Whether 11 U.S.C. §707(a) allows for the dismissal of a non-consumer individual chapter 7 case filed in bad faith—and if so, what constitutes bad faith—is a question that continues to vex the courts.  The four Circuits that have addressed the issue of whether a case filed by an individual debtor with primarily non-consumer (business) debts [1] can be dismissed for bad faith under §707(a) are split [2], [3] and lower court decisions on the matter are similarly diverse. [4]  The majority view appears to be that bad faith does constitute cause under §707(a) with many courts adopting either a “totality of the circumstances” or egregious conduct analysis. [5]  Under both approaches, the courts consider whether the debtor lives a “lavish lifestyle.” 

Several courts have found cause to dismiss a case for bad faith after determining that an individual business debtor could repay a significant dividend to creditors over five years if he would curtail his excessive expenses. [6]  In making these rulings, the courts have found the means to skirt the plain language of the Code, which excludes individual business debtors from the abuse and good faith provisions of §707(b), [7] and have tiptoed around the legislative history which explicitly prohibits considering ability to pay as “cause” under §707(a). [8]  These decisions appear to be in tension with the underlying policy reasons for treating individual business debtors and individual consumer debtors differently.  If embraced by more courts, such an interpretation of §707(a) threatens to interfere with bankruptcy’s broader economic objectives of encouraging innovation and investment by ensuring chapter 7 relief is available to individual business debtors.

There is obvious allure in dismissing an individual business debtor’s chapter 7 case for bad faith when a filing under chapter 13 or chapter 11 would result in a larger dividend to creditors.  First, the creditors’ recovery would clearly be maximized and their exposure to risk lessened.  Lessening creditors’ risk could have the added benefit of putting downward pressure on the cost of credit.  Secondly, holding individual business debtors to the same standard of living imposed on individual consumer debtors under §707(b)(1)-(2) appeals to our sense of fairness.  Why should individual business debtors be permitted to pay for luxury vehicles and second homes when the lifestyles of individual consumer debtors are hemmed in by the provisions of the means test?   

While the individual business debtor who spends $2,700.00 a month maintaining his yacht [9] but does not pay his creditors may not be a particularly sympathetic character, the provisions of the Code and the policy behind chapter 7 liquidations do not require him to be.  If he is willing to surrender his non-exempt property for distribution, a lavish lifestyle resulting from the income a debtor has been able to generate after the failure of his business should not be taken as evidence of bad faith.  To do so would require the individual with business debt to pay creditors of a failed venture from the earnings of a subsequent successful endeavor, creating a disincentive for entrepreneurial risk-taking.  Such a result undercuts the long-standing economic considerations that shape bankruptcy policy. [10]

The relief provided by a chapter 7 bankruptcy—allowing an individual with primarily business debt to exchange his nonexempt property for a discharge of his debt—encourages the kind of economic risk-taking that creates jobs, fosters innovation and rewards persistence.  That an individual business debtor may be denied the benefits of a liquidation simply because he has been able to bounce back from a failed venture could create perverse incentives: debtors may opt to file a bankruptcy immediately after the failure of their business, or they may be disinclined to get back into the ring if they know their future success will be for the benefit of their past creditors.  Worst of all, they may decide against taking the risk of starting a business altogether.  A good faith standard that ultimately penalizes a once-failed entrepreneur for subsequent success risks chilling the kind of business investment and innovation that bankruptcy protection is designed to encourage.

The Supreme Court’s decision in Local Loan Co. v. Hunt [11] supports the contention that individual business debtors are entitled to a chapter 7 discharge regardless of post-venture income and expenses.  The Court explains that the purpose of bankruptcy is to “relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh.” [12]  Though this language is often quoted in relation to the §707(b)(3) good faith requirement of a debtor with primarily consumer debts, the Court in Local Loan was actually addressing the individual business debtor.  The Court goes on to explain that the rationale behind bankruptcy is to provide the debtor with a fresh start “…free from the obligations and responsibilities consequent upon business misfortunes.  This purpose of the [bankruptcy] act has been again and again emphasized by the courts as being of public as well as private interest, in that it gives to the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.” [13] The bargain struck in a chapter 7 bankruptcy is a kind of quid pro quo—the debtor surrenders his non-exempt property for the benefit of his creditors in exchange for the discharge of the debt resulting from a failed business venture.  The entrepreneur is then free to re-enter the marketplace and try again, without the cloud of a past failure overhead. 

