Dealing with the Insolvent Customer:
If your customer uses the proceeds from the sale of product you
supplied on credit to pay other creditors, is it fraud so that your
claim may survive the bankruptcy?By Bradley D. Blakeley
You sell your product on unsecured credit to a sole
proprietor business. The customer uses the proceeds from the sale
of product you provided to pay other creditors. You go unpaid.
The customer files personal bankruptcy and schedules your claim
as unsecured, to be discharged through the bankruptcy. By virtue
of the customer using the proceeds from the sale of your product,
do you have a basis to have your claim deemed nondischargable?
How do the nondischargability provisions of the Bankruptcy Code
work, and in what instances may a vendor use these laws to have
the claim survive the bankruptcy, allowing the vendor to pursue
payment in the future? A bankruptcy court, In re Wright,
recently considered the issue and found the vendor's debt could
Debtor Pays Other Creditors with Proceeds from Vendor's
In Wright, the vendor sold seed on credit
to the debtor, a sole proprietor. They had a long trade relationship,
wherein the vendor would sell the debtor on credit and the debtor
would repay the vendor based on its cash flow. The debtor sold
the product purchased from the vendor on credit, using the proceeds
to pay other creditors. The debtor encountered financial difficulties
and filed an individual Chapter 13. The vendor's open account for
product sold on credit was unpaid.
The vendor was scheduled by the debtor as an unsecured
creditor. The vendor filed a lawsuit with the bankruptcy court
contesting that its claim should not be discharged as the debtor
defrauded and embezzled the proceeds. The vendor also argued that
its claim should not be discharged through the bankruptcy as the
debtor owed a fiduciary duty to the vendor which was breached when
the debtor paid other creditors with the proceeds from the sale
of product it provided on credit.
Elements Of A Nondischargable Action
Should a debtor that files bankruptcy defraud a
vendor, the vendor may be able to have its claim "ride through" bankruptcy.
A vendor may also seek to have its particular debt to be ordered
nondischargable, or object to the debtor's discharge, wherein all
of the debtor's debts are ordered non-dischargeable.
The most common causes of action to exclude particular
debts from discharge are: (1) fraudulently incurred obligations;
(2) fiduciary fraud and embezzlement; and (3) willful and malicious
The nondischargable provisions provide that the debtor
must be an individual. Thus, if the vendor sold to a sole proprietorship,
or holds a personal guarantee on a sale to a corporation, LLC or
partnership, the vendor has a claim against an individual. There
are no nondischargable claims against a corporation, as the corporation
is not entitled to a discharge in bankruptcy. If the vendor sold
to a corporation, and the insider of the corporation filed bankruptcy,
the vendor may still have a nondischargable claim against the individual,
but must establish an alter ego claim against the insider.
Where property is obtained by the debtor's false
pretense, false representation or actual fraud such claim may be
excepted from discharge. Under the fraud nondischargeable provision,
the vendor may establish either oral or written fraud by the debtor.
With the oral fraud, the vendor must establish fraud and its reasonable
reliance on the debtor's representation. If the fraud is in writing,
the vendor must establish that the false financial statement is
materially misleading and the vendor reasonably relied on the false
The vendor may also have its claim ride through bankruptcy
where it can be established that the debtor defrauded the vendor
while in a fiduciary capacity. The vendor may also have its claim
ride through bankruptcy where the debtor committed a willful injury.
Courts have found that where a debtor has converted a vendor's
property, such as collateral subject to a purchase money security
interest may result in a nondischargable claim.
If the vendor seeks to deny a debtor's discharge,
objections may be based on the following: (1) the debtor transferred,
concealed or destroyed property within one year before the bankruptcy
filing or any time after the filing; (2) the debtor concealed,
destroyed or failed to keep books and records; (3) the debtor made
a false oath or withheld information from an officer of the estate;
(4) the debtor is unable to explain loss of his property; (5) the
debtor has received a discharge in a prior bankruptcy within six
years; and (6) the debtor has had a discharge waived or denied
in a prior bankruptcy case. Many of the grounds for objecting to
a discharge may also constitute federal crimes. Be mindful that
the vendor must act quickly with commencing these claims, which
may require filing 60 days after the First Meeting of Creditors.
Debtor May Discharge Vendor's Claim
The Wright court determined that the vendor
failed to prove that the debtor defrauded the vendor by selling
its product and using the proceeds to pay other creditors. The
court found that the vendor did not take a security interest in
the goods nor the proceeds from the sale of the goods. The court
also noted that the vendor did not require the debtor to segregate
the proceeds in a separate account. Further, the court found that
the vendor failed to take steps to protect their product when they
believe the debtor may be converting the product.
Issues for the Credit Professional and Dischargeability
In crafting the nondischargeabilty exceptions to
the Bankruptcy Code, Congress intended that a dishonest debtor
might not evade its debts. With these provisions a vendor may be
able to have its debt ride through bankruptcy. The credit professional
must be mindful of the time limits to timely file a complaint to
have the particular debt or all of the debts excepted from discharge.
1. 282 B.R. 510 (Bankr. M.D. Ga. 2002)
Reprinted by permission from Trade Vendor Quarterly Blakeley & Blakeley
LLP Spring 03