A New Weapon for Creditors to Protect Their Security Interests from Discharge

By: Sean Scuderi

St. John's Law Student

American Bankruptcy Institute Law Review Staff

 

Recently, the United States Bankruptcy Court in the Western District of Texas gave secured lenders a new weapon to attack the discharge of debt by a debtor who sold collateral without the creditor’s knowledge and used the proceeds to pay unsecured debts.  In In re Barnes

[1]

, the Court held that the sections 727(a)(2) and (7)

[2]

fraudulent transfer grounds for objection to discharge apply to collateral dispositions where the debtor had an intent to defraud the secured creditor.  In Barnes, the debtor, through his business of Mobar, LLP, sold off his store in Guadalupe without the required approval of Franklin Bank, S.B.B. (“the Bank”), which held a security interest in it, and the Small Business Association (“SBA”).

[3]

  Not only did the debtor not receive approval, but he also failed to notify the Bank or the SBA of the sale.

[4]

  The debtor used the proceeds of the sale to pay off unsecured debtors when the money should have gone to the Bank.

[5]

  The Bank brought an adversary proceeding to determine the dischargability of its claim against the debtor and to object to the discharge.

[6]

The Bank argued that the debtor’s use of the sale proceeds constituted non-dischargeable embezzlement under the section 523(a)(4) exception to discharge.

[7]

  The court rejected that position on the grounds that a mere security interest was not sufficient to support an embezzlement claim.

[8]

  The court reasoned that the debtor was the owner of the collateral and therefore could not embezzle his own property.

[9]

  Thus, when an owner of collateral sells that property and withholds the proceeds from the lienholder, he does not embezzle funds from the lienholder pursuant to 11 U.S.C. § 523(a)(4).

[10]

  However, the court decided to deny the discharge of the debtor’s debt to the Bank because the court determined the debtor violated 11 U.S.C. § 523(a)(6) and 11 U.S.C. § 727(a)(2) and (7).

[11]

  The debtor’s conduct of selling the Bank’s collateral without its knowledge or approval and transferring the proceeds to other creditors constituted a “willful and malicious injury by the debtor” to the Bank.

[12]

  Finally, the court the debtor caused Mobar LLP, which was owned solely by the debtor and his wife and whose assets were held as security by the Bank, to transfer property with the intent to hinder, delay, and defraud the Bank.

[13]

 

When a debtor is attempting to discharge his debt, there are exceptions that exist to protect creditors’ interests.  Some of these exceptions can be used to protect a creditor holding a security interest, and their applicability is largely dictated by the conduct of the debtor.  The court in In re Barnes discussed three of these exceptions.  The first issue was whether the debtor had embezzled funds from the Bank, which would deny discharge.  Embezzlement under 11 U.S.C. § 523(a)(4) has been defined as “the fraudulent appropriation of property by a person to whom such property has been entrusted or into whose hands it has lawfully come.”

[14]

  The majority of courts have held a security interest is not equivalent to ownership and is not enough of an interest to support a claim of embezzlement.

[15]

  Second, under section 523(a)(6), a discharge is not permitted if the creditor suffers a willful and malicious injury at the hands of the debtor.

[16]

  An injury is willful if it is “a deliberate or intentional injury, not merely a deliberate or intentional act that leads to injury.”

[17]

  Under this statute, the focus of the analysis is on the injury, and In re Miller

[18]

explains that to determine if an injury is “willful and malicious” one must see if “there is either an objective substantial certainty of harm or a subjective motive to cause harm” in the debtor’s conduct.

[19]

  Finally, sections 727(a)(2) and (7) deny discharge if an insider “transferred, removed, destroyed, mutilated, or concealed” property of a debtor “with the intent to hinder, delay, or defraud a creditor.”

[20]

  This statute has typically been used to deal with a debtor secretly converting nonexempt property to exempt property in order to save it from the grasp of creditors.

[21]

 

The Barnes decision clarified the rights of a creditor with a security interest.  A creditor does not have a strong claim under section 523(a)(4) because of the nature of a security interest.  The collateral is still under the ownership of the debtor, and “[n]o person can embezzle from himself.”

[22]

  Although this decision prevents creditors holding a security interest to use section 532(a)(4) to protect their interest, the decision gave these creditors a new weapon to protect their interests under section 727.  If the debtor disposes of assets of a corporation or business, which are held as security by the creditor, the creditor may be able to use section 727 to deny discharge of the debt.  For the first time, the court has explained how section 727 can be used by a creditor to deny discharge when the debtor disposed of the security interest.

[23]

  Unlike under section 523(a)(6), the focus of the analysis in section 727 is on the debtor’s intent.

[24]

  By using 11 U.S.C. § 523(a)(6) along with 11 U.S.C. § 727, a creditor can pose broader arguments to deny a discharge of the debt owed to it based upon the injury caused by the debtor’s conduct and now the intent of the debtor.



[1]

369 B.R. 298 (Bankr. W.D. Tex. 2007).

[2]

11 U.S.C. § 727(a)(2 & 7) (2006).

[3]

In re Barnes, 369 B.R at 302.

[4]

Id.

[5]

Id. at 303.

[6]

Id. at 301.

[7]

See 11 U.S.C. § 523(a)(4) (2006).

[8]

In re Barnes, 369 B.R. at 306.

[9]

Id.

[10]

Id. (citing 11 U.S.C. § 523(a)(4) (2006)).

[11]

Id. at 307 (citing 11 U.S.C. § 523(a)(6) (2006)); id. at 309 (citing 11 U.S.C. § 727(a)(2) (2006)); id. (citing 11 U.S.C. § 727(a)(7) (2006)).

[12]

Id.

[13]

Id. at 302, 309.

[14]

In re Weber, 892 F.2d 534, 538 (7th Cir. 1989) (quoting Moore v. United States, 160 U.S. 268, 269 (1895)).

[15]

See In re Tinkler, 311 B.R. 869, 877 (Bankr. D. Colo. 2004).

[16]

11 U.S.C. § 523(a)(4).

[17]

Kawaauhau v. Geiger, 523 U.S. 57, 61–62 (1998).

[18]

156 F.3d 598 (5th Cir. 1998).

[19]

Id. at 606.

[20]

11 U.S.C. § 727(a)(2) (2006).

[21]

See, e.g., Matter of Swift, 3 F.3d 929 (5th Cir. 1993).

[22]

In re Contella, 166 B.R. 26, 30 (Bankr. W.D.N.Y. 1994).

[23]

See In re Barnes, 369 B.R. at 307–09.

[24]

Id. at 307.