This debtor-friendly policy makes sense when taking into account that over 50% of small businesses fail within the first four years [14] and that a significant percentage of entrepreneurs attempt to start a business more than once. [15]  When viewed through the lens of encouraging investment and economic growth, the chapter 7 liquidation and discharge emerges as a businessperson’s safety net against long-term financial ruin.  The purpose of a chapter 7 liquidation in the case of an individual business debtor is precisely to allow the debtor another opportunity to succeed, recognizing that the economy benefits from the success of entrepreneurs.  By looking into the income, expenses and “lavishness” of an individual business debtor’s lifestyle after he has rehabilitated himself from a failed venture, the courts have conflated the Code’s treatment of debtors with primarily consumer debt and those with business debt and have overlooked the important role chapter 7 liquidation and discharge plays in encouraging the entrepreneurial spirit.

The Bankruptcy Code requires debtors to file a schedule of their assets and liabilities. [1] Official Bankruptcy Form 6, Schedules A through J provides the means by which debtors notify the bankruptcy court, creditors and other parties in interest of their various assets, liabilities, income and expenses. Regardless of whether the debtor has used an attorney, nonattorney bankruptcy petition preparer or is acting pro se, the debtor must sign his or her petition declaring “under penalty of perjury that the information provided in this petition is true and correct.” [2] In a perfect world, the debtor will list all of his or her assets and liabilities in the petition and the trustee will administer the estate and perhaps make some distributions to the debtor’s creditors. [3] Upon the conclusion of the case, the debtor will receive his or her discharge [4] and begin with a “fresh start.” [5] The fresh start does not mean that the debtor begins with nothing as there are various assets that the debtor may retain as exempt pursuant to the Code. [6] However, courts have consistently held that the “fresh start” is reserved for the “honest but unfortunate debtor.” [7]
           
In the typical consumer’s chapter 7 or 13 case, the debtor will list all of his or her assets in schedules A and B and the corresponding exemptions and security interests in schedules C and D. Many assets are very easy to identify and value: bank accounts, vehicles, houses, individual retirement accounts, etc. Some are more difficult to value, including household goods and collectibles. One asset that may be both difficult to identify and value is the debtor’s interest in existing causes of action that he or she may have against a creditor or other third party. This article will examine the consequences of failing to schedule these claims as well as the difficulties debtors may have in later attempting to amend their schedules to include the causes of action.

Section 541 of the Code is very broad in its definition of “property of the estate” and includes “[e]very conceivable interest of the debtor, future, nonpossessory, contingent, speculative, and derivative…[including] causes of action owned by the debtor or arising from property of the estate.” [8] The Second Circuit has stressed the importance of disclosure of assets given the broad scope of § 541:

Given the wide scope of § 541, the debtor’s obligation to disclose all his [or her] interests at the commencement of a case is equally broad. Because full disclosure by debtors is essential to the proper functioning of the bankruptcy system, the Bankruptcy Code severely penalizes debtors who fail to disclose assets: While properly scheduled estate property that has not been administered by the trustee normally returns to the debtor when the bankruptcy court closes the case, undisclosed assets automatically remain property of the estate after the case is closed. “A debtor may not conceal assets and then, upon termination of the bankruptcy case, utilize the assets for [his or her] own benefit.” [9]

The doctrine of judicial estoppel may be used to bar the dishonest debtor from trying to cash in on a cause of action that he previously failed to list in his or her petition. In its simplest form, the doctrine “prevents a party from asserting a factual position in a legal proceeding that is contrary to a position previously taken by him [or her] in a prior legal proceeding.” [10] The purpose is to “preserve the integrity of the courts by preventing a party from abusing the judicial process through cynical gamesmanship.” [11] Courts base the application of judicial estoppel on the need to preserve the integrity of the bankruptcy system, which necessarily requires debtors to fully and honestly disclose all of their assets. [12] The simple failure to disclose a claim in a person’s bankruptcy proceeding has resulted in courts invoking judicial estoppel to prevent that person from asserting that claim after obtaining their discharge.



