A discharge in bankruptcy isn’t available when a debtor engages in fraud or other dishonest acts. This article summarizes a recent case in which a federal bankruptcy court denied the debtor’s discharge under Chapter 7 of the Bankruptcy Code. The opinion provides a useful guide to the types of conduct that prove fraudulent intent.
In re Burg, Case No. 22-60172. Adv. No. 22-06011. U.S. Bankruptcy Court (D. Minn. December 29, 2023).
The purpose of a discharge in bankruptcy is to “relieve an honest debtor from his financial burdens and to facilitate the debtor’s unencumbered fresh start,” explained the U.S. Bankruptcy Court for the District of Minnesota in the recent case of In re Burg.
However, such relief isn’t available when a debtor destroys or conceals property with the intent to defraud creditors; conceals, destroys, or fails to preserve books and records; or engages in certain other dishonest acts. Here’s why the court in this case denied the debtor’s discharge under Chapter 7 of the Bankruptcy Code.
The plaintiffs, a husband and wife who owned and operated two electrical contracting businesses, hired the debtor in 2011. The plaintiffs began to discuss selling their companies to the debtor in 2013. He subsequently took out a bank loan to finance the purchase, paying roughly half of the purchase price at closing with the remainder to be paid in monthly installments over 10 years.
Included in the loan terms was a subordination agreement that required the debtor to maintain a minimum debt service coverage ratio (DSCR) each quarter. This ratio is typically based on net operating income divided by debt service, including principal and interest. In this case, if the debtor’s DSCR fell below 1.25 times debt service, payments to the plaintiffs would be suspended until the DSCR was brought back above the threshold.
The debtor made installment payments to the plaintiffs for over two years. Then the bank notified him that he’d failed to meet the DSCR threshold for two quarters and must suspend payments to the plaintiffs. He never made another payment.
Although the DSCR was below the threshold, the companies remained profitable. However, the debtor engaged in various questionable activities to siphon profits from the businesses. For instance, the debtor hired an old high school friend as a “consultant.” According to the trial testimony, the consultant helped the debtor avoid paying the money he owed to the plaintiffs. For example, the debtor would take money out of the companies and pay it as a consulting fee to his friend, who would then invest it in real estate. The debtor also provided unpaid electrical services to the consultant and to another company he owned, then he deleted the accounting records associated with those services.
In addition, the debtor attempted to settle his debt with the plaintiffs, threatening to file for bankruptcy if they didn’t settle. Ultimately, the debtor closed the companies; terminated their employees; and siphoned more funds through payments of severance benefits, wages and vacation time. He filed for bankruptcy, and the plaintiffs filed a motion to deny the debtor’s discharge.
The court denied the debtor’s discharge under several Bankruptcy Code sections, including Section 727(a)(2)(A)-(B). Under this section, a court may deny a discharge if, among other things, the debtor removes, destroys or conceals property of the debtor with the intent to hinder, delay, or defraud a creditor or an officer of the bankruptcy estate.
The debtor argued that the property in question belonged to the companies, not him. The court disagreed, finding that the debtor’s actions destroyed the value of his property — that is, his stock in the businesses.
The debtor also denied having the requisite intent. But the court found that the debtor’s conduct overwhelmingly supported a finding of fraudulent intent. Specifically, he transferred, removed, destroyed or concealed the companies’ assets and business records in order to:
The court also denied his discharge under five other similar Bankruptcy Code sections.
Proving fraudulent intent with direct evidence is often difficult. However, in this case, the court noted that such intent may be “inferred from the facts and circumstances of the debtor’s conduct.” Its opinion provides a useful guide to the types of conduct that support such an inference.
For more information on why bankruptcy courts may deny a debtor’s discharge, contact us today.