of debts. In other words, the debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order forever prohibiting the debtor’s creditors from taking any form of collection action on discharged debts, including legal action and communications with the debtor, such as telephone calls, letters, and personal contacts. Generally, excluding cases that are dismissed or converted, individual debtors receive a discharge in more than 99 percent of chapter 7 cases.

However, the Bankruptcy Code sets forth an extensive list of debts that are nondischargeable. Unfortunately, nondischargeability is not automatic – a creditor that holds such a debt must file a complaint with the Bankruptcy Court seeking to have the debt declared nondischargeable. A nondischargeability complaint must usually be filed within about sixty (60) to ninety (90) days after the debtor files his or her bankruptcy petition. 

The largest category of nondischargable debts are those incurred through: 1) false pretenses, a false representation, or actual fraud; or 2) obtained through the use of a statement in writing, which is materially false regarding the debtor’s financial condition, and on which the creditor reasonably relied.

As one would imagine, the terms “false pretenses, false representations, or actual fraud” can encompass many types of dishonest behavior. An important consideration the court will make is whether the debtor intentionally and knowingly made the false/fraudulent representations. To except a debt from discharge under this section, the false representations giving rise to the debt must have been knowingly and fraudulently made. In other words, the failure to pay a debt is not sufficient, even if there is no excuse for the failure. The debtor has to incur the debt knowing that he will not be able to pay the debt, and knowing that the statements he is making to the creditor about his ability and intention to pay are untrue.

A creditor alleging fraud has the burden of proving that the debtor knew that any stated intention to repay was false and that the debtor nevertheless deliberately incurred the debt. The fact that the debtor was insolvent does not by itself provide a sufficient basis for inferring the debtor’s intent. A debtor’s honest belief that a debt would be repaid in the future, even if in hindsight found to have been very unrealistic, negates any fraudulent intent.

Use of a materially false writing concerning the debtor’s financial position comes up often in transactions that required the debtor to complete a credit application. On most credit applications, lenders will ask a debtor to list their monthly income and their current outstanding debts. Lenders then use this information to determine the debtor’s “debt-to-income” ratio. If the debtor falsely inflates their income, or omits certain debts, then the debt-to-income is inaccurate. If the court determines that the creditor reasonably relied upon the credit application in making the loan, then the debt is nondischargeable.

by Scott Schuster

Small cases, that often do not seem to be worth pursuing at all, can have a big impact on your company’s bottom line. I have often heard clients say “I want to pursue this as a matter of principle, but I’m not sure it’s worth the cost.” Some attorneys agree. However, pursuing and winning such a case tells the world that you are serious about collecting your debts and that message is often far more valuable than expected.

I recently defended a case wherein the debtor attempted to discharge certain student loans through bankruptcy. The amount of the debt was small ($20,000) and the monthly payment ($122 per month for 25 years) was insufficient to make any noticeable impact on the client’s monthly financials.

However, the debtor’s case was absolutely frivolous because the Bankruptcy Code makes discharge of student loans subject to very stringent conditions. The Code states that student loans are not discharged unless the debtor can show that it would be an “undue hardship” to force the debtor repay the debt. Typically, to prove an undue hardship, a debtor must provide evidence that the debtor has minimized his or her expenses and maximized his or her income.

The aforementioned case was frivolous because the debtor, who was disabled and only earned $1,300 per month from social security disability, lived in a $285,000, five bedroom, three bathroom home that was paid for by her husband. Debtor’s SSI income was used to support the $1,800 in mortgage payments the family made each month. More egregiously, the Debtor was disabled when she accepted the student loan and agreed to repay the money.

Despite the fact that paying $122 per month would not cause an “undue hardship,” Debtor filed a complaint seeking to discharge the student loan. The client immediately asked whether the case was “worth pursuing.” Clearly, the client would win the case if we fought hard enough, but the debt was small.

