LEGAL GUIDE
Written by attorney Jeffrey Chiao Hsu | Jun 8, 2012

Section 727 Discharge: Why Debtors Must Be Honest

Imagine an individual files for chapter 7 protection. This debtor is now entangled in an adversary proceeding via an objection to discharge claim under 11 U.S.C. § 727(a)(3) for intentionally and willfully destroying important records from which the debtor’s financial condition might be better ascertained. If the only reason the debtor destroyed the records was to stonewall the trustee and other creditors in determining what constituted property of the estate, this could be a violation pursuant to § 727(a)(3) that would justify a denial of discharge. Assuming the trustee or a creditor of interest filed the 727 claim, should this debtor be entitled to settle the claim for money, for a partial discharge, or otherwise?

When an individual files for chapter 7 bankruptcy protection, that person’s main objective is typically to obtain a discharge. [1] However a discharge is not freely granted, and a party of interest, such as a creditor or trustee, may object to a Debtor’s general discharge under 11 U.S.C. § 727. [2] Unlike § 523 claims that object to the dischargeability of a particular claim against the debtor, a § 727 claim seeks to deny the debtor a discharge in the bankruptcy case, thus preserving the enforceability of all applicable debts against the debtor post-bankruptcy.

Section 727 claims all share a common thread in that “they all concern fraud or similar misbehavior against creditors." [3] However, whether the parties in interest may settle 727 claims is a more unpredictable matter [4] as bankruptcy courts must balance themselves as courts of economics [5] while upholding the fundamental tenets of bankruptcy law, including the principle that only an “honest but unfortunate debtor" is entitled to discharge. [6]

While compromise is the linchpin of bankruptcy practice [7], Bankruptcy Rule 7041 requires that settlement of 727 claims may not be dismissed without proper notice to the trustee, the United States trustee, and such other persons as the court may direct, and only on order of the court containing terms and conditions which the court deems proper. [8] Against this backdrop, it is understandable that courts have adopted three general approaches in determining the propriety of 727 settlements. [9] Accordingly, practitioners must be well-versed in the various approaches and understand the justification behind each approach in an attempt to settle such claims.

Conclusion

For the uninformed debtor, bankruptcy law can present overwhelming challenges. The issues regarding 727 settlements are no different. The interpretations of certain bankruptcy laws sometimes differ among states, by districts within each state, and sometimes even between judges in the same district.

The lessons for someone contemplating bankruptcy are clear: (1) keep and maintain all documents and records that may be relevant to your bankruptcy before, during, and after the bankruptcy filing; (2) be honest and completely truthful with your bankruptcy attorney at all times; and (3) be upfront and candid with all major players in the bankruptcy system including the case trustee, the bankruptcy judge, and the United States Trustee’s Office.

The current case law shows a trend towards the "Cautious But Pragmatic Method Where A Court Has Final Say," and court opinions in recent cases demonstrate the importance of the settlement provisions. Courts are concerned with the economics of the case and preservation of judicial resources. Settlements will not be approved unless it is financially sound for all involved and payouts are feasible, not imagined.

Understand that the practice of bankruptcy law is not entirely academic. Bankruptcy law is not practiced in vacuum – rather the economic impact of decisions, particularly with respect to 727 actions is an ever-present underlying factor. Courts, attorneys, trustees, and debtors must all balance the importance of a debtor’s fresh start versus the equitable division of estate assets to all creditors. That is the true essence of bankruptcy law.

[1] Marrama v. Citizens Bank, 549 U.S. 365, 376 (U.S. 2007)(stating that the “principle purpose of the Bankruptcy Code is intended to give a ‘fresh start’ to the ‘honest but unfortunate debtor."’ citing Grogan v. Garner, 498 U.S. 279, 286, 287, (1991)).

[2] The appropriate procedure for filing an objection to discharge is through an adversary proceeding pursuant to Bankruptcy Rule 7001(4)).

[3] Thomas H. Jackson, The Fresh Start Policy in Bankruptcy Law, 98 Harv. L. Rev. 1393, 1440-41 (citing Local Loan Co. v. Hunt, 292 U.S. 234, 244 for the proposition that only an “honest but unfortunate debtor" is entitled to a discharge).

[4] Terrence L. Michael & Michael R. Pacewicz, Settling Objections to Discharge in Bankruptcy Cases: An Unsettling Look at Very Unsettled Law, 37 Tulsa L. Rev. 637, 644 (2002) (“Not surprisingly, [pursuant to Bankruptcy Rule 7041,] bankruptcy courts have often been asked to approve settlements between debtors and creditors or debtors and the bankruptcy trustee which call for dismissal of an objection to discharge. What is surprising is the range of answers given by the bankruptcy courts").

[5] Id. at 643.

[6]Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934).

[7] Terrence L. Michael & Michael R. Pacewicz, Settling Objections to Discharge in Bankruptcy Cases: An Unsettling Look at Very Unsettled Law, 37 Tulsa L. Rev. 637, 643 (2002).

[8] Fed. R. Bankr. P. 7041.

[9] In re de Armond, 240 B.R. 51, 55 (Bankr.C.D.Cal. 1999).

Additional resources provided by the author

www.justice.gov/ust/

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