While no reasonable investor would fund a business on the brink of financial ruin, sometimes, that’s exactly where investors find themselves. This happens when debtors lie about their financial health to secure a loan.
What surprises many clients is that investors often find themselves with no recourse against duplicitous debtors if they fail to take a critical step as part of their due diligence. For various reasons, the most well-intentioned creditors seeking investment opportunities find themselves empty-handed when their debtors file for relief from the debts in bankruptcy court. Unless a bankruptcy judge declares a debt nondischargable, creditors can be completely out of luck.
Fortunately, though, all hope is not lost. The U.S. Bankruptcy Code protects creditors, too, including provisions that allow certain claims to be declared nondischargeable. This means that bankrupt debtors may still be legally on the hook to repay debts, even if the rest of their debts are discharged (released) through the bankruptcy process.
While there is a booming industry of lenders who knowingly take (calculated!) risks in lending funds to debtors without fully knowing their financial situations, this article is directed to the unwitting lender who did not fully understand the risk involved in a transaction. Lenders can – and should – take certain vital steps to ensure they understand a debtor’s financial health before entering a transaction.
Non-Dischargeable Debt: The Bankruptcy Code’s Lender Protection Provision
The U.S. Bankruptcy Code protects creditors by barring debtors from discharging certain debts if they obtained such debt by false representations or fraud, including a failure to disclose their financial hardships or challenges.
In a bankruptcy case, debtors can seek relief from various debts, many of which will be discharged unless a creditor files an objection. These actions will take the form of an “adversarial proceeding” under the Bankruptcy Code and will lead to an entirely separate legal action.
11 USC 523(a)(2) is a mainstay of the bankruptcy system. In short, it protects creditors from losing money to a debtor who may have misrepresented – or failed to disclose the full extent of – his financial situation.
Let’s take a closer look at the Bankruptcy Code’s language:
(a) A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt . . . .
(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by—
(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition;
(B) use of a statement in writing—
(i) that is materially false;
(ii) respecting the debtor’s or an insider’s financial condition;
(iii) on which the creditor to whom the debtor is liable for such money, property, services, or credit reasonably relied; and
(iv) that the debtor caused to be made or published with intent to deceive[.]
Stated differently, this section of the Bankruptcy Code allows creditors to seek a court declaration that their debts were obtained by false pretenses, a false representation, or actual fraud, and are therefore nondischargeable.
Although the Code doesn’t define the terms false pretenses, false representation, or actual fraud, a bankruptcy court will apply rules and guidelines established in prior cases with similar fact patterns.
Most importantly, however, the Code only allows false representations about the debtor’s financial condition to serve as the basis of a dischargeability objection if those misrepresentations were made in writing.
The law affords a basic protection: If a debtor lied about (or concealed the full extent of) his financial situation, in writing, before you loaned it money, the debtor may be prohibited from receiving the benefit of having the debt discharged through the bankruptcy system. This means that as a creditor, you may be able to ask a judge to declare your debt nondischargeable.
What Should You Do to Protect Yourself Before Lending Funds to a Business?
Simply put, you, as the lender and potential creditor, must insist that everything related to the financials of your debtor is put in writing before lending anything to keep open the possibility that your claim would be considered non-dischargeable. Ultimately, it will be your burden to prove that the debtor’s statements were materially false and that you relied on those statements to make the loan. If you do not have these representations in writing, unfortunately, you are out of luck.
If you’re a creditor, it’s your burden to prove that the debtor was intentionally deceitful, misleading, or fraudulent in his dealings. You must also prove that you relied on the debtor’s misrepresentations in deciding to lend him funds.
To ensure your claim remains nondischargeable and to keep your debtor on the hook, develop a practice of collecting financial statements from your debtors before lending any funds. If you lend money to either an individual or business, secure a written statement about the debtor’s financial situation.
The best way to do this is by requesting the following information from the debtor:
- written profit and loss statements
- balance sheets
- cash flow statements
- bank records for multiple pertinent time frames
Also, demand that the debtor make written representations that the financial documents provided are true and accurate and that the financial documents disclose all his liabilities. If it turns out that the debtor falsified those statements in any way, you will then have a leg to stand on should you object to the discharge of your debts in bankruptcy court.
These critical steps can be useful in other ways: They will force the debtor to be open and transparent. Securing accurate financial statements will help you assess the debtor’s financial health, potentially saving you from making a bad business decision (that is, lending money to a debtor on the cusp of financial ruin).
Contact Our Experienced Business Law Attorneys.
If you find yourself in need of advice and representation regarding a dischargeability dispute or any number of bankruptcy issues, our attorneys are experienced in representing both debtors and lenders and are here to help.
At Wilson Ratledge, we assist businesses in taking steps to keep them financially secure, while protecting them from legal pitfalls. For assistance growing your business or navigating a deal, contact one of our experienced North Carolina business attorneys today at 919-787-7711 or via our contact form below.