Corporate Fraud is Discharged in Chapter 11

I found out the hard way that corporate fraud is discharged in chapter 11 (provided of course that a plan is confirmed that is not a liquidating plan).  I say the hard way because I advised Judge Wayne Johnson recently that I was going to file a non-dischargeability complaint in the corporate chapter 11 and he said something like, “you can’t do that,” and I responded something like, “Oh yes I can.”  He then read me sections 523 and 1141 and I backed off and promised to review the code before filing anything.   The issue came up last week when someone posted the same question on a listserve and Prof. Mark Scarberry from Pepperdine responded explaining the reasoning behind the rule.

Mark wrote:

Section 523(a) applies, by its terms, only to debtors who are individuals (flesh-and-blood human beings). Section 523(a) refers to section 1141 and thus applies to chapter 11 discharges of individuals. Section 1141(d)(2) confirms that result by providing that the chapter 11 discharge does not discharge an individual debtor from debts that are excepted from the discharge by section 523.

Section 727 applies only in chapter 7 cases. See section 103(b). (Note that the exceptions from discharge in section 523(a) are irrelevant in a chapter 7 case where the debtor is not an individual, because section 727(a)(1) prevents any such non-individual debtor from receiving a chapter 7 discharge.)

Here is my best understanding of the policy behind the non-applicability of section 523(a) to non-individual chapter 11 cases.

A short way of putting it is that in the archetypal case the reorganized debtor that continues in business will be owned by the prepetition creditors. They were not responsible for the wrongdoing (fraud or whatever) that is the basis for nondischargeability under section 523(a).

Here is the longer version:

Unsecured creditors holding claims in a dissenting class are entitled to all the value of the debtor if they demand it, up to the full amount of their claims. If the debtor remains in business after completion of the chapter 11 case, then any nondischargeable debts would have to be paid in full by the reorganized debtor.  The result would be that some of the debtor’s value would have to be diverted at 100 cents on the dollar to the holders of the nondischargeable claims.  That would reduce the value that other creditors could receive; the other creditors would bear the cost.  If they had to bear that cost, then section 523(a) would turn into a priority provision that requires certain creditors to be paid ahead of others. But the judgment as to which claims ought to receive priority is embodied in section 507(a), not in section 523(a), which is not a priority provision.

To the extent that one creditor harmed other creditors by acting wrongfully (or in a seriously inequitable way), the creditor who caused the harm can be equitably subordinated under section 510(c).