The Unlisted Creditor and the Interplay of §§ 523(a)(3) and 726(a)(2): A Circuit Split Continues

In a no-asset chapter 7 case, an unlisted debt is generally discharged. However, the outcome is much less favorable to debtors in asset cases where a known creditor is omitted from the schedules.[1] This leaves debtors with potentially staggering debts after receiving a discharge and surrendering assets to the trustee simply because they did not list a particular creditor, regardless of the reason for their failure to do so. Sometimes the assets surrendered are in such trivial amounts they would have resulted in the unlisted creditor receiving a limited or no distribution had they been properly listed and filed a claim, but the debtors are potentially left burdened for years by what was often only a mistake or a typo.

But for many debtors, the mere failure to list a claim, depending on when the failure is discovered, may not be fatal to receiving a discharge of the debt. A circuit split on the interplay of § 523(a)(3) and § 726(a)(2) of the Code offers some hope to debtors who discover their mistake in time to permit a creditor to participate in distribution.

Circuits can be divided into those taking a “plain language” approach[2] to § 523(a)(3) and those who are guided by the “distribution” approach,[3] which focuses on the interplay of §§ 523(a)(3) and 726(a)(2).[4] The split arose over whether a claim filed after the claims bar date but before distribution — known as a “tardily” filed claim — and that can still be paid in chapter 7 since it is filed prior to distribution[5] constitutes a “timely” claim under § 523(a)(3). “Timely” is not defined by the Code.

A tardily filed claim under § 726 would reduce whatever amount the debtors owe if the debt cannot be discharged. And in the plain-language approach jurisdictions, the matter ends there. The plain-language courts take the position that § 523(a)(3)’s use of the word “timely” excludes any claim filed after the bar date, including tardily filed claims under § 726; the reasons for the failure to list are irrelevant in the plain-language-approach jurisdictions.[6]

However, in distribution-approach jurisdictions, even though the claim is filed after the claims bar date, the debt is not excepted from discharge because § 723(a)(2) intercedes to result in the tardily filed claim becoming a “timely” claim for purposes of § 523(a)(3). The tardily filed claim can participate in distribution, and therefore there is no prejudice, as the unlisted creditor receives exactly what it would have received if it had been properly listed.[7]

In Horlacher,[8] following the widely cited distribution approach case of Ricks,[9] the court examined a case in which the debtors had failed to list a debt and the creditor did not have actual knowledge of the case in time to file a claim, but the chapter 7 trustee had not yet made distributions. The court found that because the creditor in that case could still file a “tardy” claim against the debtors, which would become a timely claim when filed under 11 U.S.C. § 726(a)(2)(C), the creditor’s claim was “timely” under § 523(a)(3)(A) of the Code and was not excepted from discharge.[10]

The court opined that “Section 726(a)(2)(C) acknowledges th[e] difference between a chapter 7 case and a chapter 11 or 13. It allows a chapter 7 creditor to participate in distribution if the creditor had no knowledge of the bar date and files a claim after the set 90-day deadline but before distribution of the estate. In a chapter 7 case, as long as there has been no distribution of assets, there is no harm or prejudice to the creditor in allowing a claim that is filed after the typical bar date for filing.”[11]

In a recent distribution-approach case, the court in Snyder adopted the distribution approach, determining that courts following this approach take a holistic view, narrowly construing exceptions to discharge.[12] However, in that case as in others, the debtors’ degree of knowledge of the potential claim was also a significant consideration.[13]

The case of Schlueter[14] is widely cited in plain-language jurisdictions. The facts are similar to those of Horlacher. However, the debtor in Schlueter did not file an adversary proceeding to determine dischargeability until after the chapter 7 trustee had made distribution. The Schlueter court concluded that “The Debtor produced no evidence that the literal application of § 523(a)(3)(A) is at odds with the literal application of § 726(a)(2)(C). One section governs the consequences for a debtor’s failure to schedule a claim of which she has knowledge; the other section governs distribution of assets. The bankruptcy court did not err in finding that State Farm lacked actual notice so as to permit the timely filing of a proof of claim.”[15]

In cases where distribution has not yet occurred, it is worthwhile for debtors’ counsel to consider filing an adversary proceeding to assert that a debt is dischargeable by virtue of the interplay of §§ 523 and 726 and to file claims on behalf of unlisted creditors. As there is a circuit split, continuing appeals will be required to resolve this issue nationally. Advising both debtors and creditors of this unresolved matter is of paramount importance for counsel.