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«Line Drawing and the Bankruptcy Discharge: Why Prepetition Stipulations Are Enforceable but Prepetition Waivers Are Not* I. INTRODUCTION “The legal ...»

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BALLOBIN FINAL 1/2/2011 12:44:41 PM

Line Drawing and the Bankruptcy Discharge:

Why Prepetition Stipulations Are Enforceable but

Prepetition Waivers Are Not*

I. INTRODUCTION

“The legal effect of the discharge is powerful in its simplicity: the

debtor is freed from the obligation to pay prebankruptcy debts.”1

Although the consumer debtor has no right to discharge, it is regularly granted to debtors who have not run afoul of any of the provisions of § 727(a),2 which is “the heart of the fresh start provisions.”3 When the debtor is freed from liability for prepetition debts, the debtor’s creditors suffer the loss of nonpayment. Therefore, creditors desire a bankruptcy system that does not overly favor debtors. In general, the current Bankruptcy Code represents an appropriate balance between prodebtor and procreditor views. Despite the balance, creditors continue in their attempts to circumvent the bankruptcy discharge, which has the potential to erode the effectiveness of a debtor’s fresh start. Because the automatic stay and discharge injunction prohibit the types of postpetition actions a creditor can take to collect a debt, creditors tend to focus their efforts on prepetition preventive measures. The scope of this Comment, therefore, is limited to prepetition attempts creditors make to transform a debt that is otherwise dischargeable into one that is nondischargeable.

In particular, the analysis of this Comment is confined to Chapter 7 consumer cases—the most common type of bankruptcy case.4 This * Kristin L. Ballobin. J.D. 2010, University of Kansas School of Law; M.S. & B.S. 2007, Kansas State University. I would like to thank Professor Stephen Ware for his guidance and comments in the development of this Comment. I would also like to acknowledge the assistance of Pat Edwards and the Kansas Law Review staff in the writing and editing process. Finally, I would like to thank my friends and family for their unwavering support in my educational and professional endeavors.

1. Charles Jordan Tabb, The Scope of the Fresh Start in Bankruptcy: Collateral Conversions and the Dischargeability Debate, 59 GEO. WASH. L. REV. 56, 56 (1990).

2. See 11 U.S.C. § 727(a)(1)–(12) (2006).

3. S. REP. NO. 95-989, at 98 (1978), reprinted in 1978 U.S.C.C.A.N. 5787, 5884.

4. For example, the Central District of Illinois reports that in 2009 a total of 10,788 bankruptcy cases were filed, of which 8475 were Chapter 7 cases—over 78% were Chapter 7. Statistics, U.S.

BANKR. CT.: CENT. DISTRICT OF ILL., http://www.ilcb.uscourts.gov/CMECF/filinGsold/calendar_ 369 BALLOBIN FINAL 1/2/2011 12:44:41 PM 370 KANSAS LAW REVIEW [Vol. 59 Comment demonstrates that both a prepetition waiver of discharge in total and a prepetition waiver of discharge of a specific debt are unenforceable. Further, public policy and the purpose behind the Bankruptcy Code support the unenforceability of such waivers. Also, the Comment discusses the enforceability of prepetition stipulations in a later bankruptcy proceeding and the general collateral estoppel effect that state law will grant to those stipulations. In general, bankruptcy courts should grant issue-preclusive effect to state court stipulations because it promotes judicial economy and validates the time the state court expended in drafting them. The main objective of this Comment is to analyze and compare prebankruptcy waivers and stipulations so that the enforcement of one over the other can be justified satisfactorily.

Part II of this Comment offers a quick overview of the purpose behind the bankruptcy system and the background necessary to grasp the effect discharge has on debtors and creditors. Part III discusses prepetition waivers and prepetition stipulations in state court judgments.

In relation to prepetition stipulations, Part III discusses the types of debts that are excepted from discharge, the United States Supreme Court’s limited guidance on collateral estoppel in dischargeability proceedings, and the jurisdiction of courts over the discharge exceptions. Part IV analyzes the enforceability of prepetition waivers and stipulations. It concludes that prepetition waivers of discharge are not and should not be enforceable, while also concluding that prepetition stipulations should be enforceable and entitled to collateral estoppel effect. Part IV draws a distinction between prepetition waivers and stipulations and demonstrates why they should be treated differently in bankruptcy dischargeability proceedings.