My advice to the client was to take a step back and look at the case in the grander scheme of its business operations. The Debtor’s attorney in the case has practiced for many years and files dozens of bankruptcies each year. If the client were to “roll over” and show that it would not fight the smaller cases, the attorney would know what he could get away with in future cases. One thing I pointed out to the client is that debtors’ attorneys tend to be very friendly with one another and tend to share their experiences. As a result, showing weakness in this case could give rise to dozens of frivolous student loan dischargeability actions in the future.

In the end, we litigated the matter. The parties exchanged discovery, conducted depositions, and eventually filed motions with the court seeking summary judgment. Debtor’s counsel was flabbergasted; he repeatedly said ”I cannot believe your client is fighting this case.” In the end, he probably spent ten times more time and effort on the case than he expected. I flew to Philadelphia to argue the case and put our argument – that Debtor’s lavish lifestyle is not an “undue hardship” – on the record. The Judge agreed and entered an order in our favor, excepting the debt from discharge and guaranteeing that the debtor could not take the easy way out.

Yes, the client spent some money to litigate the case and the immediate result ($122 per month for the next 25 years or so) will make no difference to the client’s year-end profit. However, the client took a stand and made it known that, as a matter of principle, frivolous cases will be defended. Debtor’s attorneys will think twice about filing such a claim the next time around.

by Scott Schuster

In 2005, a record number of debtors filed bankruptcy prior to the effective date of the amendments to avoid the amendments to the bankruptcy code that made it more difficult for debtors to file bankruptcy. After the amendments took effect, the number of bankruptcies being filed nosedived. Many people attributed the lower number of filings to the new amendments. Those “in the know” realized that the shortage in bankrutpcy filings was a result of the high number of bankruptcies filed just before the amendments took effect. We all believed that the new amendments, while more budensome for debtors, would not significantly lower the number of bankruptcy filings in the long term.

Not surprisingly, according to the United States Trustee’s office, bankruptcies are once again on the rise at near record levels. See http://www.uscourts.gov/bnkrpctystats/bankruptcystats.htm. Of course, with the economy in a deep recession, this news is not unexpected. With the rise in bankruptcies, here are a few things to keep in mind as a creditor:

First, debtors are finding themselves overextended with credit cards, lines of credit and other unsecured loans. If a debtor comes to you asking for credit, it is extremely important in these times to do your homework to make sure that the debtor is able to repay any credit you extend. That means more than just asking for paystubs or bank account information. Often, Debtors with high income levels have high expenses. It’s important to check both before extending credit.

Second, now more than ever, cash up front is a creditor’s best friend. If you don’t extend credit, or only extend minimum credit amounts, you’re less likely to get burned by a debtor filing bankruptcy. Right now, it may be better to turn down a sale than to sell product that ultimately is never paid for.

Finally, preference actions are on the rise. In the past few months, our office has seen a significant increase in the number of preference actions being filed against creditors. As a creditor, its important to know that you may have valid expenses that can reduce or even eliminate your preference exposure. If you find yourself on the wrong end of a preference action, experienced bankruptcy counsel might be able to help.

Bob Bernstein’s Get P.A.I.D. book has a lot of helpful tips for managing your business in a struggling economy. The economy is something that we all have to deal with and it appears that only the strong will survive. Have a plan, be prepared, and you too can survive these trying times.

Who’s responsible for this mess?

The facts of a recent bankruptcy case perfectly illustrate one aspect of the recent economic collapse - loan defaults. In the case, a 51 year old, disabled and unemployed debtor making approximately $5,000 per year from social security disability took a $20,000 cash advance from his credit card. The cash advance represented approximately three times his yearly income from social security disability. The debtor used most of the money to pay other bills, such as his mortgage and utilities. He spent the remainder of the money on miscellaneous items, such as clothing, food, and gasoline. One week after taking the cash advance, he filed bankruptcy and sought to discharge the credit card loan.

The creditor challenged the debtor and sought to have the loan declared “nondischargeable.” The creditor argued that the debtor committed fraud because it was clear that the debtor could not possibly repay the debt. The debtor’s response was that the credit card company never should have loaned an unemployed and disabled person living on extremely fixed income $20,000.

