Fraudulent Transfer Claim Precluded by Discharge Injunction

Posted by NCBRC - April 8, 2021

Because an action for fraudulent transfer is not merely a collection action, the creditors were precluded by the discharge injunction from pursuing their state court appeal of that action even though the predicate debt was found to be nondischargeable in the debtor’s bankruptcy. SuVicMon Dev. Inc. v. Morrison, No. 20-11681 (11th Cir. March 25, 2021).

The creditors were three corporations that sued the debtor in state court for securities fraud. They later added a claim for fraudulent transfer of property they claimed the debtor transferred to his sons to shield from a judgment in the securities fraud case. At trial, the creditors obtained a jury verdict in their favor on the securities fraud claim but lost the fraudulent transfer claims. The debtor filed for chapter 7 bankruptcy, and the creditors moved for, and received, a finding that the state court securities fraud judgment was not dischargeable under section 523(a)(19). After the debtor obtained his discharge, the creditors sought to continue their state court appeal of the fraudulent transfer claim. The bankruptcy court found the continuation of the fraudulent transfer case would violate the discharge injunction. The district court affirmed.

On appeal to the Eleventh Circuit, the creditors presented two arguments. First, they argued that the discharge injunction did not apply to the fraudulent transfer case because it was an action to recover on a debt that was not discharged in the debtor’s bankruptcy. The court disagreed. The court distinguished fraudulent transfer cases from execution actions which are generally in rem proceedings against the debtor’s property to satisfy an existing debt. A fraudulent transfer case, the court found, is an independent action requiring that the plaintiffs establish elements such as intent to hinder, delay or defraud a creditor. Further, under Alabama law, in addition to fashioning an in rem remedy against the debtor’s property, a court may award compensatory and punitive damages. Thus, a fraudulent transfer action may lead to debt that is independent of the predicate debt the transferor sought to avoid.

For these reasons, the court rejected the creditors’ first argument that the discharge injunction was inapplicable.

The creditors next argued that they should be permitted to proceed against the debtor as a nominal defendant because the fraudulent transfer case was intended to recover property from the third parties in possession. The creditors pointed to Owaski v. Jet Florida Systems, Inc. (In re Jet Florida Systems, Inc.), 883 F.2d 970 (11th Cir. 1989) (per curiam), where the court held that a creditor could proceed nominally against a defendant on a discharged debt in order to collect from the defendant’s insurance company. The creditors also cited section 524(e) which provides that “[e]xcept as provided in subsection (a)(3) of this section, discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.”

Applying Jet Florida, the court found two factors must be present before a creditor may be permitted to continue to pursue a debt in post-discharge litigation: first, the debtor must be a necessary party to the post-discharge action, and second, it must be “sufficiently certain” that the debtor will not suffer any personal economic burden undermining his fresh start. The court noted that bankruptcy discharge is intended to protect the debtor, not to deprive the creditor of recovery where the debtor would be only nominally involved, or allow an insurer to escape its obligations. Finding that application of the Jet Florida doctrine modifies the discharge injunction and may be a fact-intensive inquiry, the appropriate standard of review was for abuse of discretion.

The court found the bankruptcy court did not abuse its discretion when it found that the discharge injunction prohibited the creditors from pursuing their state court appeal. As to the first prong of the Jet Florida test, Alabama law permits a fraudulent transfer action to be taken against the transferees without participation of the transferor. As to the second prong, the court found that because this case did not involve an insurer to bear the cost of post-discharge litigation, the debtor would be likely to suffer an economic burden if named as a party to the state court action.

The court affirmed.

SuVicMon 11th Cir March 2021

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