Business Debtors Beware!
Author: Mark D. Liston, Kokoszka & Janczur, P.C.
Editor: Frank J. Kokoszka, Kokoszka & Janczur, P.C.
The prime feature of a chapter 7 bankruptcy for most individual debtors is the discharge. However, there are exceptions to the discharge and these exceptions fall into two major categories. The exception of a particular debt from discharge and the denial of the debtor’s discharge entirely. These two exceptions serve different purposes. As for the first (provided for by Section 523 of the Bankruptcy Code), certain debts are deemed particularly important, so these debts cannot be dischargeable. Examples include generally child support, taxes, and student loans (this does not mean that taxes and student loans are always non-discharageable) . Additionally, debts incurred by criminal, immoral, or otherwise improper conduct cannot be discharged. Examples include theft, fraud, deliberate injury to person or property, and debts arising from drunk-driving accidents. The principle is that if you owe someone a debt because you wronged them, you do not deserve a discharge of that debt.
With respect to denial of the discharge entirely (provided by Section 727 of the Bankruptcy Code), the policy is that a debtor who does something dishonest or knowingly improper within the bankruptcy process itself should not receive a discharge of any debts. Examples include transferring or concealing assets, failure to fully disclose the information required on the bankruptcy forms, testifying falsely, and refusing to obey a court order. Conversely, the general rule embodied in Section 727 is essentially that the “honest but unfortunate debtor” who cooperates with the trustee and the court should receive a discharge.
However, one glaring exception to that general rule can be found in Section 727(a)(3), which provides for the denial of discharge where “the debtor has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor’s financial condition or business transactions might be ascertained, unless such act or failure to act was justified under all of the circumstances of the case.” (Emphasis added.) Concealing, destroying, mutilating, and falsifying obviously involve a dishonest or wrongful motive, but that is not necessarily true of the mere failure to keep or preserve records. Indeed, the debtor’s intent is simply not a factor in determining whether they have failed to keep or preserve adequate business records. Instead, “[t]he statute places an affirmative duty on the debtor to create books and records accurately documenting her financial affairs.” In re Lindemann, 375 B.R. 450, 467 (Bankr. N.D. Ill. 2007). If the debtor has not done so, then her discharge must be denied unless she can show that her failure to create and maintain records was “justified,” a standard that is usually not satisfied by the debtor’s after-the-fact explanations. This is true regardless of whether the failure to keep records stemmed from any improper motive.
Additionally, the records must be “comprehensible,” in that they clearly and intelligibly reflect the debtor’s business transactions. In re Juzwiak, 89 F.3d 424, 429 (7th Cir. 1996). Records are only adequate if they are organized and “provide the trustee or creditors with enough information to ascertain the debtor's financial condition and track his financial dealings with substantial completeness and accuracy for a reasonable period past to present." Lindemann, 375 B.R. at 468. And whether they are adequate is a question of quality, not quantity, so merely producing a large volume of confusing, incomplete, or unorganized records is insufficient. Courts have repeatedly stated that they should not have to sift through reams of complicated and poorly organized documents in order to reconstruct the flow of the debtor’s assets or financial situation. It has even been said that “‘too many’ is just as bad as ‘not enough.’” In re Vandewoestyne, 174 B.R. 518, 522 (Bankr. C.D. Ill. 1994).
There are no types of records specifically required in every case, and what is adequate has to be decided based on the particular facts of the debtor’s case, such as the type, size, and complexity of the business. Nonetheless, something like a “morass of checks and bank statements” will likely be insufficient. Union Planters Bank, N.A. v. Connors, 283 F.3d 896, 899 (7th Cir. 2002). As for the period of time prior to the bankruptcy filing the records must cover, some courts have found two years to be sufficient, though it may be longer if warranted by the particular facts of the debtor’s case.
It should be noted that the failure-to-keep-or-preserve prong of this exception is generally not implicated in consumer bankruptcies. In re Scott, 172 F.3d 959, 970 (7th Cir. 1999). Instead, its principal application is to business debtors. This tempers the harshness of the rule, but it will still come as a surprise to many business debtors to learn that they may be denied a discharge solely because they had been sloppy or careless in their recordkeeping. After all, the average business debtor had no intention of filing for bankruptcy before his business began failing or he suffered a sudden financial catastrophe, and therefore he didn't knowingly disregard the duty imposed on him by bankruptcy law to keep adequate records. Additionally many debtors are in bankruptcy because of their poor—yet not dishonest—handling of their finances, including poor record-keeping. To find out the very reason for their bankruptcy is also the reason they are denied a discharge will strike them as draconian, especially since the trustee will still liquidate all their non-exempt assets.
Courts have considered the seeming harshness of this rule and have tailored the application of the law accordingly, so that the education, experience, and sophistication of debtors are taken into consideration when determining the adequacy of their records. Lindemann, 375 B.R. at 468. So, for example, a bricklayer will not be held to the same standard as a lawyer or accountant. Nonetheless, there is still the potential for a simple, honest debtor to do his best to cooperate with the trustee and disclose fully but still walk away without a discharge because the trustee or a disgruntled creditor files an adversary proceeding and is able to show that the debtor’s business records are unsatisfactory.
Under the statute, it is possible for a debtor to show that their failure to keep or preserve records was “justified under all of the circumstances of the case,” though it does not give clues as to when the failure is justified. In cases where courts have found a failure to keep or preserve adequate records, it is very rare that the debtor has been able to justify that failure. Explanations that documents were destroyed by flooding; destroyed by a landlord after an eviction; eaten by mice, and in the possession of a third party have all been rejected. In re Hansen, 325 B.R. 746, 762 (Bankr. N.D. Ill. 2005); In re Wasserman, 332 B.R. 325, 333 (Bankr. N.D. Ill. 2005); In re Costello, 299 B.R. 882, 889 (Bankr. N.D. Ill. 2003); In re Fink, 351 B.R. 511, 524 (Bankr. N.D. Ill. 2006).
One argument in support of this exception to discharge is that creditors, the trustee, and the court have the right to know the financial condition of the debtor and how that condition came about, but the debtor’s failure to keep adequate business records effectively deprives them of that right. Additionally, the trustee and court may not be able to fully ascertain whether the debtor is truly “honest but unfortunate” if he did not maintain records of his business transactions sufficient to track his recent financial history. Others would respond that a discharge should only be denied on the basis of the failure to keep or preserve business records if there is some evidence that such failure was the product of a dishonest intent.
At any rate, it is essential that individuals who owe primarily business-related debts and their attorneys do their best to ensure adequate records exist before filing for bankruptcy under Chapter 7.
If you have any questions, either because you are considering filing for bankruptcy or you are a creditor of a business debtor, please contact Mark Liston or Frank Kokoszka at 312-443-9600.