Court of Appeals Says FCC Penalty Demand Survives Chapter 11 Corporate Debtor Clearance

A Federal Communications Commission’s (“FCC”) Chapter 11 corporate debtor’s monetary penalty obligation resulting from “consumer fraud” survived the discharge of the debtor’s plan of reorganization, even when the FCC “was not a victim of the fraud,” the U.S. District Court for the Southern District of New York ruled on September 2, 2021. In re Fusion Connect Inc., 2021 WL 3932346, *1 (SDNY 2 September 2021). On appeal, the court reversed the bankruptcy court’s dismissal of the government’s non-discharge complaint, explaining that the fraud exception to discharge extends to debts owed to “creditors who have not been defrauded themselves”, like the government here. Identifier., at 2 o’clock. According to the court, the bankruptcy court had upheld the debtor’s reorganization plan with a broad release (i.e. release) of pre-bankruptcy debt, but the order confirming the plan set “the stakeholders… warns against the fact that [the FCC Penalty] could attach to the new [reorganized] entity”, while its terms made the discharge of this liability “an open question”. Identifier.at 12.

Relevance

The Fusion the decision is important. A corporate debtor seeking reorganization relief under Chapter 11 typically wants to clean up its balance sheet by eliminating unsecured liabilities with a release clause in a reorganization plan, permanently preventing creditors from enforcing their pre-bankruptcy claims. . When the bankruptcy court confirms the plan, the discharge will be a key part of the confirmation order. As the Third Circuit recently pointed out in a similar context, “debtors [must] know your liabilities [in order to] implement a viable plan for a fresh start. Ellis v Westinghouse Electric Co., LLC, 2021 WL 3852612, *7 (3d Cir. 30 Aug 2021). According to the Third Circuit, however, “the debtor’s interest in a fresh start is not absolute, as the Bankruptcy Code attempts to strike the” delicate balance between the competing interests of creditors pursuing their claims and debtors obtaining a new beginning and a finality.’” Identifier.to *4 (quote omitted).

Facts

Debtor’s predecessor (“B”) had been engaged in the consumer scam “for years”. WL 3932346 to *1. As a result, B entered into a consent decree with the FCC in 2016, acknowledging its fraud, agreeing to issue refunds to consumers and pay a “$4.2 million U.S. civil penalty (“FCC Penalty”). ”) in equal monthly installments over five years…. By its terms, the consent decree linked [B’s] successors, assigns and assignees”. Identifier. B then paid $1.2 million in consumer refunds and credits and began paying the FCC penalty. Identifier. *2. In 2018, however, Fusion, the debtor here, had merged with B’s parent company, leaving “Fusion as the owner of [B’s] company and responsible for the pending FCC penalty. Identifier.

Fusion filed a Chapter 11 petition in 2019 with “$2.1 million of the $4.2 million FCC penalty” unpaid. The FCC filed a proof of claim for this amount and the bankruptcy court upheld Fusion’s reorganization plan in late 2019. Upon confirmation of the plan, the bankruptcy court “declared that Merger’s continuing obligation for the pending civil penalty [to the FCC] ‘will depend on the determination of whether these bonds can be discharged’” — that is, whether they will survive the plan of reorganization. Identifier.

Bankruptcy court litigation

The government filed a non-discharge complaint in early 2020, alleging the FCC penalty was not dischargeable under Code §523(a)(2)(A), made enforceable by Code §1141 (d)(6). Although the government admitted that the fraud-discharge exception in §523(a) applied only to bankruptcy cases “involving individual debtors…, Congress, in enacting the Discharge Fraud Act of 2005, Abuse Prevention and Consumer Protection, in Code §1141(d)(6), had extended [the fraud exception to discharge] corporate debtors in Chapter 11 [cases].” Identifier.

The bankruptcy court granted Fusion’s motion to dismiss the government’s complaint. It “agreed with Fusion that the exception to the discharge for liabilities resulting from fraud does not apply to the FCC penalty because this exception does not reach debts owed to creditors who have not been defrauded themselves.Because the victims of [B’s] the fraud was made up of consumers, not the government, [reasoned the bankruptcy court,] Section 523(a)(2)(A), and therefore Section 1141(d)(6)(A), does not reach the FCC penalty. Identifier. at 2 o’clock.

On-call analysis

The appeals court noted that “the government’s appeal raises a pure question of law: a civil penalty payable in the United States arising from [a consumer fraud] constitutes a debt arising from [fraud]so that the sanction is exempt from bankruptcy discharge under [Code] § 1141(d)(6). Identifier. at 3.

Statutory framework and binding precedent. A Chapter 11 plan of reorganization “releases the debtor from any debt that arose before the date of this confirmation.” Code § 1141(d)(1). “The discharge of these debts serves the bankruptcy policy of providing debtors with a ‘fresh start’ to allow them to continue their businesses without pre-bankruptcy debts.” DPWN Holdings (USA) Inc. v United Airlines747 F.3d 145, 150 (2nd Cir. 2014).

Code § 523(a)(2)(A) “has … long prohibited debtors from satisfying their debts because of their fraud, embodying a core policy animating the Code of granting relief only ‘to “an honest but unhappy debtor”. Cohen v. from La Cruz, 523 US 213, 217-18 (1998). This provision generally applies to Chapter 7 cases involving individual debtors. Congress thus intended to ensure that “all debts resulting from fraud are exempt from discharge, regardless of their form”. Archer vs. Warner538 US 314, 321 (2003).

