The U.S. Court of Appeals for the Fifth Circuit recently held that debts arising from a scheme to deprive mortgagees of surplus foreclosure sale proceeds were non-dischargeable, affirming the bankruptcy court’s judgment against the debtor in consolidated adversary proceedings filed by various lenders that held first mortgage liens.

A copy of the opinion is available at:  Link to Opinion.

The debtor orchestrated a mortgage fraud scheme by which a straw buyer acquired property subject to a first mortgage at a condominium association’s foreclosure sale. The buyer then entered into a “tax-transfer loan agreement” with two Texas companies controlled by the debtor, the purpose of which was to pay delinquent property taxes on the property. Upon paying the taxes, the tax-transfer lender received a tax-transfer lien against the property.”

The “purchaser/borrower” would then promptly default and not make payments as required under the tax-transfer loan agreement, and the debtor “would instruct the trustee of the tax-transfer deed to foreclose on the property. From the foreclosure sale proceeds, the trustee took a $1,000 fee, paid the private lenders’ tax transfer liens in full, and delivered the excess proceeds to the purchaser/borrower.”

The deeds of trust transferring title omitted language requiring the trustee to distribute surplus funds to junior lienholders according to their priority before paying the “Grantor” as required by Texas law.

A bank that was deprived of surplus sale proceeds from foreclosures on three properties sued the debtor and co-conspirators.  The debtor filed a Chapter 11 bankruptcy in February 2010, which was dismissed slightly more than a month later.  He filed a second bankruptcy case about three months later.

In November 2010, several other banks filed adversary proceedings seeking a determination of non-dischargeability, which were consolidated by the bankruptcy court.

In January 2012, the bankruptcy court dismissed the debtor’s bankruptcy case, finding that he had “abused the [bankruptcy] process by filing two Chapter 11 petitions within the last 2 years [without filing] a plan and disclosure statement.” However, by stipulation of the parties the bankruptcy court reserved jurisdiction to adjudicate the pending adversary proceeding.

The trial court case went to trial in January 2013, but settled mid-way through. The settlement provided that if the debtor failed to pay the bank $500,000 by a date certain, the bank would be entitled to seek relief from the automatic stay for entry of an agreed judgment.

In February 2013, before the bankruptcy court “issued findings and conclusions” in the consolidated adversary proceeding, the debtor filed a Chapter 7 bankruptcy, which was assigned to the same bankruptcy judge.

“The bankruptcy court lifted the automatic stay so the federal district court could enter agreed judgment, which was entered on April 24, 2013. The following day, the bankruptcy court issued its opinion in the adversary proceeding, concluding that the debtor “was liable to the … Plaintiffs for the aggregate amount of the excess proceeds, and that his debts arising from the state-law violations were nondischargeable.”

On May 16, 2013, the debtor filed a suggestion of bankruptcy “formally notifying the court of his Chapter 7 filing.” Shortly thereafter, on May 29, 2013, the bankruptcy court entered final judgment against the debtor in the adversary proceeding in the amount of $268,477.78. In addition, “[t]he bankruptcy court emphasized that its determination of nondischargeability, although rendered in adversary proceedings brought during [debtor’s] previous Chapter 11 case, applied to [his] newly filed Chapter 7 case.”

On May 30, 2013, the same bank that had obtained the agreed judgment in the district court filed an adversary proceeding in the debtor’s Chapter 7 case, seeking a determination that the judgment was not dischargeable.

The debtor appealed the bankruptcy court’s non-dischargeability opinion to the trial court on June 12, 2013.

On Sept. 30, 2014, the bankruptcy court granted partial summary judgment in the bank’s favor, finding that the debtor was collaterally estopped from challenging the earlier non-dischargeability opinion. After hearing testimony on three disputed issues of fact, the bankruptcy court held that the agreed district court judgment “was a nondischargeable debt.”

The debtor moved to certify a direct appeal to the Fifth Circuit, which the trial court granted.

On Sept. 29, 2015, the trial court affirmed the bankruptcy court’s non-dischargeability opinion. The debtor appealed this ruling also, and the two appeals were consolidated.

On appeal, the debtor argued that (a) “the bankruptcy court erred in ruling that his debts to [the banks] were nondischargeable; (b) “the bankruptcy court violated the automatic stay in his Chapter 7 case by entering the nondischargeability judgment; (c) the settlement agreement in the trial court case “extinguished all pre-settlement causes of action, including actions to determine nondischargeability[;]” (d) the bankruptcy court erred in finding that he instructed the trustee to foreclose on the [properties]”; and (e) “the bankruptcy court erred by giving preclusive effect to the [judgment in the adversary proceeding].”

The Fifth Circuit began its analysis by explaining that whether a debt is dischargeable is a question of federal law under the Bankruptcy Code, the nondischargeability of a debt “must be established by a preponderance of the evidence” and “exceptions to discharge must be strictly construed against a creditor and liberally construed in favor of a debtor so that the debtor may be afforded a fresh start. … However, the Bankruptcy Code limits the opportunity for a new beginning to the ‘honest but unfortunate debtor.’”

The Court then turned its attention to section 523(a) of the Bankruptcy Code, which “sets forth the categories of nondischargeable debt. Relevant here, section 523(a)(4) “excepts from discharge debts ‘for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny. … Section 523(a)(6) excepts from discharge debts ‘for willful and malicious injury by the debtor to another entity or to the property of another entity.”

The Fifth Circuit rejected the debtor’s argument that “the bankruptcy court erred in imputing to him the actions and intent of his co-conspirators in determining nondischargeability.”

First, the Court found that the bankruptcy court’s ruling of nondischargeability “under §§ 523(a)(4) and 523(a)(6) is sufficiently supported by factual findings regarding [the debtor’s] individual intent and conduct.”

Second, the Fifth Circuit explained that “[i]n any event, the intent and actions of [the debtor’s] co-conspirators is sufficient to support nondischargeability under § 523(a)(4)[,]” relying on its 2001 decision in Deodati v. M.M. Winkler & Assocs., which focused on the fraud exception in section 523(a)(2) and held that innocent partners that were held jointly and severally liable based on the acts of one partner could not discharge the debt because “the plain meaning of the statute is that debtors cannot discharge any debts that arise from fraud so long as they are liable to the creditor for the fraud.”

The Court applied the reasoning in Deodati to § 523(a)(4) because “a debtor cannot discharge a debt that arises from larceny so long as the debtor is liable to the creditor for the larceny. … It is the character of the debt rather than the character of the debtor that determines whether the debt is nondischargeable under § 523(a)(4).”

Because the debtor was not challenging “the bankruptcy court’s findings that he participated in the civil conspiracy to deprive [the banks] of excess proceeds from foreclosure sales or that” he was liable under state law as a result, and also did not dispute the bankruptcy court’s conclusion that he engaged in acts constituting “larceny” under § 523(a)(4), the Fifth Circuit concluded that the debtor’s “debts to [the banks] ‘arise’ from larceny and are nondischargeable in bankruptcy.”

The Fifth Circuit then turned to address the debtor’s argument “that bankruptcy court violated the automatic stay in his Chapter 7 case by entering the [nondischargeability judgment].” The Court rejected this argument because the Bankruptcy Code expressly allows creditors to file adversary actions to determine dischargeability. In addition, even assuming it was error for the bankruptcy court to enter the adversary judgment, the error was harmless because the outcome would have been the same and he “was not prejudiced by the bankruptcy court’s failure to lift the stay.”

Accordingly, the Fifth Circuit affirmed the rulings of the district court and the bankruptcy court in both adversary proceedings.