Advice of Counsel Must Be Given in Advance to Constitute a Defense, Circuit Says

The “advice of counsel” defense only applies in discharge litigation if the debtor receives advice before taking action that could result in the loss of discharge, the Tenth Circuit said.

The individual debtors confirmed a chapter 11 plan calling for them to sell real property and pay the proceeds to the secured creditor. The debtors closed the chapter 11 case but did not sell the property. The lender obtained a judgment in state court and placed liens on the property.

The debtors reopened the case, sought sanctions against the lender for filing liens, and filed a motion to approve a sale of the property.

The bankruptcy court denied the motion for sanctions but granted the sale motion, providing, however, that the debtors must pay the sale proceeds to the lender.

The debtors sold the property but used the proceeds to pay nondischargeable tax debt. They did not pay the lender.

Subsequently, the debtors converted their case to chapter 7 and filed a motion for discharge.

The trustee initiated an adversary proceeding to deny discharge under Section 727(a)(6), which calls for the denial of discharge if the debtor “has refused . . . to obey any lawful order of the court” other than an order to answer a question or testify.

The bankruptcy judge granted the debtors’ discharges, relying on the advice of counsel defense. The district court reversed, holding that the debtors were not entitled to discharges.

The Tenth Circuit upheld the denial of discharge in a nonprecedential opinion on December 7, laying out the elements of the “advice of counsel” defense in the context of Section 727(a)(6).

With regard to the burden of proof under Section 727(a)(6), the party objecting to discharge must first show that the debtor received the order and failed to comply. The burden then shifts to the debtor to explain noncompliance. The court will deny discharge if it finds that the debtor’s noncompliance was willful.

A subjective belief that the order was invalid will not excuse a willful failure to comply, the appeals court said. In other words, a debtor who believes the order to be incorrect must appeal and comply in the meantime, absent a stay pending appeal.

The bankruptcy court granted the discharges after finding that the debtors had shown that their conduct was not willful because they relied on the advice of counsel that the order directing payment was invalid. Evidently, counsel also told the debtors they could use the proceeds to pay taxes.

To overcome the finding of fact, the circuit court said it must have a “definite and firm conviction” that the trial court made a mistake in its fact-finding.

The finding was clearly erroneous, the appeals court said, because the debtors received advice of counsel 10 months after the sale closed. The circuit court agreed that the finding was clearly erroneous because the debtors had not explained “their failure to comply with the Sale Order between when the sale closed and when they received counsel’s letters.”