5th Circuit Affirms Damages Flowing from Foreclosure Scheme are Nondischargeable in Bankruptcy

The United States Court of Appeals for the Fifth Circuit has found that a bankruptcy Debtor was involved in a scheme allegedly designed to deprive mortgage holders of foreclosure sale proceeds, and that the damages flowing from that scheme are nondischargeable under the U.S. Bankruptcy Code.

The scheme at question involved a Debtor who allegedly bought Texas properties at condominium association foreclosure sales, which were subject to first lien mortgages.  Shortly after the purchase, the Debtor would enter tax transfer loan agreements with companies already under the Debtor’s control.  These agreements would arrange for the Debtor’s companies to pay property taxes on the condominiums in exchange for a lien on the property.

Texas tax law requires that, after a foreclosure sale, tax transfer liens take priority, junior liens are extinguished, and all excess funds are paid out to the junior lienholders in the appropriate order of priority.  The Debtor, however, allegedly drafted deeds of trust that omitted language which would allow for the payment of the excess funds to the junior lienholders.   Instead, the excess money was diverted to entities controlled by the Debtor.

Multiple banks who held these discarded junior liens brought suit seeking to recover excess funds from the foreclosure of properties held by the Debtor.  While litigation from the suits was pending, the Debtor filed for Chapter 11 bankruptcy twice, and later for Chapter 7 bankruptcy.  Following these filings, the banks brought adversary proceedings seeking the finding of nondischargeability despite the bankruptcy filings.    The bankruptcy court found that the damages were nondischargeable despite the bankruptcy filings and automatic stays associated with such filings.  The Debtor appealed the bankruptcy court’s decision up to the Fifth Circuit.

The Fifth Circuit stated that nondischargeability is a matter of federal law, and must be established by a preponderance of the evidence.  It then discussed two categories of debt that are nondischargeable under the Bankruptcy Code.  The first category of debt is debt accrued as a result of fraud, defalcation while acting in a fiduciary capacity, embezzlement, or larceny.  The second is debt which accrues due to willful and malicious injury.

The Court held that the alleged actions of the Debtor were sufficient to support a determination of nondischargeability under both categories, and noted that in determining whether a debt is nondischargeable it is necessary to consider the character of the debt, rather than the character of the debtor.

The Court also held that although the automatic stay that ensues due to the filing of a bankruptcy petition does halt collection efforts, creditors are still able to file adversary actions, including dischargeability actions, to resolve issues arising under the Bankruptcy Code.

The full opinion can be found here: http://www.ca5.uscourts.gov/opinions/pub/15/15-20600-CV0.pdf.