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One of the basic purposes of the Bankruptcy Code (the “Code”) is to give insolvent debtors a fresh start.  However, the Code does require that such debtors are honest.  To that end, the Code provides certain exceptions to discharge of debt.  The exception outlined in Section 523(a)(2)(B) may come into play when a debtor has made use of a false personal financial statement (“PFS”) in securing credit and now seeks a discharge in bankruptcy of the associated debt.  The debtor may have borrowed funds directly or guaranteed repayment of the debt by a third party.  As discussed below, in order to prevail, a creditor must timely object to discharge and prove each required statutory element.

A. Timely Objecting to Discharge

Pursuant to Rule 4007(c) of the Federal Rules of Bankruptcy Procedure, a creditor must object to discharge of the debt within 60 days after the first date set for creditor’s § 341 meeting.  This can be accomplished by initiating an adversary proceeding (a lawsuit within the bankruptcy) and filing a complaint objecting to discharge.

B. Proving the Exception to Discharge

To advance the policy of providing a fresh start to the debtor, the creditor bears the burden of proving by a preponderance of the evidence that the exception to discharge applies.  In order to meet that burden, the following five questions must be answered with a “yes”:

1. Did the debtor use a statement in writing?  If the debtor completed and submitted a PFS as part of the credit application process, he or she will be unlikely to dispute this element.

2. Is the written statement materially false?  Courts have defined “material falsity” as “an important or substantial untruth” and have described a materially false statement as “one that paints a substantially inaccurate picture of a debtor’s financial condition by misrepresenting information of the type which normally would affect the decision to grant credit.”[1] Moreover, “[t]he omission, concealment, or understatement of liabilities will ordinarily constitute a materially false statement.”[2]

In analyzing whether this element has been proven, courts often examine whether the creditor or lender would have extended the credit or made the loan had it known of the debtor’s true financial condition.

3. Does the written statement describe debtor’s financial condition?  As with the first element, if the debtor submitted a PFS as part of the credit approval process, a court should find that this element has been proven.

4. Did the creditor actually and reasonably rely on the written statement in extending credit?  In analyzing this element, courts are not to subjectively evaluate and judge a creditor’s lending policy and practices or second guess a creditor’s lending decisions.[3]  However, in determining the reasonableness of a creditor’s reliance on a case by case basis, the court will consider:  “(1) whether the creditor’s standard practices in evaluating credit-worthiness were followed and (2) whether there existed a ‘red flag’ that would have alerted an ordinarily prudent lender to the possibility that the information is inaccurate.”[4]

Common scenarios in which courts have found a lack of reasonable reliance by creditor include when: (1) the creditor knows the disclosed information is not accurate, is incomplete or inconsistent, or the PFS is erroneous on its face; (2) the PFS itself fails to solicit adequate or sufficient information; (3) the creditor’s investigation of the PFS suggests the statement is false or not complete; or (4) the creditor does not independently verify (or require the debtor to verify) the accuracy of the information contained in the PFS.[5]

5. Was the written statement made or published with the intent to deceive?  In order to prove this final element, a creditor must show that the debtor acted in bad faith as compared to simply using poor effort to complete the PFS.  Because a debtor is unlikely to ever admit acting fraudulently, intent to deceive may be inferred where “a person knowingly or recklessly makes a false representation which the person knows or should know will induce another to make a loan.”[6]

Factors the court may consider in analyzing this element include:  (1) the nature of the relationship between the creditor and debtor; (2) the sophistication of the debtor with regard to financial matters; and (3) the debtor’s reliance, if any, on professionals in preparing the PFS.

Objecting to discharge of a debt in bankruptcy can be both time-consuming and costly.  However, depending on the actions of the creditor and debtor when credit was initially extended as well as the amount of debt at issue (among other considerations), a creditor may decide that objecting is in fact an appropriate course of action should the debtor choose to file for bankruptcy protection.

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[1] See Matter of Bogstad, 779 F.2d 370, 375 (7th Cir. 1985) (citations omitted) and Midwest Comm. Fed. Cr. Union v. Sharp (In re Sharp), 357 B.R. 760, 765 (Bankr. N.D. Ohio 2007) (citation omitted).

[2]Collier on Bankruptcy, ¶ 523.08, at 523–72 (15th ed. 2015).

[3] Peoples Trust and Sav. Bank v. Hanselman (In re Hanselman), 454 B.R. 460, 465 (Bankr. S.D. Ind. 2011).

[4] Id. at 464-65 (citation omitted).

[5] See Household Fin. Corp. v. Howard (In re Howard), 73 B.R. 694, 703 (Bankr. N.D. Ind. 1987).

[6] Id. at 465-66 (quotation omitted).


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