In Cannon-Stokes v. Potter, [13] a debtor filed a no-asset chapter 7 petition and discharged approximately $98,000 in unsecured debts. Shortly thereafter, she filed a suit against her employer seeking $300,000 in damages. The Seventh Circuit, like many other circuits before it, [14] applied judicial estoppel and held that the debtor’s failure to list the cause of action in her petition precluded her from recovering on it later. In its analysis, the court reasoned that

By making [litigants] choose one position irrevocably, the doctrine of judicial estoppel raises the cost of lying. A doctrine that induces debtors to be truthful in their bankruptcy filings will assist creditors in the long run (though it will do them no good in the particular case) - and it will assist most debtors too, for the few debtors who scam their creditors drive up interest rates and injure the more numerous honest borrowers. Judicial estoppel is designed to prevent the perversion of the judicial process. [15]
Thus, the doctrine not only protects the creditors but it is also intended to protect the integrity of the judicial system. [16]

Generally, judicial estoppel involves three elements: (1) the party against whom the estoppel is asserted must have argued an inconsistent position in a prior proceeding; (2) the prior inconsistent position must have been adopted by the court in some manner; and (3) the party asserting the inconsistent position derives an unfair advantage or an unfair detriment is imposed on other parties. [17] Although not an element of judicial estoppel, courts may also find that it would be inappropriate to apply the doctrine if the party’s prior representation was based on inadvertent error or good faith mistake. [18] In the bankruptcy context, courts have held that the failure to list the cause of action is the same as saying that the cause of action does not exist thus satisfying the first element. For example, in Kee v. Evergreen Prof’l Recoveries Inc., [19] a debtor failed to list a potential suit against one of her creditors under the Fair Debt Collection Practices Act and was precluded from pursuing that claim after her case concluded.

The judicial adoption of the prior inconsistent position will take place when the debtor obtain his discharge but has even been found upon confirmation of a party’s chapter 13 plan while the case was still pending. In Allers-Petrus v. Columbia Recovery Group LLC, [20] a debtor filed a petition for relief under chapter 13 after sending the defendant a demand letter related to a potential suit under the Fair Debt Collection Practices Act. The cause of action was neither listed in her petition nor her plan that was confirmed three months after the filing of the petition. The Fair Debt Collection Practices Act suit was filed after the petition was filed but before the chapter 13 plan was confirmed. The defendant moved for summary judgment, arguing judicial estoppel and in response the debtor amended her schedules to list the claim. The defendant objected to the amended schedule arguing that it contained false and misleading information. While the objection to the amended schedule was pending before the bankruptcy court, the district court granted the defendant’s motion based on judicial estoppel. The court rejected the debtor’s argument that the proposed amendment would nullify the court’s acceptance of any prior inconsistent statement and held that “the bankruptcy court need not discharge debts before the judicial acceptance prong is satisfied.” [21] However, in Williams v. Republic Recovery Servs. Inc., [22] the court declined to apply judicial estoppel where a debtor had filed a motion to amend her plan and schedules to include her suit against the defendant.

The simplest illustration of the unfair advantage element is that the debtor can emerge with his or her discharge and a sizeable asset in the form of the cause of action. In Cannon-Stokes, that unfair advantage would have been the retention of a suit worth “three times the value of the debts she had discharged.” [23] In other cases, courts have not required a specific monetary gain by the debtor but focused instead on maintaining the integrity of the judicial system itself. In Allers-Petrus, the debtor’s proposed amended schedules listed the claim as exempt from her creditors but the court rejected her “no harm” argument and found that all three elements had been satisfied.

Another factor to consider in the unfair advantage element is whether it is the debtor or the estate that stands to benefit from the decision not to apply judicial estoppel. In Swearingen-El v. Cook County Sheriff's Dept., [24] the district court declined to apply judicial estoppel finding that the debtor was pursuing the suit for the benefit of creditors.

