In a chapter 11 corporate reorganization, the debt arising from violation of state consumer protection laws is nondischargeable only when the state is defrauded, not when consumers are defrauded, according to Bankruptcy Judge Brendan L. Shannon of Delaware.
Judge Shannon’s Feb. 14 opinion represents a second proposition: Creditors are unlikely to win a lawsuit that would blow up confirmation of a large, heavily negotiated chapter 11 plan.
The dischargeability dispute arose in the reorganization of subsidiaries of Takata Corp. that manufactured defective airbags, resulting in the largest recall in U.S. history. Prior to bankruptcy, two states and the U.S. Virgin Islands sued Takata for making false statements and violating state consumer protection laws.
The debtors sued in bankruptcy court for a declaration that any damages in the suits would be dischargeable.
In an individual’s bankruptcy, 19 types of debts are excepted from discharge under Section 523(a). For a corporate debtor in chapter 11, only debts of the type in Section 523(a)(2)(A) or (a)(2)(B) can be excepted from discharge under Section 1141(d)(6). Those subsections relate to fraud or fraudulent representation.
Section 1141(d)(6) includes an additional requirement that a nondischargeable debt must be owing to a “domestic governmental unit.”
The debtors argued that the debts were not owed to the states because the claims were for damages to consumers. Judge Shannon disagreed.
He said that the state laws gave the states standing to sue on behalf of their citizens. Nonetheless, he said, “judgments would constitute obligations owed to the states” and therefore would be “owed to a domestic governmental unit.”
The debtors prevailed on the second issue dealing with fraudulent representation. Judge Shannon said that the Supreme Court “has strictly construed Section 523(a)(2)” to require proof that the fraudulent representation was “made by a debtor to the affected creditor and that the creditor must have [justifiably] relied.”
In the Takata case, Judge Shannon said there was no allegation that the states received or relied on the debtors’ representations.
Summing up, Judge Shannon said “there is no question” that corporate debtors “may obtain a discharge from claims of individuals for the precise conduct that forms the basis” for the state’s claims. Similarly, Judge Shannon ruled that the debtors are entitled to discharge the states’ claims because “Congress has precluded a discharge” only when “the governmental unit is the actual victim of a corporate debtor’s fraudulent conduct or representations.”
Judge Shannon “buttressed” his conclusion by reference to Section 523(a)(7), where a debt owing by an individual to the government for a fine, penalty or forfeiture owing is nondischargeable. Congress did not include (a)(7) in the types of debts that are nondischargeable in chapter 11.
Given that the conduct alleged by the states “fall[s] squarely” under (a)(7), Judge Shannon said that civil fines and penalties unrelated to a governmental unit’s “own actual losses” are discharged in chapter 11.
The states appealed immediately, but the appeal may become moot if the states do not obtain a stay of Takata’s impending confirmation order pending appeal.
In district court, the states might try an argument based on Husky International Electronics Inc. v. Ritz, 136 S. Ct. 1581, 194 L. Ed. 2d 655, 84 U.S.L.W. 4270 (2016), where the Supreme Court held that a debt can be nondischargeable under Section 523(a)(2)(A) even if the debtor made no misrepresentation to the creditor.
Arguably, Husky undercuts the debtors’ contention that the misrepresentation must be aimed at the states. It is possible, however, that Husky, a controversial decision, will be limited to cases under Section 523(a)(2)(A) involving nondischargeable debts owing by individuals. In addition, the states may not be able to rely on Husky if the argument was not raised in bankruptcy court.