Business Law

Willard v. Lockhart-Johnson (In re Lockhart-Johnson) (9th Cir. BAP)

The following is a case update written by Uzzi O. Raanan, a partner at Danning, Gill, Israel & Krasnoff, LLP, analyzing a recent decision of interest:

Deciding a previously unresolved issue, the United States Bankruptcy Appellate Panel of the Ninth Circuit held that, to assert a nondischargeability claim against the non-filing spouse of a bankruptcy debtor, a plaintiff must affirmatively obtain a nondischargeability determination by commencing an adversary action against that person within 60 days of the meeting of creditors. See Willard v. Lockhart-Johnson (In re Lockhart-Johnson), 2021 WL 3186115 (9th Cir. BAP 2021).

To read the full opinion, click here.

FACTS

In 2017, plaintiff Sharlene Willard (“Willard”) sued Steve Johnson (“Steve”), among others, for breach of a home repairs contract. She obtained a default judgment (“Judgment”) against Steve for around $10,000. Two years later, Willard attempted to garnish the wages of Steve’s wife, Sherrie Nicole Lockhart-Johnson (Debtor), who filed a bankruptcy case under Chapter 7.

In her bankruptcy schedules, Debtor stated that she was married but either legally separated or living apart from her spouse for the past eight years. She initially did not list Willard as a creditor but ultimately amended her Schedule E/F indicating that the Judgment was community debt.

In March 2020, Willard filed an adversary action against the Debtor alleging that the Judgment was nondischargeable under 11 U.S.C. section 523(a)(2)(A), namely by “false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition.” According to the complaint, the state court had ruled that Debtor was not liable under the Judgment but, because Debtor listed the debt in her schedules as a community obligation, she was attempting to discharge it.

Debtor filed a motion to dismiss, arguing that Willard failed to state a claim for fraud against her. According to the motion, Debtor never made false material statements to Willard, was living apart from Steve at the time his contract with Willard arose, does not owe any money to Willard, and the latter had conceded the state court ruling that Debtor “was not liable for the debt.”

At the hearing on the motion to dismiss, Willard stated that after obtaining the transcript of the state court action she realized that the state court had not ruled that Debtor was not liable under the Judgment. She argued that the Judgment “was a community obligation and ‘by discharging the debt, [the bankruptcy court would be] discharging a debt against community property and [making] it impossible to collect because [Debtor] and her husband are married and living together. Even if [the court were to] say I could still go after his individual assets, it’s a community property debt.’”

The bankruptcy court granted the motion to dismiss with prejudice, holding that Willard failed to allege any misconduct by the Debtor and even conceded that Debtor did not owe her any money.

Willard appealed to the Ninth Circuit’s Bankruptcy Appellate Panel (“BAP”), which held that the trial court did not err by dismissing Willard’s complaint but abused its discretion when it denied leave to amend. It vacated the order of dismissal with instructions that Willard be allowed to amend her complaint.

REASONING

On appeal, Willard again argued that, even though Debtor was not involved in the proceedings giving rise to the Judgment, the debt belonged to the community and under state law community property is liable for debts incurred by either spouse during the marriage.

The BAP noted that the question raised by Willard implicated Section 524(a)3), which states in relevant part,

(a)       A discharge in a case under this title—

(3)       operates as an injunction against the commencement or continuation of an action . . . to collect or recover from, . . . property of the debtor . . . that is acquired after the commencement of the case, on account of any allowable community claim,[1] except a community claim that is excepted from discharge under section 523, 1192, 1228(a)(1), or 1328(a)(1), or that would be so excepted, determined in accordance with the provisions of sections 523(c) and 523(d) of this title, in a case concerning the debtor’s spouse commenced on the date of the filing of the petition in the case concerning the debtor, whether or not discharge of the debt based on such community claim is waived.

11 U.S.C. § 524(a)(3) (emphasis added.)

Thus, Willard was correct that if Debtor were to receive a discharge, Willard would still be able to collect against Steve’s separate property but not against any community property obtained post-petition, including Steve’s wages. See Roaz v. Kimmel (In re Kimmel), 378 B.R. 630, 636 (9th Cir. BAP 2007). In other words, regardless of whether the claim against the community is attributable to the acts of a filing debtor, under Section 524(a)(3), “‘all community property acquired post-bankruptcy is protected by the discharge.’” Id. at 635-36.

