The Surprising Benefits: Fraud Debt Collections in Bankruptcy

 Posted on July 16, 2018 in Discharge of Debts

Being accused of defrauding a creditor is unusual in consumer bankruptcy cases. A creditor would have to jump through significant hoops.

Most Debts are Discharged (Permanently Written Off) in Bankruptcy

The federal Bankruptcy Code has a list of the kinds of debts that are not discharged. This list details the conditions under which these kinds of debts don’t get discharged. (See Section 523 on “Exceptions to discharge.”)

Essentially, all your debts get discharged unless any of them fit one of the listed exceptions.

The Fraud Exception

One of the most important exceptions to discharge is the one stating that debts, “to the extent obtained, by... false pretenses, false representation, or actual fraud,” might not be discharged. (Section 523(a)(2)(A) of the Bankruptcy Code.)

This is an important exception to discharge because it could apply to many different kinds of debts. The other exceptions to discharge apply to very specific categories of debts. For example, these other exceptions include child and spousal support, various taxes, and student loans. But the fraud exception could apply to just about any debt if it was incurred in a fraudulent way.

What Makes for a Fraudulent Debt?

Your creditor would have to demonstrate that its debt should not be discharged because you incurred that debt fraudulently. If the creditor fails to do so the debt WILL get discharged and you’ll no longer legally owe it.

To avoid discharge of the debt, the creditor would have to present evidence and prove EACH of the following:

1. you made a representation
2. which you knew at THAT time was false
3. you made that representation for the purpose of deceiving the creditor
4. the creditor relied on this representation
5. the creditor was damage by your representation.

For example:

1. a person gets a loan by representing that he or she has a certain amount of income
2. while knowing that income amount was inaccurate
3. with the purpose of fooling the creditor into making the loan
4. resulting in the creditor relying on this income information in making the loan
5. and losing money when the person didn’t pay back the loan

What Happens When a Creditor Alleges Fraud

Proving all five of these necessary elements often isn’t easy. So creditors tend not to object unless they believe they have a strong evidence of fraud. In the vast majority of consumer bankruptcy cases no creditors raise any fraud-based challenges.

When a creditor does raise such a challenge it does so in a specialized lawsuit in the bankruptcy court. This “adversary proceeding” usually focuses directly on whether the creditor can prove the five elements of fraud.

Such adversary proceedings almost always get settled. That’s because the amount of money at issue doesn’t justify the expense in attorney fees and other costs that can accrue quickly for both sides.

Staying Allegedly Fraudulent Debts

The “automatic stay” imposed against virtually all creditor collection action also applies to allegedly fraudulent debts. If the creditor has alleged fraud prior to your bankruptcy filing, the filing will at least temporarily stop all collection on the debt. The “automatic stay” stops “any act to collect, assess, or recover a claim against the debtor.” (Section 362(a)(6) of the U.S. Bankruptcy Code.)

Then, as mentioned above, the debt will either get discharged or not. If the creditor doesn’t file an adversary proceeding in time, the debt DOES get discharged. If the creditor files an adversary proceeding but then doesn’t prove fraud, the debt is discharged.

On the other hand, if the creditor does prove fraud the debt is not discharged and the creditor can then pursue the debt. It gets a judgment stating that the debt is not discharged and collectible. Then the creditor can use all the usual collection methods to collect the debt.

However, because these matters are usually settled, the settlement usually includes an agreed payment plan. So in the unlikely event that a creditor DOES allege fraud against you, files a timely adversary proceeding, AND convinces the bankruptcy judge that all the elements of fraud were present, you would still very likely have a workable way to pay the debt without worrying about being hit by unexpected collection actions.