The Problem with Monetary Considerations in § 727 Settlements

By Victoria Grantham

Section 727 is a potent tool in the arsenal of an aggrieved creditor, but, as Uncle Ben wisely told Peter Parker in Spiderman, “With great power comes great responsibility.” It is through this lens that litigators should view § 727 and ensure they are utilizing best practices in settlements to avoid the appearance of allowing a debtor to “buy a discharge.”

The § 727 Settlement Problem: Have You Bought Your Discharge?

Section 727 enumerates circumstances in which a debtor should be denied a discharge. The conduct described in § 727 is sufficiently grave as to warrant a general denial of a debtor’s discharge for all creditors. This includes maliciously concealing or destroying property of the estate, failing to keep or withholding business records or records of estate property, making false claims to the court, and failing to account for losses of estate assets.1 Attorneys representing frustrated creditors often bring suit under § 727(a)(2), which specifically allows for the denial of a debtor’s discharge where the debtor acted

with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of property under this title, has transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed — (A) property of the debtor, within one year before the date of the filing of the petition; or (B) property of the estate, after the date of the filing of the petition.2

These actions may be brought in conjunction with an action brought under § 523(a)(2), alleging similar grounds, but only requesting the court to deny the discharge of the debtor’s debt to the creditor, not a denial of the debtor’s discharge generally. As in all adversary proceedings, the parties may settle their disagreement before going to trial. In § 727 actions, however, any monetary settlements may be, and should be, reviewed by the court to ensure the debtor has not “bought their discharge.” In In re Bullis, the court identified the concerns about these settlements, stating:

The essential proposition is that as a matter of public policy, the debtor is either entitled to a discharge or is not. There is no middle ground. If he is entitled to a discharge, he ought not be required to pay additional amounts to either a creditor or the estate for his entitlement. Payment for a discharge is inimical to his fresh start. If, on the other hand, he is not entitled to a discharge, he should not be permitted to purchase a discharge.3

Courts have weighed in on this issue for decades, examining the arrangements of the settlement and questioning whether it violates public policy to allow the debtor to exchange relief from the charges of a § 727 complaint for some amount of money.4 The court’s further discussion in In re Bullis highlights the three major approaches that courts have generally taken when addressing a proposed settlement of a case brought under § 727.

The first approach is finding that any settlement of a § 727 case is per se impermissible.5 The second approach, nicknamed by the Bullis court as the “trustee approach,” requires that the terms of the settlement be disclosed to all creditors, the trustee assigned to the case where applicable, and the U.S. Trustee. The theory behind this approach is that the original plaintiff has acted like a trustee of all creditors in litigating the § 727 case, and that by abandoning the case, another party can assume the position of the plaintiff if they object.6 The court would then approve the settlement unless the parties object or there is a motion to substitute a party. This approach has created disagreements among courts as to whether intervention and substitution are permissible under Rules 7024 and 7025 of the Federal Rules of Bankruptcy Procedure.7

The final approach adds another element to the trustee approach in which the court independently scrutinizes the settlement to determine its appropriateness, even if the terms of the settlement are served to the relevant parties and no objection from those parties is received. This seems to be the most popular approach that courts use when asked to approve agreements dismissing § 727 claims. Courts utilize the appropriate framework in their circuit to review the settlement agreement among the parties and determine whether it is appropriate given the claims brought.8 Parties hoping for approval of their settlements will have to advocate for their settlement and meet the elements required by their relevant standards, adding an additional step to the resolution of their cases and more litigation expenses.

Playing by the Rules: Bankruptcy Rule 7041 and Local Rules

Bankruptcy Rule 7041(b) only requires that notice of a dismissal of an adversary proceeding must be served “to the trustee, the [U.S. Trustee], and any other person the court designates.” Still, notice of the dismissal of an adversary proceeding is not sufficient to address the public policy concerns raised by a monetary settlement of a § 727 case. Rule 7041 does not require that notice of a settlement or the terms of the settlement that led to the dismissal of the adversary proceeding be served.

Attempting to ameliorate the concerns of a bad-faith § 727 settlement and dismissal, many jurisdictions have adopted local rules that require some enhanced disclosure to the court or other parties. Forty-two of the 94 federal bankruptcy districts include some variation of this rule in local rule sections related to Bankruptcy Rules 4007, 7007, 7041, 9013 and 9019.9 Most of these rules require that the party serve either all creditors or the trustee in the case and the U.S. Trustee with notice of the settlement and its contents or consideration paid in exchange for dismissal.10 The parties can then object to the settlement if they believe that the debtor is essentially buying their discharge. If the case is in a district in which the court will allow an objecting party to substitute themselves as the plaintiff, that motion could also be made at that time. However, some jurisdictions only require the disclosure of the terms to the court, meaning that the court solely bears the burden of determining whether the settlement is fair.11

Avoiding the § 727 Settlement Trap

There are a few best practices that can be implemented to avoid complicating the litigation of otherwise resolvable matters. The first, and probably the easiest, is for lawyers to ensure that § 727 actions are only brought very deliberately in cases in which the debtor’s behavior warrants its relief. Creditors’ lawyers should carefully decide whether § 727 is the best option to pursue litigation or whether a claim under § 523 would be more appropriate. Creditor’s lawyers could be tempted to bring suit for both §§ 727 and 523 claims when alleging fraud perpetrated by the debtor that harmed the creditor. While it is in their purview to do so, this could make settlement more difficult if that is a potential resolution that the parties would want to pursue.

Making careful decisions at the initial pleading stage about the most appropriate statutory approach to the goals of a creditor’s litigation could save a potential quagmire if parties are hoping to settle later. Having a clear litigation strategy and an understanding of the implications of § 727 claims before initiating suit against a debtor can help litigators determine what statutory approach is best for their client’s goals.

Courts can also help address this issue by following the trend of adopting local rules that require settling parties to notify other interested parties under the terms of the agreement with time to object. As previously stated, 42 of the 94 federal bankruptcy court districts have adopted rules requiring disclosure of the terms of the settlement to the court and other parties if attempting to dismiss a § 727 claim. If other parties are given notice of the settlement, those parties can then object or move for substitution; if no parties object, the court may use the lack of objection to inform its decision as to the appropriateness of the settlement agreement.

The Advisory Committee for the Federal Rules of Bankruptcy Procedure could also consider adding to Rule 7041 the enhanced notice requirement requiring the terms of a settlement agreement of a suit commenced under § 727 to be served to at least the assigned trustee where applicable and U.S. Trustee or, preferably, to all creditors. This would standardize the practice and remove the burden from the courts of having the sole burden of determining a settlement’s appropriateness and deciding what notice and to whom is appropriate.

Conclusion

Section 727 is an exceptionally powerful Bankruptcy Code section for creditors seeking justice against bad debtors. Advocates should bring § 727 actions where the debtor’s actions warrant a general denial of their discharge. Settling these actions with monetary consideration comes with significant public policy concerns, however. Courts have addressed this through their decisions and additions to their local rules to lessen the likelihood of debtors essentially paying for a discharge.

Lawyers would benefit from ensuring that their zealous advocacy does not bind their hands later to pursuing or dismissing an action for which the litigation goal was to be resolved by settlement. Careful lawyering and an understanding of the implications of the Bankruptcy Code can alleviate frustrations down the road.

Tori Grantham is the career law clerk for Hon. John T. Laney, III of the U.S. Bankruptcy Court for the Middle District of Georgia in Columbus.