Cowin v. Countrywide Home Loans, Inc. (In re Cowin), 864 F.3d 344 (5th Cir. 2017) –

Deed of trust holders sought to except debts from discharge in a debtor’s individual chapter 11 case on the grounds of debtor’s larceny, embezzlement, or willful and malicious injury. This was based on an alleged conspiracy to (1) strip their liens from property through tax lien foreclosure sales and (2) misappropriate excess foreclosure sale proceeds. The bankruptcy court found in favor of the deed of trust holders; the district court affirmed; and the debtor appealed to the Fifth Circuit.

The scheme involved use of tax-transfer liens authorized under state law. A third party purchaser/borrower bought property subject to a senior mortgage at a condominium association foreclosure sale. It then entered into a tax-transfer loan agreement with one of the debtor’s companies for purposes of paying real property taxes. In exchange for paying the taxes, the debtor’s company received a tax-transfer lien against the property.

Under state law, tax-transfer liens took priority in a foreclosure sale. Junior liens are extinguished and excess funds if any are to be paid to the junior lienholders in order of priority. The grantor should not receive anything until the junior lien holders are paid.

However, the deeds of trust given to the debtor’s companies securing the transfer-tax liens omitted the language requiring the deed of trust trustee to distribute any amounts required by law (e.g. to junior lien holders) before paying the grantor. The objective was to divert funds that should have been paid to the pre-existing mortgage holders to entities controlled by a co-conspirator.

Immediately after entering into the tax-transfer loan agreement, the purchaser/borrower would default, and the debtor would instruct the tax-transfer deed of trust trustee to foreclose. The trustee took a $1000 fee, paid the tax-transfer lien in full, and delivered the excess proceeds to the purchaser/borrower.

One of the pre-existing lenders sued the debtor and other co-conspirators seeking to recover the excess foreclosure sale proceeds and other damages. While that litigation was pending, the debtor filed a chapter 11 bankruptcy. That bankruptcy case was dismissed, but the debtor filed a second chapter 11 bankruptcy a couple of months later.

Several other lenders filed adversary proceedings in the second case for a determination that their debts were nondischargeable. While those proceedings were pending, the bankruptcy court dismissed the case, finding that filing two chapter 11 petitions within two years was an abuse of process. However, at the request of the parties, the court retained the adversary proceeding for final adjudication.

The bankruptcy court issued an opinion in the adversary proceeding, finding the debtor liable for the excess proceeds and determining that the debts arising from state-law violations were nondischargeable. Before the court entered final judgment, the debtor formally notified the court of a new chapter 7 filing. The court went ahead and entered final judgment in the adversary proceeding, emphasizing that its determination of nondischargeability applied to the new chapter 7 case as well.

The first lender filed an adversary proceeding in the chapter 7 case and also obtained a determination that it had a nondischargeable debt.

The debtor appealed both judgments. He raised a number of arguments in the consolidated appeal, including procedural matters such as whether it was proper to give effect to the judgment in the adversary proceeding, which he contended violated the automatic stay in the chapter 7 case.

The Fifth Circuit noted that nondischargeability is a matter of federal law governed by the Bankruptcy Code, it must be established by a preponderance of the evidence, and exceptions must be strictly construed against a creditor and in favor of the debtor to facilitate the debtor’s “fresh start.” But, the Code gives the opportunity for a fresh start to “the honest but unfortunate debtor.”

The dischargeability exceptions at issue in this case were debts “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny” or debts “for a willful and malicious injury by the debtor to another entity or to the property of another entity.”

The debtor conceded that he participated in a conspiracy to divert proceeds from the pre-existing lenders, that he was liable for state-law violations, and that the conspiracy met the federal standard for “larceny” or “willful or malicious injury.” But somehow he did not believe this was enough because he claimed the bankruptcy court should not have imputed the actions and intent of his co-conspirators to him in determining nondischargeability.

The Fifth Circuit rejected the debtor’s argument on several grounds. First, it concluded the bankruptcy court’s determination was supported by its findings regarding the debtor’s own intent and conduct. He personally used his companies to participate in the scam; he personally omitted language from the deeds of trust regarding distribution of amounts required by law,; he personally instructed the trustee to foreclose knowing that the properties were encumbered by pre-existing mortgages; and the structure of the conspiracy showed that he acted purposefully and intentionally in depriving the lenders of their liens and right to excess proceeds. Further, the bankruptcy court found that the debtor acted with intent to cause financial injury.

Regardless, a debtor cannot discharge debts that arise from fraud as long as it is liable to the creditor for the fraud. In other words, the Bankruptcy Code focuses on the nature of the debt, not the culpability of the debtor. The debtor is bound by the fraud of another if it is a knowing and active participant in the fraud. Similarly, a debtor cannot discharge a debt arising from larceny if it is liable to the creditor for the larceny.

As for the argument that the bankruptcy court’s entry of a judgment in the chapter 11 adversary proceeding violated the automatic stay in the chapter 7 case, the Fifth Circuit was skeptical that the stay applied to adversary proceedings filed in the same court in which a bankruptcy case is pending. Generally, the stay protects against creditors acting outside of bankruptcy. Many courts have found that the stay does not bar actions that are expressly allowed under the Bankruptcy Code. Regardless, in this case the error in entering the judgment notwithstanding the automatic stay would be harmless.

Accordingly, the court affirmed the lower court rulings.

It was clear that the debtor knowledgeably participated in a conspiracy to defraud the pre-existing mortgagees and make off with their money. For those who do not deal with dischargeability on a routine basis, it may seem puzzling why it was so difficult to reach the end result here.

Vicki R Harding, Esq.