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.