The Supreme Court confirmed in Cohen that the actual fraud of a Chapter 7 debtor renders its liability non-dischargeable under section 523(a)(2)(A). He also ruled “that an award of ‘treble damages assessed by reason of fraud'” was not dischargeable because it “fell within the scope of ‘any debt’ relating to ‘money, goods, services or credit” that the debtor has fraudulently obtained.” Identifier.at *4, quoting Cohen, 523 U.S. at 218 and Code § 523(a)(2)(A). The Court pointed out that because “the award of treble damages” in Cohen fell under the defense fraud exception, “the creditor has[d] a “right to payment” corresponding to these damages. Identifier.at *5, quoting Cohen523 United States at 218-19.

Section 1141(d)(6)(A). Congress “Imported [in 2005] the relevant content of Code § 523(a)(2)(A) in Chapter 11 [cases] via § 1141(d)(6)….” Identifier. “Section 1141(d)(6)(A) extends section 523(a)(2)(A) to [chapter 11 cases]exempting from ‘the release of a debtor who is a corporation from any debt…of a type specified in paragraph (2)(A) or (2)(B) of section 523(a) which is owed to a national government unit. ” Identifier. at 5. In extending Section 523(a)(A) to corporate debtors in Chapter 11 cases, the court explained in FusionCongress was “presumed… [have] adopt[ed]» the interpretation of the Supreme Court in Cohen. Identifier. The district court therefore treated the Cohen analysis as “governing the question presented” here. Identifier.at 6.

FCC Penalty Not Releasable Under Code 1141(d)(6)(A). The district court therefore held that the “FCC penalty fell within the § 523(a)(2)(A) exception to the discharge, as discussed in Cohenand extended to Chapter 11 corporate debtors via 1141(d)(6)(A). Identifier., at 7 O’clock. He first underlined the “magnitude” of the Supreme Court’s decision Cohen reasoning: “§ 523(a)(2)(A) prohibits the discharge of any liability arising out of fraud.” Identifier. (emphasis in text), citing Cohen523 US at 222. The district court also relied on other appellate decisions. Seefor example In re Pleasant219 F.3d 372, 375 (4th Cir. 2000) (non-dischargeable debt “must not be due, in whole or in part, to a victim of the fraud, or represent compensation” for the victim); Hatfield vs. Thompson555 BR 1, 12 (10th Cir. BAP 2016) (“[T]there is no requirement that the debt be for something the debtor obtains from the creditor. “).

Rejection of merge arguments. Rejecting Fusion’s argument that the fraud in question “must have been directed against the creditor holding the debt”, the district court relied on “the decisions of the Eleventh and Third Circuits finding that the requirement of § 523(a)(2)(A) of fraud consistent with the common law elements of fraud is satisfied where the party or parties defrauded were persons other than the bankruptcy creditor [case].” 2021 WL 3932, 346, at *9. For example, the Securities and Exchange Commission (“SEC”) had obtained a non-dischargeable civil fraud judgment against the debtor because of his fraudulent investors”[e]even if the fraud had not been directed against the SEC. Identifier.citing In re Bilzerian, 153 F.3d 1278, 1280 (11th Cir. 1998). And the Third Circuit ruled that the SEC’s civil fraud judgments against the debtor were “undischargeable because proof of fraud had been established as to [the debtor’s] customers…even if the fraud had not been directed against the SEC. In re Bocchino194 F.3d 376, 382-83 (3d Cir. 2015).

The district court also dismissed as “exceptionally unconvincing” Merger’s argument that the bankruptcy court’s reversal “would place the burden on the reorganized entity’s stakeholders to [B’s] wrongdoing that occurred even before Fusion acquired the company. Identifier., at 12. Not only did the “stakeholders” knowingly assume B’s pre-existing liability to the United States, but the bankruptcy court also warned them that the FCC penalty could survive any release obtained by Fusion. in the order confirming the plan. “A shareholder of the new company therefore had his eyes opened that [this] liability, such as other continuing liabilities or business costs and risks, could be ongoing. Identifier.

Political implications. More importantly, allowing Fusion “to get rid of a regulatory fraud penalty in this way could cause harm.” Identifier. For example, it could encourage “the strategic transfer of such liabilities to a successor entity willing to file for reorganization under Chapter 11”, particularly where the entity “had a recent history of fraud”. Identifier. “…[C]The bears cautioned against interpreting the Code in a way that would create perverse incentives for debtors that do not align with the Code’s goals. Identifier.citing In re Murphy282 F.3d 828, 874 (5th Cir. 2002); KeyBank Nat’l Ass’n v. Franklin Advisers Inc., Co.600 BR 214, 231 (SDNY 2019) (rejecting a “rule that … would create perverse incentives for parties to engage in delay and maneuvering in both bankruptcy reorganization and related litigation”).

The merger can probably appeal to the second circuit. But the district court’s thorough, carefully reasoned, and sensible opinion will stand up to scrutiny. Chapter 11 should not be a haven for corporate debtors with fraudulent pasts.