Judicial estoppel is intended “to protect the integrity of the judicial process” but it is also “an equitable doctrine invoked by a court at its discretion.” [25] Thus, a debtor may avoid the application of judicial estoppel if the failure to disclose was the result of inadvertent error or a good faith mistake. [26] This issue often arises when debtors are representing themselves or argue that they were not aware of the cause of action at the time that they filed their schedules. Some courts have held that judicial estoppel should not be applied “when the prior position was taken because of a good faith mistake rather than as part of a scheme to mislead the court.” [27] However, blind reliance on bad advice from an attorney or ignorance of the law are not always going to save a debtor from the application of judicial estoppel. The Fifth Circuit rejected a debtor’s argument that she relied on her attorney’s statement that her discrimination claims were “irrelevant” and affirmed a district court application of judicial estoppel to her claims. [28] The Seventh Circuit also rejected that argument in Cannon-Stokes. [29] Similarly, the Fifth Circuit has also held that “the debtor's failure to satisfy its statutory disclosure duty is 'inadvertent' only when, in general, the debtor either lacks knowledge of the undisclosed claims or has no motive for their concealment.” [30]

Aside from the application of judicial estoppel, another problem with failing to schedule a claim is that the discharged debtor does not even have standing to assert the claim. “Generally speaking, a pre-petition cause of action is the property of the chapter 7…estate and only the trustee in bankruptcy has standing to pursue it.” [31] The trustee’s exclusive standing exists even when the debtor fails to schedule the claim:

Once an asset becomes part of the bankruptcy estate, all rights held by the debtor in the asset are extinguished unless the asset is abandoned back to the debtor pursuant to § 554 of the Bankruptcy Code. At the close of the bankruptcy case, property of the estate that is not abandoned under § 554 and that is not administered in the bankruptcy proceedings remains the property of the estate. Failure to list an interest on a bankruptcy schedule leaves that interest in the bankruptcy estate. [32]

Application of judicial estoppel is designed to protect the integrity of judicial proceedings. In the cases discussed, it was applied in cases where the debtor failed to disclose an asset and then tried to cash in on that asset later. But what happens when the debtor vaguely discloses the claim or places one value on the cause of action in his bankruptcy schedules but then seeks a different amount in the actual litigation? There are few reported opinions on this application of judicial estoppel.

In Whitworth v. Nat’l Enter. Sys., [33] a debtor listed a potential Fair Debt Collection Practices Act claim in his petition valued at approximately $1,000. Thereafter, he filed suit seeking $274,500 in damages. The defendant in the underlying suit filed a motion for summary judgment based on judicial estoppel seeking to limit the debtor’s damages to the $1,000 listed in the bankruptcy petition. The court declined to limit the damages and noted that “there is a substantial difference between failing to disclose a claim altogether and in arguably undervaluing a claim on a bankruptcy petition.” [34] The court further reasoned that the debtor would satisfy his obligation so long as enough information is provided to put creditors and the trustee on notice of the claim and that its value is uncertain. [35]

Similarly, in Sparkman v. Zwicker & Assocs. PC, [36] a debtor listed a claim as a “[p]otential claim under Fair Debt Collection Practices Act” with “[m]aximum statutory damages of $1,000” and a current value of $0. [37] The defendant sought to have the court apply judicial estoppel and preclude the plaintiff from recovering damages because she listed the claim’s current value as $0. The court declined, holding that “listing the current market value of the FDCPA Claim as zero dollars is not tantamount to taking a position that the claim is worthless.” [38] Courts have been reluctant to limit a debtor’s recovery on causes of action to the amounts listed in their schedules and have even denied trustees’ attempts to revoke abandonment of claims when a debtor recovers more later. [39] Thus, courts are less amenable to binding a debtor to the dollar amount on the schedules and are more concerned with whether the trustee and creditors have been put on notice of the claim.

In the end, the scheduling of causes of action in the debtor’s petition is important to all interested parties. Clearly the intentional failure to disclose the claim will not be looked upon kindly by subsequent courts and can be used as a defense in the underlying litigation. Specifically, if the debtor stands to gain everything while the creditors will not recover anything, a court is much more likely to apply judicial estoppel and bar the claim. Additionally, trustees and creditors need to be mindful of the debtor’s valuing of the cause of action and its applicable exemption so as to avoid a situation where the debtor undervalues the claim in the schedules and later enjoys the windfall of a substantial award or settlement.