A Curious Case of Fraud and Bankruptcy

 A Curious Case of Fraud and Bankruptcy by Mark KaufmanA new client came to me admitting that he’d been defrauded hundreds of thousands of dollars. While the most direct route would be to sue the other party now and ask questions later, it’s in my client’s interest to get a result that’s actually payable—not to mention that unnecessary litigation is not a good use of money.

For his part, the debtor claimed to want to do the right thing and create an agreement that would allow him to pay the debt back over time. This led me on a law-finding mission to determine how my client might be impacted if the debtor later filed for bankruptcy. Would an agreement constitute a waiver of my client’s rights to hold the debtor liable for the fraud?

Here’s what I learned.

Generally, all claims for debts are discharged upon the filing of chapter 7, or personal, bankruptcy. However,  Section 523(a) and (c) of the Bankruptcy Code allows for the non-dischargeability of debts that were incurred because of fraud. This was good news, but I was dubious that it would be that simple.

Initially, it seemed that even with Section 523, if the debtor didn’t admit that he had defrauded my client, and they entered into a payment agreement anyway, all my client would have left at judgment day is a contract, and that contract could be dismissed or discharged along with all other debts in bankruptcy court. However, there’s case law, including two decisions from the U.S. Supreme Court, holding that regardless of what lawsuit or settlement embodies the debt, the bankruptcy court can look behind that agreement or judgment to determine whether it was a debt that arose out of fraud. Meaning that if the debtor breached the contract by failing to make payments, and we were ready to demonstrate the fraud, the fact that we had reached a settlement agreement today would not prevent us from seeking to collect the debt tomorrow.  

And then I thought of a second potential problem: the statute of limitations for fraud may expire by the time the debtor fails to pay this settlement agreement and files for bankruptcy.

What I discovered is that, we just would need to sue for any breach of contract (that is, failure to pay under the settlement agreement) within the applicable statute of limitations (6 years in New York State) or within the 60-day period of a bankruptcy court’s notice to creditor. That way, the breach of contract would be timely preserved for the bankruptcy court’s determination, and that court could consider, under the now-famous Section 523(c), whether the debt as embodied in the contract was based in fraud and therefore non-dischargeable — even if the statute of limitations for fraud has passed by the time the debtor had stopped making payments under the agreement.  

Of course, the preferred outcome would be for the debtor to pay his debt, so all parties could avoid the wastefulness and uncertainty of litigation. But the takeaway is an important one both for attorneys and their clients trying to recover a debt that arose out of fraud: you don’t have to worry that making a deal and resolving a case now necessarily means you’re waiving rights to protect your claim in the event that the other side of the deal goes bankrupt.

Mark Kaufman

Mark S. Kaufman
Kaufman & Kahn

747 Third Avenue
32nd Floor
New York, NY 10017
Tel. (212) 293-5556
Fax. (212) 355-5009

Blogs offer an accessible way for readers to learn more about issues that are important to them, but their short format is in no way representative of the entire breadth of knowledge that an attorney possesses. The only way to ascertain your legal rights and responsibilities is to engage an attorney in an official capacity, as a client.

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