II. OVERVIEW OF THE BANKRUPTCY PROCESS

As the Supreme Court has long recognized, the bankruptcy process “gives to the honest but unfortunate debtor... a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.”5 Two recurring themes have grown from the preceding statement. First, to seek relief under the stats.aspx (last visited Oct. 14, 2010). Also, the Central District of California reports that from January 2009 to December 2009, a total of 98,469 cases were filed, of which 75,817 cases were Chapter 7—approximately 77% were Chapter 7. 2009 Filings for Central District, U.S. BANKR.

CT.: CENT. DISTRICT OF CAL., http://www.cacb.uscourts.gov/cacb/statistics.nsf/DistrictSumRep?





ReadForm&Year=2009 (last visited Oct. 14, 2010).

5. Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934).

BALLOBIN FINAL 1/2/2011 12:44:41 PM 2011] LINE DRAWING AND THE BANKRUPTCY DISCHARGE 371 Bankruptcy Code, the debtor must be “honest but unfortunate.”6 Second, the purpose of the bankruptcy process is to grant the debtor a fresh start.7 A debtor takes advantage of bankruptcy by filing a petition, which is sometimes referred to as “an order for relief” by the Code.8 Once the filing fee has been paid, the petition is considered “filed” and “[a]t that instant, a bankruptcy estate is created and an automatic stay on all collection actions against the debtor, [and] the debtor’s property” is in effect.9 Once the debtor has completed the bankruptcy process, the court will generally grant the debtor a discharge pursuant to § 727(a) of the Bankruptcy Code. Although the term is not specifically defined in the Code, “a discharge... discharges the debtor from all debts that arose before the date” the bankruptcy petition was filed.10 However, the practical effects of the discharge are covered more fully in § 524(a).

This section, among other purposes, indicates that the discharge “operates as an injunction against the commencement or continuation of an action... to collect [or] recover... any such debt as a personal liability of the debtor.”11 The previous injunction is permanent and will prevent a creditor from later asserting that the debtor is still responsible for payment.12 The effect of the discharge, therefore, is sweeping.

As stated above, the bankruptcy system has been created to assist “the honest but unfortunate debtor.”13 The negative implication of the Supreme Court’s statement is that the Bankruptcy Code will not assist a dishonest debtor, and numerous sections have been included in the Code

6. Id.

7. Id. (“One of the primary purposes of the Bankruptcy Act is to ‘relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh free from the obligations and responsibilities consequent upon business misfortunes.’” (quoting Williams v. U.S. Fid. & Guar.

Co., 236 U.S. 549, 554–55 (1915))).

8. ELIZABETH WARREN & JAY LAWRENCE WESTBROOK, THE LAW OF DEBTORS AND

CREDITORS: TEXT, CASES, AND PROBLEMS 115 (6th ed. 2009) (“In order to begin a bankruptcy case, the debtor files a petition. The petition is the basic register for bankruptcy relief....”); see also 11 U.S.C. § 301(b) (2006) (“The commencement of a voluntary case under a chapter of this title constitutes an order for relief....”).

9. WARREN & WESTBROOK, supra note 8, at 116.

10. 11 U.S.C. § 727(b) (emphasis added).

11. Id. § 524(a)(2).

12. See, e.g., Lone Star Sec. & Video, Inc. v. Gurrola (In re Gurrola), 328 B.R. 158, 175 (B.A.P. 9th Cir. 2005) (stating that the discharge injunction protects the debtor from personal liability). This case is also a good example of debtors’ misunderstanding regarding the effect and extent of the discharge injunction. Id. at 160 (“Ignorance. Pure ignorance. The debtor was amazingly ignorant of the legal consequences of his bankruptcy discharge.”).

13. Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934).

BALLOBIN FINAL 1/2/2011 12:44:41 PM

372 KANSAS LAW REVIEW [Vol. 59

to prevent such a possibility.14 Because the underlying purpose of the Code is to give the honest debtor a fresh start, many creditors, especially unsecured creditors, end up with the bad end of the deal. Therefore, some creditors have attempted to circumvent the discharge provisions of the Code by requiring the debtor to waive discharge of a specific debt long before the debtor even contemplates filing for bankruptcy. Other creditors file a prebankruptcy lawsuit against the debtor and get a state court judgment or consent decree entered. These prebankruptcy actions and their enforceability (and authority) are the subject of Parts III and IV of this Comment.

