When Might A Creditor File A Lawsuit Against The Debtor? Does This Mean The Case Will Go To Trial?

1. Nondischargeability Adversary Proceedings

A. Challenging The Dischargeability Of A Particular Debt Under Section 523

When a creditor files a lawsuit against the debtor in bankruptcy, it’s usually to determine the dischargeability or nondischargeability of a particular debt under section 523 of the Bankruptcy Code. Section 523 lists the types of debts that are nondischargeable in an individual bankruptcy. That sort of lawsuit — called an adversary proceeding in bankruptcy parlance — is a dispute between the debtor and only the challenging creditor, and does not involve any other creditor.

1. The Never Dischargeable Debts

Some kinds of debts are not dischargeable as a matter of course. For example, most tax debt is not dischargeable. Similarly, obligations to pay child support or alimony, and fines or penalties imposed by a Judge as a punishment are not dischargeable.

2. Student Loans

Student loans are typically not dischargeable unless the debtor successfully challenges their nondischargeability. However, a student loan adversary proceeding is difficult for a debtor to win unless the debtor has sustained severe post-education, permanent health problems.

3. Fraud, Breach Of Fiduciary Duty, Willful And Malicious Harm

There are three kinds of debts that will be discharged unless a creditor successfully challenges their discharge. They are: (a) Debts incurred through fraud, (b) debts resulting from a breach of a fiduciary duty, including embezzlement and larceny, and (c) debts that result from doing willful and malicious harm to a person or property. (One exception: A willful and malicious harm to property debt is dischargeable in Chapter 13 as long as the debtor completes the plan.) If a creditor does not successfully challenge the discharge of a debt under one or some combination of these three theories, then the debt will be discharged.

A recurrent fact pattern involves a debtor who files for bankruptcy protection while being sued by a creditor in the California Superior Court. The filing of the bankruptcy petition triggers the automatic stay, which stays or stops the Superior Court lawsuit. The creditor has three options.

First, the creditor may ask the Bankruptcy Judge to lift the stay for the limited purpose of returning to the Superior Court and continuing the lawsuit.

Second, the creditor may initiate an adversary proceeding in the Bankruptcy Court to challenge the discharge of the debt.

Third, the creditor may take no action, meaning that the debt will be discharged when the debtor receives a discharge.

If the creditor successfully moves the Court for relief from the automatic stay, but doesn’t also initiate a nondischargeability adversary proceeding then the debt will be discharged — even if the creditor wins the state court action, making the state court victory a pyrrhic victory.

Very few section 523 adversary proceedings go to trial because the bankruptcy ethos is for settlement. Settlement is favored primarily because of the cost of litigation, the uncertainty of the trial outcome, and the bankruptcy goal of quick resolution. However, occasionally the case goes to trial, and sometimes one or both sides appeal the verdict. Since the appeal leads to further expense, uncertainty, and case protraction, a lot of money must be at stake to make it worthwhile.

B. Challenging The Entire Discharge Under Section 727

A creditor can also initiate an adversary proceeding to challenge the entire discharge under section 727 of the Bankruptcy Code, rather than just the discharge of a particular debt. Thus, in theory the creditor can either challenge the discharge of a specific debt, or challenge the entire bankruptcy discharge. However, savvy creditors rarely seek to challenge the entire discharge.

Part of the problem with challenging the entire discharge lies in the fact that unlike a section 523 adversary proceeding that only affects the suing creditor, an adversary proceeding under section 727 affects all the other creditors. As a consequence, any settlement also affects the other creditors. Therefore, as part of the settlement process, the other creditors must be given an opportunity step in and prosecute the adversary proceeding.

2. Avoiding Fraudulent And Preferential Transfers

A creditor could, in theory, mount an action to avoid a fraudulent or preferential transfer. However, in a Chapter 7, the creditor might not have standing to do so because the action is an asset of the bankruptcy estate. Instead, the Trustee is the one who has standing to avoid the transfer and recover the asset.

However, if the Trustee abandons the right to do the avoidance action, the creditor might have standing to prosecute the action. Of course, if the trustee were to abandon the action, then it’s probably not worth pursuing because trustees don’t abandon worthwhile claims.

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