Dischargeability and the Disappearing Debtor: How to Preserve the Debt

In many common nondischargeability claims, the plaintiff creditor must prove the debtor defendant’s intentional misconduct. A default judgment for an underlying breach of contract or tort is insufficient on its own to support nondischargeability. The creditor must put on specific evidence of the debtor’s intent. This constitutes black-letter law under the Bankruptcy Code.

Proving intent can be challenging in its own right, but the problem becomes more complex if the debtor cannot be located. It is not unheard of for a debtor to disappear after the completion of the core matters in a chapter 7 or 13 case. For example, a foreign national may decide to return to his or her home country, but the creditor’s nondischargeability action may still be pending, subject to proof of debtor’s intent in the underlying claim. If the debtor is not around, it may be difficult to prove the intent to support a nondischargeability judgment.

Fortunately for creditor counsel, the court’s procedural rules provide them with protections. The primary protection is under Federal Rule of Bankruptcy Procedure 7037, which provides a range of sanctions for failure to participate in discovery. Although entry of a dispositive order is an extreme sanction, courts recognize it as valid against a nonparticipating party in nondischargeability actions.

A Creditor Must Prove Debtor’s Intentional Conduct
One of the most common claims for nondischargeability arises when a debtor obtained money, services or credit by using a materially false statement of the debtor’s financial conditions. [1] The statute requires the plaintiff prove “that the debtor caused [the statement] to be made or published with [the] intent to deceive.” [2] Courts recognize that a plaintiff must prove the debtor’s intent as a necessary element before entering a nondischargeability judgment. [3]

Similarly, a denial of discharge may require a plaintiff creditor to establish the debtor’s intent. The discharge should be denied if the debtor, “with intent to hinder, delay or defraud a creditor or an officer of the estate,” has transferred, removed, destroyed, mutilated or concealed property of the debtor or the bankruptcy estate. [4] The discharge also should be denied if the debtor “knowingly of fraudulently” engaged in misconduct concerning the debtor’s assets and liabilities. [5] These provisions require a plaintiff to prove the debtor’s intent in order to obtain a denial of discharge. [6] A debt also is nondischargeable if it arises from a “willful and malicious injury by the debtor to another entity or to the property of another entity.” [7] Although the statutory language is not explicit, courts have held that a plaintiff must prove the debtor’s intent to cause an injury. [8]

A Creditor May Not Have Any Direct Proof of Intent When the Bankruptcy Starts
When a bankruptcy commences, a creditor may only know that debtor owes it money. The creditor may have even obtained a pre-petition default judgment without conducting any discovery. In either instance, the creditor may not have any evidence about debtor’s intent except for its own records of the debt. As a result, the creditor will need to conduct discovery in the bankruptcy proceeding to establish a debtor’s intentional misconduct and obtain a nondischargeability judgment.

A creditor can face additional challenges in chapter 7 and 13 cases. A chapter 7 debtor may receive a discharge before the nondischargeability action is resolved. Similarly, a chapter 13 debtor may have confirmed a plan during the pendency of the nondischargeability action. The debtor may decide that he or she already obtained the benefit of bankruptcy. As a result, the debtor may not participate in the nondischargeability action. This occurs with pro se debtors who may not understand the procedure. There also are numerous cases arising when defendants and their counsel have lost contact with each other.

If the debtor ignores the adversary proceeding or walks away from court entirely, the plaintiff may obtain a default judgment on the underlying substantive claim, but to obtain the nondischargeability judgment, the plaintiff still needs to develop the evidentiary record to establish the debtor’s intentional conduct. [9] “This practice is motivated by the risk that a creditor may obtain a default judgment, regardless of the merits of the complaint, against an honest debtor who is in such a precarious financial condition that the debtor cannot afford to defend a nondischargeability claim.” [10] If a debtor has disappeared, the creditor may not be able to conduct discovery and obtain evidence to prove the debtor’s intent. The creditor needs to consider alternative methods to obtain a nondischargeability judgment.

