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Preference Repayment Does Not Revive Pre-Bankruptcy Claim

By: Myron A. Bloom

You may have been confronted by these facts, or some variation of them. A person is alleged to have committed an act that if proven would render a claim against that person nondischargeable in a bankruptcy case. The person is confronted, and without necessarily agreeing to have committed the act, nevertheless agrees to pay the putative victim. An agreement is signed, and payments are made.

However, within 90 days of the payments, the person files for bankruptcy. A trustee demands return of the money paid in the 90-day period. The putative victim complies, but before paying, files a nondischargeability complaint against the debtor. After all, says the putative victim, as far as I am concerned, I was a creditor pre-bankruptcy, the debt arose out of what may be proven to be nondischargeable conduct, and I had to give back the money. Can the putative victim pursue the nondischargeability action?

These were the facts presented to the U.S. Bankruptcy Court for the Eastern District of California and, ultimately, to the Bankruptcy Panel for the 9th U.S. Circuit Court of Appeals in Busseto Foods Inc. v. Laizure.

One of the jointly filing debtors had been employed by Busseto Foods Inc. After the debtor's departure as the company's controller and chief financial officer in 2004, the replacement discovered "irregularities in banking records kept by" the debtor. The debtor "had allegedly embezzled significant funds from [Busseto]" and agreed to repay. A final payment of about $38,000 was made to Busseto in June of 2005. Within 90 days of making this final payment, the debtor filed for Chapter 7 relief.

The Chapter 7 contacted Busseto and demanded repayment of the money paid by the debtor to it within the 90-day preference period. Busetto ultimately settled with the Chapter 7 trustee for $34,000. Before it settled with the trustee, Busseto filed a complaint against the debtor alleging nondischargeability under Section 534(a)(4) of the Bankruptcy Code; it then settled with the trustee and filed a proof of claim equal to the amount it paid to settle the alleged preference.

The debtor moved to strike the complaint and the bankruptcy court dismissed. The court reasoned that there was no debt owing to Busseto on the petition date, and Section 502(h) of the code, which allows an entity to file a proof of claim for property that is turned over to an estate, creates a claim only against the estate and does not reinstate a personal claim against a debtor.

Busseto appealed.

The bankruptcy appellate panel noted that Busseto acknowledged in its nondischargeability complaint that no debt was owing as of the petition date, but that under Section 502(h) of the code, the claim should be revived, or reinstated, as of the petition date once it paid money to the Chapter 7 trustee in settlement of the trustee's preference claim.

In support of its position, Busseto cited to a 1988 bankruptcy court decision from the Northern District of California, In re Hackney, in which that court held that Section 502(h) was ambiguous and that strong policy reasons existed for reviving nondischargeable debt upon repayment of a preference.

Policy reasons cited by that court included a clearly expressed limitation on the fresh start policy of the code, reinstating the nondischargeable nature of the debt would not result in a debtor having to pay twice, and that not reinstating the nondischargeable nature of the debt would make it less likely, not more likely, that the claim would be satisfied.

The panel took issue with the holding in Hackney. First, the panel indicated that with the exception of Hackney, every other case cited by Busseto held that Section 502(h) stands for the proposition that a person who returns funds to a trustee under the circumstances cited in that subsection is entitled to assert a claim against the estate, but those cases do not suggest that Section 502(h) revives a claim against a debtor. In fact, noted the panel, even though the Hackney court concluded that the language of Section 502(h) is ambiguous, it recognized that the section "has as its subject matter the allowance of claims or interests against a bankruptcy estate."

Second, although the panel found Hackney to be "thorough and well-reasoned," the panel stated that "our present inquiry ends with [Hackney's] initial impression that Section 502 pertains solely to claims against the estate." Examining Section 502(h)'s reference to other subsections of Section 502, the panel stated that all references in other portions of that section refer to claims against the estate and to provisions dealing with allowance and disallowance of such claims.

Thus, although Hackney may provide compelling policy arguments for reviving a nondischargeability claim upon repayment of a preference, those arguments must give way to the overriding policy of interpreting statutes according to their plain meaning. Here, the plain meaning of Section 502(h) compelled a finding that revival of a nondischargeability claim against a debtor after repayment of a preference was not appropriate. Thus, Hackney would not control.

Busseto, on appeal, also attempted to argue that the bankruptcy court erred in holding that Busseto did not have a claim on the petition date - it had, it argued, a contingent claim. The panel would not consider this argument, however, suggesting not only did other statutory provisions - specifically, Section 727(b) - possibly eviscerate this position, but also that Busseto had not raised this position before the bankruptcy court or even in its opening brief on appeal.

Busetto's final argument was, as the panel put it, "skeletal." Busseto argued that just as a settlement agreement cannot transform a nondischargeable tort-created debt into a dischargeable contract debt, a payment of money in settlement of such a debt and release given thereunder should not preclude a claim for nondischargeability. The panel gave this argument short shrift. It stated that Busseto offered no rationale for this leap in logic, and that it cited to no authority for this position. The panel found this latter omission to be contrary to Fed.R.Bankr.P. 8010(a)(1)(E), and thus found that Busseto had "waived the issue on appeal."

The result seems puzzling. If no money had been paid to Busseto, it would have been able to maintain a nondischargeability action. Why, then, should the fact that the debtor paid the debt back, albeit with the preference period, alter the decision? Could artful drafting of a settlement agreement have better protected Busseto? Once again, plain meaning drives a result. Plain meaning is clearly here to stay.

This article is reprinted with the permission from the October 13, 2006 issue of The Legal Intelligencer.  Copyright 2006 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.