General Discharge Barred Suing the Debtor to Collect a Nondischargeable Debt

The Eleventh Circuit ruled that the debtor’s discharge barred the holder of a nondischargeable debt from suing the debtor for fraudulently transferring estate property, even though the trustee had abandoned the fraudulent transfer claim.

Circuit Judge Gerald B. Tjoflat held that the fraudulent transfer claim was not just an effort at collecting a nondischarged debt, which would have made it immune from the discharge injunction.

In his March 25 opinion, Judge Tjoflat narrowed Eleventh Circuit precedent, Owaski v. Jet Florida Systems Inc. (In re Jet Florida Systems Inc.), 883 F.2d 970 (11th Cir. 1989) (per curiam), which had opened the door a crack for suing a debtor after discharge.

The Abandoned Fraudulent Transfer Claim

Before bankruptcy, several creditors had sued the debtor for violation of state securities laws. The suit also lodged actual and constructive fraudulent transfer claims against the debtor and against his sons, as recipients of the fraudulent transfers.

After the debtor filed a chapter 7 petition, Bankruptcy Judge Clifton R. Jessup, Jr. of Decatur, Ala., modified the automatic stay to permit the suit to go forward in state court. Judge Jessup did not permit execution of a judgment, if the creditors were to obtain one.

The creditors also filed suit in bankruptcy court seeking a declaration that the debts arising from the suit would be nondischargeable. While the nondischargeability suit was pending, the debtor received a general discharge.

After trial, the state court entered judgment for about $1.2 million against the debtor on the state-law securities claims. However, the state court gave judgment in favor of the debtor and his sons on the fraudulent transfer claims. The creditors filed an appeal to the Alabama Supreme Court on denial of the fraudulent transfer claims.

Bankruptcy Judge Jessup granted summary judgment in favor of the creditors, declaring that the $1.2 million judgment was nondischargeable under Section 523(a)(19) as a debt for violating securities laws.

Somewhere along the way, the chapter 7 trustee issued a no-asset report and abandoned the estate’s interest in the fraudulent transfer claims.

The creditors filed a motion in bankruptcy court seeking permission to continue the appeal of the unfavorable fraudulent transfer judgment. If the appeal were successful, they wanted leave to sue the debtor on the fraudulent transfer claims.

Judge Jessup allowed the creditors to continue the appeal against the sons. However, he ruled that the discharge injunction barred the creditors from suing the debtor on the fraudulent transfer claims in state court. He also decided that Jet Florida was inapplicable to allow suit against the debtor because defending the fraudulent transfer suit would burden the debtor’s discharge.

The district court affirmed, leading to the appeal to the Eleventh Circuit.

The Nondischargeable Debt Didn’t Permit the Fraudulent Transfer Suit

The creditors made two arguments on appeal. First, they claimed that any action to collect a nondischarged debt is not barred by the discharge injunction.

Judge Tjoflat answered succinctly, “The plaintiffs’ argument is incorrect,” giving multiple reasons.

Judge Tjoflat said that the fraudulent transfer suit “differs . . . from execution on a judgment.” It was not a mere collection action, like a writ of attachment or a garnishment to collect a judgment.

Judge Tjoflat explained that the fraudulent transfer suit was “a distinct cause of action,” where the creditors might win damages in excess of their underlying claim or even punitive damages.

Although the securities fraud judgment was not discharged, he held that “the plaintiffs’ fraudulent transfer claims are not thereby excepted from discharge.”

In other words, “a fraudulent transfer action does not function as an execution proceeding,” Judge Tjoflat said, “and the fact that the underlying claim is non-dischargeable does not compel the conclusion that the fraudulent transfer claim is non-dischargeable.”

The Jet Florida Issue

In Jet Florida, the creditor held a nondischargeable defamation claim against the debtor. The creditor sought to proceed nominally against the debtor to recover on an insurance policy.

The Eleventh Circuit allowed the suit to proceed, believing that the debtor’s status as a nominal defendant would not impair the debtor’s fresh start because the insurer would provide a defense. The appeals court did not believe that a debtor’s discharge should allow an insurer to escape its obligations.

Judge Tjoflat interpreted Jet Florida as imposing two requirements: (1) The debtor’s presence in the suit must be a “genuine prerequisite” to the plaintiff’s recovery; and (2) it must be “sufficiently certain” that the suit will not impose “any economic burden on the debtor” that would interfere with the debtor’s fresh start.

In the case on appeal, the creditors failed both tests. Under Alabama law, the creditors could sue the sons, as recipients of fraudulent transfers, without suing the debtor, as the transferor. Second, there was no certainty that the sons would provide an adequate defense.

Standards of Appellate Review

The Eleventh Circuit had not previously defined the standards of appellate review under Jet Florida.

Judge Tjoflat held that appellate review is largely for abuse of discretion, and he found none. He reasoned that finding an exception to discharge is “functionally analogous” to a modification of the automatic stay, where there is review for abuse of discretion.

Similarly, the finding of “sufficient certainty” about an economic burden on the debtor is like a finding of fact and is committed to the bankruptcy court’s sound discretion.

However, a finding that the debtor’s presence in the suit is a prerequisite is a “pure issue of law” to be reviewed do novo.