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Bankruptcy court holds that state consumer fraud claims against corporations are dischargeable in bankruptcy

Section 1141(d)(6)(A) and section 523(a)(2) of the Bankruptcy Code together provide that debts owed by a corporation to a government entity are not dischargeable if such debts were obtained by false representations. Does this rule apply to claims by government entities seeking to enforce consumer fraud laws, where the government entities were not themselves the victims of the fraud? On February 14, 2018, the United States Bankruptcy Court for the District of Delaware held that it does not, ruling that such claims against corporations brought by states on behalf of their citizens are dischargeable in bankruptcy. In re TK Holdings Inc., Case No. 17-11375, 2018 Bankr. LEXIS 414 (Bankr. D. Del. Feb. 14, 2018).

The debtors, part of a group of affiliated corporations collectively referred to as “Takata,” are manufacturers and distributors of automotive safety systems. Certain airbags sold by Takata were subject to an investigation and large-scale product recall, and the ultimate parent, Takata Corporation, eventually pleaded guilty to wire fraud. Hawaii, New Mexico, and the Virgin Islands also filed claims against Takata on account of false or misleading statements it made to the public about the airbags, seeking civil penalties, restitution, and disgorgement.

In June 2017, the debtors commenced a chapter 11 case and later filed a reorganization plan. In December 2017, they sought a declaration that the state claims can be discharged upon confirmation of the plan. The states responded that such claims are immunized from discharge by Bankruptcy Code section 1141(d)(6)(A) and section 523(a)(2).

Section 1141(d)(6)(A) provides in part that “the confirmation of a plan does not discharge a debtor that is a corporation from any debt . . . of a kind specified in paragraph (2)(A) or (2)(B) of section 523(a) that is owed to a domestic governmental unit.” Section 523(a)(2) refers to debt “for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by” certain false representations. The debtors argued that because the state claims were grounded in harms to citizens of the states but not the states themselves, the claims were not debts “owed to a domestic government unit.” They also argued that because the states did not themselves suffer losses due to the alleged false representations, the debts were not “obtained by” those representations. The states argued that since the underlying state consumer protection laws gave the states standing to pursue claims for fraud upon their citizens, any judgment would be “owed” to the states under section 1141(d)(6)(A). They further argued that section 523(a)(2) does not require that the claimant itself rely on or suffer losses on account of the misrepresentations.

The bankruptcy court sided with the debtors. It agreed with the states that the debts at issue were “owed to a domestic governmental unit” under section 1141, because if judgments were issued in the states’ favor, the money would be owed to the states. But the court also concluded that for states to be protected by section 523(a)(2), the false representations must be made to the states themselves, and then relied on by the states, rather than simply to their citizens. In support of this proposition, the bankruptcy court relied on Field v. Mans, 516 U.S. 59, 69 (1995), which it interpreted as establishing the general principle that creditors are protected by 523(a)(2) only if they rely on the misrepresentations at issue and are damaged by such reliance.

While the states pointed to several cases where similar claims brought by governmental or regulatory authorities came within the protection of section 523(a)(2), the bankruptcy court distinguished these cases on the ground that the debtors in those cases were individuals rather than corporations, and thus the debts would have been dischargeable regardless of whether they were owed to a state or to individual citizens. Here, however, because section 1141(d)(6)(A) limits the non-dischargability for corporate debtors to debt owed to government entities, claims brought by actually defrauded individual citizens on the same grounds as the state consumer fraud claims would be dischargeable. It would be improper, the court reasoned, to elevate the states’ claims, grounded in harms to the public, over claims by actual members of the public directly harmed by the alleged fraud.

The court also supported its analysis with section 523(a)(7), which provides that “a fine, penalty or forfeiture payable to or for the benefit of a government unit” is not dischargeable for an individual debtor. Congress has not extended section 523(a)(7) to corporate debtors, rendering debts under section 523(a)(7) normally dischargeable for such a debtor. The court concluded that because the claims here fell within 523(a)(7), and the debtors here are corporations, the claims were dischargeable.