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The Provisional Nature of Discharge: Trustee's Knowledge of Fraud May Not Be Imputed to United States Trustee

The purpose of filing for Chapter 7 bankruptcy is to discharge debts. But even after obtaining a discharge, a debtor is not totally in the clear. A recent case in the United States Bankruptcy Court for the Western District of Michigan involves an adversary proceeding in which the United States Trustee sought to revoke a Chapter 7 debtor’s (the “Debtor”) discharge.[i]

In the case, the Debtor received a discharge on July 13, 2015. A week prior to the discharge the appointed Chapter 7 trustee (the “Trustee”) received an email from an escrow agent at a title insurance agency informing her of an upcoming sale of the Debtor’s home. The Trustee - before the discharge took effect - contacted the realtor about the pending sale who informed the Trustee of the details of the sale, which the Trustee believed to be fraudulent.

On July 28, 2015, two weeks after the discharge, the Trustee informed the United States Trustee’s office (the “UST”), via email, of the pending sale of the Debtor’s home. Both the Trustee and the UST agreed that this email was the first time the UST became aware of the pending sale. That same day, the UST filed a complaint to revoke the debtor’s discharge. The UST subsequently filed a motion for partial summary judgment on the issue of whether the trustee's knowledge of alleged fraud can be imputed to the UST in relation to section 727 (d)(1).

The motion for partial summary judgment pertains to section 727(d)(1) of the Bankruptcy Code which provides that:

On request of the trustee, a creditor, or the United States trustee, and after notice and a hearing, the court shall revoke a discharge granted under subsection [727(a)] if … such discharge was obtained through the fraud of the debtor, and the requesting party did not know of such fraud until after the granting of such discharge.

The motion filed by the UST relates to the second factor - whether the UST lacked knowledge of the alleged fraud until after the discharge. The Bankruptcy Court explained that “knowledge” of fraud exists “when the party seeking revocation first becomes aware of facts such that he [or she] is put on notice of a possible fraud.”

Neither party disputed the fact that the UST did not have actual knowledge of the alleged fraud until after the discharge, however the Debtor argued that the Trustee’s knowledge of the home sale should be imputed to the UST. The Bankruptcy Court rejected this argument and granted the UST’s motion for the following reasons. 

First, the court examined the plain language of section 727(d)(1) and the legislative history and found that neither supported the Debtor’s imputed knowledge argument. The court noted that the statute designates three distinct parties - the trustee, creditors, and the United States trustee - as having the right to request revocation of discharge, and also that it limits each party’s right to request revocation to the extent “the requesting party” knew of the alleged fraud prior to discharge. The court explained that this “suggests that this limitation on a party’s ability to seek revocation of the discharge should apply only to the extent that party had knowledge of the debtor’s alleged fraud.” The court further explained that the statute’s legislative history supports this interpretation of the statute.

The Debtor’s second argument in opposition to the summary judgement motion was that the Trustee’s knowledge of the alleged fraud should be imputed to the UST under common law principles of agency - that is, that the Trustee was acting as an agent of the UST. The court rejected this argument based on several facts, including the fact that the UST and Trustee serve different functions, and that the UST’s supervisory role over the Trustee is not unfettered as often exists in agency relationships.

Finally, the Debtor argued that failing to impute the Trustee’s knowledge to the UST will allow the UST to “get a ‘second bite at the apple’ in a way that ‘subverts the process and renders the Debtor’s discharge a ‘provisional’ order subject to the whim of the UST.” The court rejected this argument, too, explaining that section 727(d)(1), by permitting revocation of a discharge, “renders the discharge somewhat ‘provisional.’”

If you have any questions about this case, or bankruptcy issues in general, please contact Patricia Scott at pscott@fosterswift.com or 517.371.8132.

[i] United States Trustee v. Larson (In re Serena Louise Larson), Adv. Proc. No. 15-80194 (Banker. W.D. Mich., June 20, 2016).

Categories: Chapter 7, Fraud & Abuse

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