A major obstacle for debtors in bankruptcy is the issue of whether indebtedness was incurred by fraud. The bankruptcy code is specific in exempting indebtedness from discharge that is the result of fraud committed by the debtor. As a creditor seeking to be repaid, demonstrating that a particular obligation was the result of the debtor's fraudulent conduct might mean the difference between getting paid or getting nothing. But determining whether a debt is fraudulent is a tough process. What's more, the cost of getting a favorable determination of fraud has to be weighed against the likelihood of success in the courts and, more importantly, the likelihood of actually collecting money from the bankrupt entity.
Whether a debt was incurred fraudulently is extremely significant because such debt is not dischargeable in bankruptcy. As a debtor, getting an unfavorable ruling on the issue of fraudulent debt will mean that the particular debt will be exempted from the discharge and will survive the bankruptcy. If it's just one of many debts, then the prospect of having to repay that one creditor might not be worth the fight, considering that all of the other debt listed in the petition will still be discharged. However, things must be considered in the the context of the entire amount of indebtedness. In a Chapter 11 case, where the plan might sink based on the amount of debt the debtor will have when it emerges from bankruptcy, a fraud determination could be devastating. In a consumer Chapter 7 case, the debtor might often resolve the claim of fraud, as creditors, believing it unlikely they will be able to collect much more, offering very reasonable settlement terms with payments debtors can afford.
The fraud which is most often seen in the fraudulent debt context is not the traditional fraud that first comes to mind. Certainly an intentional misstatement on a credit application, such as inflating income or assets, would be considered fraud in a bankruptcy context. While such cases exist, the ready availability of information through credit reporting agencies and various information sources have eroded some of the arguments often posed by defrauded creditors. Courts are growing reluctant to reward creditors who fail to exercise any due diligence in the information age.
In the consumer cases, intentional misrepresentation type fraud cases are the exception rather than the rule. The typical fraud claim in a consumer case is usually one raised by a credit card or revolving charge company that has seen significant purchases or cash advances made on a consumer account close to the time of a bankruptcy filing. It is not uncommon for consumers in financial distress to engage in credit card kiting, which is the practice of transferring balances to obtain a low initial interest rate from an account where the high balance required minimum payments that the debtor could not afford. A debtor, transferring balances for interest rate purposes in the spring, then filing bankruptcy in the fall, should expect at least inquiries from the creditor and maybe a full claim of fraudulent debt. The focus becomes when the debtor knew he or she was in financial trouble and probably could not repay the loan, yet took the extension of credit anyway.
The difficulty in identifying fraudulent debt is probably why there are not more fraudulent debt claims. Fraud requires intentional conduct. There is no negligent fraud. The burden of proof in such a claim rests upon the creditor. In other words, unless a creditor can prove that a debtor intentionally misrepresented his income and assets or was in such dire financial circumstances that he had to have known he could not repay the debt, the creditor loses. But short of tracking down the creator of a rigged financial statement or the auditor who cooked the books or which spouse hid the monthly statements from the other, how can a creditor prove it was more likely than not that the debtor intended to defraud the creditor?
The bankruptcy code and the courts have a mechanism for assisting aggrieved creditors in this position. It is presumed that 90 days prior to a bankruptcy filing, a debtor knew he or she was in financial trouble and would not be able to repay extensions of credit made during that interval. A creditor, starting an adversary proceeding in bankruptcy court against a debtor, gets the benefit of that presumption, but the presumption can be contested. The effect of a presumption shifts the burden of proof to the other side. In an adversary proceeding against a consumer debtor for debt incurred during the presumption period, the creditor need only prove it is entitled to the presumption and it becomes the debtor's burden to prove there was no fraudulent intent. In consumer cases, the sudden loss of a job, an unexpected medical expense, or a divorce often serve as the basis for rebutting the presumption. If the debtor is successful in rebutting the presumption, the burden of proof shifts back to the creditor. The courts have wrestled with consumer issues such as balance transfers. While the trend has slowed in the wake of the economic slowdown, judges are consumers as well. During a period when credit companies were flooding the mail boxes with balance transfer offers, courts were willing to take judicial notice of the availability of balance transfer offers and not just simply fault a recalcitrant debtor for taking advantage of a business opportunity. It was not uncommon in a balance transfer situation for a trustee, creditor or judge to request the account statements from the months after a balance transfer to see whether the debtor began charging or taking cash advances from the account that had been reduced to zero by the balance transfer.
An aggrieved creditor has only a limited time to raise a fraud claim. An adversary proceeding (the tactic used to bring the alleged fraud before a bankruptcy court judge for determination) must generally be started within 60 days of the first meeting of creditors. Claims not raised in the allotted time frame are barred unless the court permits a late filing.
When a bankruptcy court makes a determination that a debt was incurred fraudulently, the debt is exempted from discharge. From a creditor's perspective, this means that if the bankruptcy itself has concluded, and the automatic stay provisions of the code no longer apply, the creditor is free to pursue collection of the indebtedness as if the bankruptcy had never happened. It is for this reason that debtors will often choose to resolve claims of fraud rather than take that chance. In the rather low percentage of consumer cases in which fraud is raised, a debtor will often choose to settle with the creditor for repayment of the debt incurred during the presumption period. An additional consideration on the debtor's side is legal fees. Generally, the fee paid to a consumer bankruptcy attorney will not provide for representation in an adversary proceeding. Faced with the presumption and the cost of the additional attorneys fees to defend the adversary proceeding, debtors will often opt for settlement.