Defenses to Discharge in Business Bankruptcy Cases Under Section 523

In a business bankruptcy, the discharge of the business’s debts relieves the business of its ongoing payment obligations. As the U.S. Courts explain, following a discharge in bankruptcy:

“[T]he debtor is no longer legally required to pay any debts that are discharged. The discharge is a permanent order prohibiting the creditors of the debtor from taking any form of collection action on discharged debts . . . .”

Through bankruptcy filings under Chapters 7 and 11, businesses can seek relief from some or all of their outstanding debts via discharge. But, creditors can—and often will—assert defenses to the discharge of businesses’ debts under Section 523 of the U.S. Bankruptcy Code. For businesses seeking relief under Chapter 7 or 11, understanding these defenses to discharge is important, and businesses anticipating these defenses should work with their bankruptcy counsel to identify the counterarguments they can assert in response.

5 Common Defenses to Discharge in Chapter 7 and 11 Bankruptcies Under Section 523

Section 523 lists several types of debts that are not eligible for discharge in bankruptcy proceedings, and when creditors believe they are entitled to protect their right to payment, they can assert the appropriate Section 523 defenses in the bankruptcy court.

Some examples of common defenses to discharge under Section 523 in business bankruptcy cases include:

1. The Business Obtained Credit Through False Pretenses

Under Section 523(a)(2)(A), a debt is not dischargeable in bankruptcy if it was obtained through “false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition.” Statements regarding a business’s financial condition are addressed separately in Section 523(a)(2)(B). If a creditor alleges that the business obtained credit through false pretenses, the creditor has the burden of proving not only that the business made a misrepresentation or omission but that the business’s misrepresentation or omission was material to the creditor’s lending decision.

2. The Business Obtained Credit Through Fraud

Along with false pretenses, creditors can also seek to prevent the discharge of their debts in Chapter 7 and 11 business bankruptcy proceedings based on allegations of other forms of fraud. For example, under Section 523(a)(2)(B), a debt is not subject to discharge if obtained through the submission of a written statement (i.e., in a commercial loan or credit application) that was:

• Materially false;
• Regarding the debtor’s or an insider’s financial condition;
• A basis for the creditor’s decision to lend (and that the creditor’s decision was reasonable); and,
• Made with the intent to deceive.

Here, too, the burden of proof is on the creditor seeking to prevent discharge. As proving fraud under Section 523(a)(2)(B) requires evidence of intent, arguing that the creditor lacks evidence of intent will be an effective defense strategy in many cases. However, if a creditor is able to obtain emails, text messages or other communications evidencing a business owner’s (or “insider’s”) efforts to defraud through discovery, then the business may need to focus on challenging the elements of materiality or reasonableness.

3. The Business (or Its Owners or Executives) Engaged in Embezzlement or Larceny

If a business owes a debt for funds or other assets acquired through embezzlement or larceny, this debt is also non-dischargeable in Chapter 7 and 11 bankruptcy proceedings. Embezzlement involves retaining third-party property without the owner’s authorization after the business rightfully comes into possession of the property (i.e., failing to return a leased asset), while larceny involves retaining third-party property without any claim of right. Both are grounds for denial of discharge under Section 523(a)(4).

4. The Business Caused “Willful and Malicious” Injury

A debt is not subject to discharge if the debt is owed “for willful and malicious injury [caused] by the debtor to another entity or to the property of another entity.” This defense to discharge, under Section 523(a)(6), generally applies when a business obtains credit, funds or other property through tortious conduct not covered under the other provisions of Section 523 discussed above.

5. The Business Failed to List the Debt In Its Bankruptcy Filing

Section 523(a)(3) provides that creditors can seek to avoid the discharge of debts that are “neither listed nor scheduled [in the business’s bankruptcy filing], with the name, if known to the debtor, of the creditor to whom such debt is owed . . . .” When seeking to avoid discharge based on Section 523(a)(3), a creditor must also prove that the business’s failure prevented the creditor from timely filing a proof of claim and that the creditor did not otherwise have timely “notice or actual knowledge” of the business’s bankruptcy filing.

Other Non-Dischargeable Debts in Chapter 7 and 11 Bankruptcies Under Section 523

While these are defenses to discharge that commercial creditors will commonly assert in business bankruptcy proceedings under Chapter 7 and Chapter 11, these are not the only grounds for non-dischargeability under Section 523. For example, Section 523 also lists the following debts (among others) as not subject to discharge:

• Certain domestic and foreign taxes and customs duties
• Fines, penalties and forfeitures “payable to and for the benefit of a governmental unit”
• Certain personal injury and wrongful death judgments involving employees’ drug or alcohol intoxication
• Criminal restitution owed under federal law
• Debts owed to pensions, profit-sharing plans and other qualified retirement plans

Additionally, while Section 523 is one source of potential defenses to discharge, creditors and trustees can seek to avoid discharge under various other statutory provisions as well. This includes seeking to avoid discharge entirely—not just discharge of individual debts—under Section 727 of the U.S. Bankruptcy Code. As a result, prior to filing for bankruptcy, businesses must carefully assess the likelihood that filing will achieve their desired result, and if they have any concerns about non-dischargeability, they should address these concerns proactively with their bankruptcy counsel.

Contact Us for More Information

If you have questions about defenses to discharge in Chapter 7 and 11 business bankruptcies, we encourage you to contact us for more information. To speak with an experienced business bankruptcy lawyer at our Miami or Fort Lauderdale law offices in confidence, please call 305-768-9909 or request an appointment online today.