Many bankruptcy cases involve adversary proceedings in which creditors seek to have certain debts deemed nondischargeable. The United States District Court for the Eastern District of Michigan (the “District Court”) recently considered, on appeal, whether the Bankruptcy Court properly held that a debt owed by a debtor (the “Debtor”) to the State of Michigan Unemployment Insurance Agency (the “Agency”) is dischargeable in a Chapter 13 case.1

In the underlying bankruptcy case, the Agency alleged that the Debtor owed almost $15,000, which included a statutory penalty for fraud, and argued that the debt was nondischargeable under section 523(a)(2)(A) of the Bankruptcy Code. The fraud claims stem from the fact that the Debtor allegedly was working full-time during a time period in which he was receiving unemployment benefits. Section 523(a)(2)(A) excepts from discharge “any debt - for money, property, [or] services...to the extent obtained by false pretenses, a false representation, or actual fraud….”

The Debtor argued that section 523(a)(2)(A) is not applicable to the statutory penalty part of the debt, because the penalty is a noncompensatory debt payable to a governmental unit that is covered by section 523(a)(7) of the Bankruptcy Code.

The Bankruptcy Court rejected the Debtor’s argument, a nondischargeable judgment was entered against him, and he appealed to the District Court. The District Court affirmed the Bankruptcy Court’s decision.

The Appeal

The bulk of the debt owed by the Debtor in this case is a penalty assessed because the Debtor allegedly obtained unemployment benefits via fraudulent conduct. The Debtor’s argument on appeal focused on the fact that while Bankruptcy Code section 523(a)(2)(A) excepts from discharge debts obtained from fraud, section 523(a)(7) states that a “fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, [that is] not compensation for actual pecuniary loss” is not excepted from discharge in the usual Chapter 13 proceeding. The Debtor argued, therefore, that section 523(a)(7), and not section 523(a)(2)(A), should apply in this case. The debt at issue cannot, the Debtor argued, be encompassed by 523(a)(7) and also fall under 523(a)(2)(A) as a nondischargeable debt.

The Bankruptcy Court and the District Court both rejected the Debtor’s argument based on their analysis of the U.S. Supreme Court’s decision in Cohen v. de la Cruz. The District Court interpreted Cohen to mean that all debts arising from fraud are nondischargeable under section 523(a)(2). In other words, there is no conflict between the two Bankruptcy Code sections. A penalty that was not related to fraudulent conflict can still be dischargeable under 523(a)(7), even though one related to fraud cannot.

The Debtor made a series of additional arguments in support of his position that the debt is dischargeable. These arguments include:

  • That the Cohen case is distinguishable because the debts owed in Cohen were owed to private parties rather than to a governmental unit;
  • That other Supreme Court cases, Kelly v. Robinson and Pennsylvania Dep’t of Pub. Welfare v. Davenport, show that debts covered by section 523(a)(7) are dischargeable in Chapter 13;
  • That the statutory history of Chapter 13 reflects Congressional intent to keep civil governmental penalties - even those that arise from fraud - dischargeable in Chapter 13;
  • That the court’s ruling would result in a statutory conflict or “absurd result;” and
  • That the court’s ruling would make either section 523(a)(2) or section 523(a)(7) “superfluous.”

The District Court, as did the Bankruptcy Court before it, rejected each of these arguments. It explained that Congress intended that all debts for fraud, including civil fraud penalties, be nondischargeable in Chapter 13, and that additional case law cited by the Debtor was either inapplicable or irrelevant in light of Cohen, as well as more recent amendments to the Bankruptcy Code. The bottom line, according to the District Court, is that if a debt is incurred as a result of fraud - even if such debt is a civil penalty - it is nondischargeable pursuant to section 523(a)(2).