So who’s responsible? Was it the debtor for taking out a loan that he couldn’t possibly afford to repay? He was desperate to pay his bills and the credit was readily available.

Was the lender at fault for extending $20,000 in credit to someone making less than $5,000 per year? The lender argued that the credit card was opened when the debtor had significantly higher income and that the lender had no idea of the debtor’s disability.

Both sides have compelling arguments but, in my opinion, THEY’RE BOTH RESPONSIBLE. Borrowers should take responsibility for their actions and so should lenders. Pointing the finger at each other is the easy way out and does not solve the underlying problem. Similar incidents are playing themselves out across the county, only, in many instances, the “debtor” is a large bank, the “creditor” lending the money is an even larger bank, and the loans are more than $20,000; they’re more like $20 million. Everyone’s pointing the finger at the banks, but let’s not forget about the debtors that borrowed more than they could afford.

Unfortunately, the credit lending standards of the last few years were so loose and so easy that such a scenario was possible. The economy was healthy enough that the financial institutions were able to conduct little or no due diligence before lending large sums of money. Debtors (individuals, small and large corporations, and even federal, state and local governments) slowly began to rely on this “easy credit” access, resulting in deficit spending across the board.

As debtors began to get in over their heads and defaults began to occur on a large scale, the economy suffered. As the economy failed, everyone suffered, including those that acted responsibly. Responsible debtors that only borrowed what they could afford to pay back were hurt by the economy when their retirement assets lost value. Similarly, responsible lenders that conducted proper due diligence before extending credit suffered as investor confidence dropped and stock prices plummeted. Hopefully, individuals, corporations, lenders and government leaders alike will learn from these mistakes.

The logic behind Pennsylvania’s arcane wage attachment laws escapes me. I cannot figure out why the Commonwealth wants to protect debtors at the expense of legitimate creditors.  What are the drawbacks to adopting more liberal wage attachment laws? Who does it hurt? The vast majority of people pay their bills, in full, when they come due and would to be affected by wage attachment. Only small minorities of people do not pay their bills and I can see no reason why the legislature would want to protect those people. Unfortunately (and inexplicably), Pennsylvania has some of the most restrictive wage attachment laws in the country.

The vast majority of states allow commercial creditors to garnish a percentage of a debtor’s wages. For example, in Alabama and California, a creditor may attach up to twenty-five percent of a debtor’s “disposable” income (i.e. income remaining after paying certain “necessities,” such as food, shelter, taxes, etc.).

Only four states prohibit or severely restrict wage attachment. South Carolina is the only state that completely prohibits wage attachment. New Hampshire prohibits “continuous attachment,” which means that creditors must file a new lawsuit each time they want to garnish a paycheck (which is rarely cost effective). Texas allows wage attachment only to pay child support.

Similarly, in Pennsylvania, wage attachment is only available to pay taxes and child support. This is particularly problematic for creditors in Pennsylvania because Pennsylvania law prohibits execution against jointly owned (marital) assets unless a creditor has obtained judgment against both husband and wife.

Two justifications have been proposed in support of Pennsylvania’s restrictive wage attachment laws. First, the legislature is concerned that wage attachment will have the effect of forcing some debtors into poverty, thereby forcing the state to bear the cost of supporting those debtors. Second, supporters believe that wage attachment is counter productive because debtors, upon receiving less of their income and having less incentive to work, quit their jobs and apply for welfare.

In the coming weeks and months, I intend to contact our local state senators and congressmen about wage attachment in Pennsylvania. There may just be support to expand the attachment laws for the benefit of all Pennsylvanians. Stay tuned . . . 

We’ve added a couple new attorneys to our blog.  Scott Schuster, an associate with the firm’s Bankruptcy & Restructuring practice area, and Shawn McClure, an associate with the firm’s Creditors’ Rights practice area.  Look for their posts in the future.