Pursue Discovery Sanctions to Obtain a Default Judgment without Proving Debtor’s Intent
The creditor still may prevail in a nondischargeability action based on the discovery sanctions under Federal Rule of Bankruptcy Procedure 7037, which incorporates by reference the entirety of Federal Rule of Civil Procedure 37. The primary basis for relief arises if the debtor defendant fails to appear at his or her deposition under Rule 30, or fails to provide a written response to interrogatories or a request for inspection under Rules 33 and 34. [11] If a defendant fails to participate in discovery, the Rules authorize the court to enter a range of sanctions including default judgment against the disobedient party. [12]

Sanctions are appropriate for discovery violations in “extreme circumstances” when the violation is “due to willfulness, bad faith or fault of the party.” [13] To establish “willfulness, bad faith or fault,” the movant must show that the disobedient party’s conduct was not outside the party’s control. [14] The exact standards may vary by circuit. For example, the Ninth Circuit holds that the court should weigh five factors to determine whether default judgment is appropriate: “(1) the public’s interest in expeditious resolution of litigation; (2) the court’s need to manage its docket; (3) the risk of prejudice to the [moving party]; (4) the public policy favoring disposition of cases on their merits; and (5) the availability of less drastic sanctions.” [15] Courts generally are concerned that a party’s failure to cooperate with discovery prevents the opposing party from “ascertaining the truth of the issue.” [16]

In weighing those factors, courts have entered a dispositive sanction where a party has disappeared and failed to comply with discovery. Primarily, courts have held that a party’s location is within its control, and the party’s absence “demonstrate[s] the requisite willfulness and fault” that justifies a dispositive sanction under Rule 37(d). [17]
Default judgments have been entered specifically in nondischargeability actions as a sanction for failure to satisfy discovery obligations. [18] Sanctions have been repeatedly imposed based on a debtor’s absence from the adversary proceeding. The dispositive sanction is sometimes based on a debtor’s failure to participate in the proceeding. [19] Other times, the debtors have left the state. One decision reflected the fact that the debtors apparently were looking for work out of state, but based on the fact that the debtors had appeared once, claimed to be hiring counsel but had not, and had not otherwise participated in the case, the court entered a default judgment for nondischargeability. [20] In another case, the debtors claimed to have moved out of state, but when the debtors did not appear at depositions or in court for a motion hearing and trial set concurrently, the court entered a default judgment. [21]

The sanction is often imposed after fruitless efforts to compel the debtor to comply with their discovery obligations. For example, a default judgment was entered in a matter that consolidated the determination of debtors’ tax liability and the dischargeability of that debt. [22] The court ruled in the government’s favor of the tax liability. The debtors then objected to the court’s jurisdiction, refused to schedule a continued deposition and refused to accept the proposed pretrial order mailed to them. The court held that the debtor’s conduct “constituted willful discovery abuses” and entered a default judgment against them as a violation under Rule 37(d). [23]

It is not unusual for a debtor to stop participating in a case after a number of prior discovery disputes. The debtor’s counsel in one case advised the court that his client had stopped responding to him. [24] Between the debtor’s absence and earlier problems with discovery, the court entered a default judgment as a sanction in the nondischargeability proceeding. Alternatively, when the debtor defendant no longer can be located, a court may issue a warning order effectively to defendant’s counsel if the defendant is not in attendance. The court may order the defendant to comply with his or her discovery obligations, subject to the risk of default judgment for noncompliance. [25]

Conclusion
The disappearance of a defendant can be problematic in any case. It can be resolved in civil litigation with a default judgment on the substantive claim under Federal Rule of Civil Procedure 55, but when a defendant disappears in a nondischargeability proceeding, the plaintiff still needs to prove the defendant’s intentional misconduct in many claims. Proof of intent may be evasive if the defendant has disappeared. The dispositive discovery sanction is an important tool for creditor’s counsel that relieves the plaintiff of its burden of proving the defendant’s intent in the underlying claim. The debt remains nondischargeable, leaving the creditor free to resume its search for the defendant and seek repayment of its debt.