III. DISCUSSION OF PREBANKRUPTCY ACTIONS BY CREDITORS

A. Prepetition Waivers of a Specific Debt Waivers of dischargeability of a specific debt are attempted frequently in prebankruptcy proceedings. Undoubtedly, prepetition waivers of dischargeability are desirable in agreements and court judgments because the creditor wants assurance that the debtor will be required to pay the debt and not escape that obligation by filing for bankruptcy. Therefore, the creditor is seeking waiver of a single debt rather than a waiver of discharge of all debts. A creditor, for example,

may negotiate a term into an agreement or judgment that plainly states:

“The debts incurred in this agreement are nondischargeable in bankruptcy.” Although parties can include prepetition waivers in virtually any settlement agreement,15 this Comment refers to two contexts where these waivers are recurring.

14. See, e.g., 11 U.S.C. § 523(a)(2)(A) (disallowing a debtor to discharge any debts obtained by fraud); id. § 727(a)(2) (withholding discharge when the debtor has defrauded an officer of the estate); id. § 707(b)(1) (allowing dismissal if “the granting of relief would be an abuse of the provisions of this Chapter”); see also Grogan v. Garner, 498 U.S. 279, 279 (1991) (stating that “the Code limits the opportunity for a completely unencumbered new beginning to the honest but unfortunate debtor by exempting certain debts from discharge”).

15. See, e.g., Herz v. Steil (In re Steil), Bankr. No. 05-02079, Adv. No. 05-9108, 2006 WL 2662694, at *1–2 (Bankr. N.D. Iowa Aug. 14, 2006). The debtors entered into a lease agreement for a convenience store with the plaintiff. Id. at *1. Debtors suddenly closed the business and failed to remit any payment to the plaintiff. Id. at *2. The parties then entered into a hand-written settlement agreement, which stated that the “agreement is binding by its signer and cancels all leases and contracts made prior to today [sic] agreement. This agreement is not to be included in any Bankruptcy Discharge.” Id.

BALLOBIN FINAL 1/2/2011 12:44:41 PM

–  –  –

1. Marital Separation Agreements and Divorce Decrees One area of the law where a prepetition waiver of the dischargeability of a certain debt arises is in the context of marital settlement agreements. Divorce proceedings can be difficult and protracted for the parties involved. One common component of these settlement agreements is support obligations. Support obligations commonly include spousal and child support, where a monthly payment is made directly to the ex-spouse in a predetermined amount as set by the marital settlement agreement.16 In drafting a marital settlement agreement, an attorney may include a provision that attempts to make the agreed obligations nondischargeable in bankruptcy. Not surprisingly then, “[b]ankruptcy law, with its underlying policy to provide the honest debtor with a fresh start, frequently collides with divorce law and the mutual obligations that arise from dissolution of a marriage.”17 In Lewis v. Trump (In re Trump), one attempt at a prepetition waiver was included in a marital settlement and separation agreement’s “General Provisions,” indicating that “[t]he provisions and obligations contained herein are to be considered as not dischargeable in bankruptcy.”18 Under the agreement, the ex-husband agreed to pay child support and, under another section titled “Assumption of Debts and Liabilities,” agreed to make monthly payments on a second mortgage, even though his ex-wife would retain the residence.19 When the debtor ex-husband filed for bankruptcy, the ex-wife filed a complaint to determine the dischargeability of the debts that had been agreed upon in their marital settlement agreement.20 Specifically, the ex-wife urged the court to honor the waiver of discharge contained in the agreement so that the debtor ex-husband would be barred from discharging those debts.21 The court concluded that “prepetition agreements to waive the benefits of a bankruptcy discharge are void, and this Court is not bound by this language.”22

–  –  –

In another case, Cotten v. Cotten (In re Cotten), the parties attempted to insert a prepetition waiver of discharge into a consensual divorce decree.23 The decree mandated that the ex-husband would make second mortgage payments on behalf of his ex-wife and that “such obligation shall... not [be] dischargeable in bankruptcy.”24 Ultimately, the court did not determine whether the provision was enforceable, although it agreed with the ex-husband that such waivers had been held unenforceable in other jurisdictions.25 Instead, the court concluded that it “need not decide whether the provision is enforceable” as other grounds existed for making the debt nondischargeable.26 Lastly, in Hester v.



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