Court Discusses “Substantial Justification” Defense to an Award of Fees Under 11 U.S.C. § 523(d).
Although the old adage “bad facts make bad law” may apply in some contexts, that is not the case here. Rather, bad facts may lead to good law, which is what happened in In re Machuca, Jr., 2012 Bankr. LEXIS 5939 (9th Cir. B.A.P. Dec. 14, 2012) (published).
Machuca involved a lender suing to keep a debtor’s consumer debt on his house junior lien nondischargeable in nature. Lender did not do well at all, losing a summary judgment in debtor’s favor that was never timely appealed. The facts were not good in showing that lender reasonably relied on loan application statements so as to be entitled to nondischargeability: (1) there were income discrepancies between debtor’s application and unsigned loan application; (2) the debtor put down a base employment income for a five-year state corrections officer that was simply implausible (almost $250,000 per year); (3) the last minute signing of the loan application, just before loan funding and after the date debtor signed the promissory note; (4) lender’s approval and funding of the loan without income verification (a “stated income” loan); and (5) suing successor lender’s purchase of the loan without income verification. These “red flags” led to a summary judgment and the lower court’s subsequent award of attorney’s fees of $9,000 to winning debtor under 11 U.S.C. § 523(d).
Red flags. Lela Davidson and Josie Aronor wave Alabama flags in their red dresses before going off to see the play "Annie" in Montgomery, Alabama. 2010. Carol M. Highsmith Collection. Library of Congress.
The Ninth Circuit B.A.P. panel affirmed the fee recovery, after determining they had no ability to even look at the summary judgment order given lender’s failure to timely appeal.
In order to obtain fee recovery under § 523(d), a debtor initially must prove (1) that the creditor sought to except a debt from discharge under § 523(a), (2) that the subject debt was a consumer debt, and (3) that the subject debt ultimately was discharged. Once these elements are established by debtor, the burden shifts to the creditor to prove that its actions were “substantially justified.” (Stine v. Flynn, 254 B.R. 244, 249 (9th Cir. BAP 2000).) In proving this defense, the creditor needs to demonstrate that it had a reasonable factual and legal basis for its claim, with a loss not automatically establishing that there was a lack of merit to the claim.
The bankruptcy appellate panel had no difficulty finding that lender failed to show substantial justification. It did not even appeal the summary judgment order. Besides that, the “red flags” were transparently present such that no prudent person could have claimed reasonable reliance based on the state of the record. Fee award affirmed.