This community property discharge applies only while the marital community continues to exist under applicable state laws. In California, for example, community property is subject to claims against an individual spouse. However, division of the community property terminates the liability of that property for community debts or the debts of the other spouse who incurred the debt.

The BAP discussed two exceptions to the community property discharge identified in Section 524(a)(3). The first is where the community debt has been held to be nondischargeable under Section 523, among other sections (where the filing debtor committed the acts giving rise to the debt), and the second where the bankruptcy court determines that it would not grant a discharge to the non-filing spouse in a hypothetical case filed on the same petition date.

Section 524(b)(2) contains two additional exceptions to the community property discharge,

(A)       the court would not grant the debtor’s spouse a discharge in a case under chapter 7 of this title concerning such spouse commenced on the date of the filing of the petition in the case concerning the debtor; and

(B)       a determination that the court would not so grant such discharge is made by the bankruptcy court within the time and in the manner provided for a determination under section 727 of this title of whether a debtor is granted a discharge.

11 U.S.C. § 524(b)(2).

The BAP acknowledged that neither the Federal Rules of Bankruptcy Procedure nor the courts have addressed how a creditor can assert its community claim when nondischargeable acts were committed by the non-filing spouse, or “expressly provide[d] the procedure for asserting hypothetical nondischargeability or objections to discharge under § 524.”

To provide such guidance, the BAP held that to prove a hypothetical nondischargeability under Section 524(a)(3) against the non-debtor spouse, a creditor must “affirmatively seek a nondischargeability determination of claims asserted under §§ 523(a)(2), (4) or (6), or have those claims discharged.” Such complaints “must be filed within 60 days of the meeting of creditors.”

According to the BAP,

To state a claim for relief from the community property discharge, where the purported fraudulent conduct is by a nondebtor spouse, a creditor must: (1) allege the existence of a community debt; and (2) allege sufficient facts to support a hypothetical claim of nondischargeability or denial of discharge against the nondebtor spouse as of the petition date.

Thus, Willard had to file a complaint within 60 days of the meeting of creditors, which she did. Her complaint also had to state a claim under either Section 523(a)(2)(A) against the Debtor or under Section 524(a)(3) against Steve, which it did not. Willard also needed to assert in her complaint that the debt in question was a community claim, which she failed to do.

While Willard failed to plead sufficient facts to support her community claim, the Court noted that the policy for granting leave to amend complaints is generally permissive. After considering the factors necessary to grant leave, the BAP concluded that Willard should have been allowed the opportunity to amend her complaint, based on representations at the hearing on the motion to dismiss that the Judgment is a community claim.

The BAP noted that had the Bankruptcy Court ruled that the community had terminated, based on Debtor’s claims that she and her husband had separated, the BAP would have agreed that further leave to amend would be futile. However, the record contains insufficient facts on this issue.

Though Willard filed her complaint within the 60-day deadline, the BAP did not opine on whether Willard’s amended claim adding Steve as a defendant would relate back to the original complaint, or whether the amendment would be time barred.

CONCURRENCE

Joining the majority opinion in full, Judge Klein drafted a concurrence in which he highlighted a “little-used tool” available to courts in situations like this case. According to Judge Klein, the Bankruptcy Court could have sua sponte ordered joinder of Debtor’s spouse as a “required” party under rule 19 of the Federal Rules of Civil Procedure and directed Willard to amend her complaint accordingly. The Concurrence provided a detailed overview of federal rules governing joinders of parties, concluding that Steve is a “required” party in this action.

AUTHOR’S COMMENTS

Both parties in this action appeared pro se, including on appeal. As Judge Klein noted in his concurrence, the parties “desperately need counsel.” Were Plaintiff represented by counsel, she likely would have been better equipped to understand the nuances of pleading nondischargeability claims against the community.

These materials were written by Uzzi O. Raanan, a partner at Danning, Gill, Israel & Krasnoff, LLP, located in Los Angeles, California, who is a member of the ad hoc group and the representative from the Business Law Section (BLS) to the CLA’s Board of Representatives. Editorial contributions were made by the Honorable Meredith Jury (United States Bankruptcy Judge, C.D. Cal, Ret.), also a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.


[1] The term “Community Claim” is defined in the Code as, “[a] claim that arose before the commencement of the case concerning the debtor for which property of the kind specified in section 541(a)(2) of this title is liable, whether or not there is any such property at the time of the commencement of the case.” 11 U.S.C. § 101(7).


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