- Posted on: May 25 2022
By: Calvin Smith [5/25/22]
One of the main reasons people and entities file for bankruptcy is to obtain a discharge of their debts. The Bankruptcy Code (U.S.C. §§ 101, et. seq) provides honest debtors with a fresh start by imposing an injunction against creditors to take any action to recover discharged debts.
Given this strong weapon in the arsenal of debtors, creditors naturally would like to have their claims excepted from the reach of that discharge. There are four specific provisions in the Bankruptcy Code that allow creditors to blunt the effect of a discharge.
First, 11 U.S.C. § 523 enumerates debts that are not dischargeable. A non-exhaustive list of such claims include:
(1) certain tax claims;
(2) money, property, services, or an extension, renewal, or refinancing of credit to the extent obtained by false pretenses, a false representation, or actual fraud;
(3) fraud or defalcation by a debtor who is a fiduciary;
(4) domestic support obligations and other debts arising from divorce or separation proceedings;
(5) willful and malicious injury to an entity or that entity’s property;
(6) certain fines, penalties, and forfeitures payable to and for the benefit of a governmental unit; and
(7) violations of Federal or State securities laws.
Second and third, pursuant to 11 U.S.C. §§ 727 and 1141, the Bankruptcy Court may approve a written waiver of all debts that the debtor executes after filing for a Chapter 7 or Chapter 11 bankruptcy.
Fourth, pursuant to 11 U.S.C. 524, the Bankruptcy Court may approve a written reaffirmation agreement by which a debtor agrees, after filing bankruptcy, to repay a specific debt if the debtor meets a lengthy set of criteria found in that section.
Some creditors have attempted to bypass these specific provisions that allow a debtor to waive all or some of the benefits of a discharge by having that debtor agree, prior to filing bankruptcy, that the debtor waives the benefit of a discharge in bankruptcy for a debt to that creditor or agrees not to file bankruptcy. These prepetition waivers of discharge may be inserted into a promissory note, a contract, a settlement agreement, or any other number of documents. For enterprising creditors that have included prepetition waivers of discharge in various agreements, the goal is clear: to protect their debts on the front end of a transaction or in connection with collection efforts against the debtor who owes them money. Such a creditor may pat themself on the back and feel confident that their position is protected in case the debtor does the unthinkable and files a bankruptcy case, but is that confidence justified?
It is not.
The vast majority of courts have held prepetition discharge waivers to be unenforceable because they are illegal, void due to public policy concerns, and violate the Code’s provisions previously discussed that lay out specific means for debts to be excepted from a discharge. Prepetition discharge waivers are ipso facto (“by the fact itself”) clauses that have long been held to violate the Bankruptcy Code.
Another well-worn ipso facto clause is a provision in a contract or note that creates a default of a debt by the very act of filing bankruptcy.
In the Eastern District of Virginia, the leading case on prepetition discharge waiver clauses is Estate of McCoy v. McCoy (In re McCoy), 2016 Bankr. LEXIS 2952 (2016)(Bankr.E.D.Va.). In that case, a woman deeded property in which she resided to her son and daughter-in-law, and the son and daughter-in-law subsequently used that property to secure a bank loan. The son died, and the woman ultimately paid the debt secured by the residence after the daughter-in-law defaulted on the debt to the bank. As a result, the daughter-in-law executed a confessed judgment note in favor of the woman. The confessed judgment contained a provision by which the daughter-in-law purportedly waived “the benefit of any law or rule of law intended for release or discharge from liability hereon…”. When the daughter-in-law defaulted on the debt to the woman, the woman initiated collection activities and the daughter-in-law filed for bankruptcy.
In addressing that clause, the Bankruptcy Court first noted that it was a type of ipso facto clause that would punish the debtor for filing bankruptcy. Id. at 66. The Court noted that it would not enforce ipso facto clauses because they were made unenforceable as a matter of law by the passage of the Bankruptcy Code, particularly Sections 541(c) and 365(e)(1), because they are void as against public policy in favor of giving debtors a “fresh start”, because they violate the legislative history of the Bankruptcy Code which prohibits “against the enforcement of clauses that ‘hamper rehabilitation efforts’ in bankruptcy”, and because numerous other courts have reached the same conclusion. At 66-69. If prepetition discharge waivers were allowed, all “astute creditors would routinely require the debtors to waive” a potential discharge. Id. If that were to happen, debtors would lose one of the most, if not the most, important weapon in their arsenal. Enforcing such “agreements would render the protections of the Bankruptcy Code obsolete.” Id.
As such, prepetition discharge waivers are unenforceable and, unfortunately for creditors, a waste of ink in an agreement. If you are a creditor or debtor with questions about the bankruptcy process, the potential discharge of your debt, or similar questions or concerns, please contact one of our attorneys.
Posted in: Business Law