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 be discharged.

Debtor Pays Other Creditors with Proceeds from Vendor's Product

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 acts.

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 financial statement.

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 Litigation

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