The Statute of Limitations Defense in Non-Dischargeability Actions

It has always been obvious that if there is a statute of limitations defense outside of bankruptcy, it files inside.  By why?  I have wondered that when asked the question over the years.  Recently I happened to stumble across section 558 which states:

The estate shall have the benefit of any defense available to the debtor as against any entity other than the estate, including statutes of limitation, statutes of frauds, usury, and other personal defenses.  A waiver of any such defense by the debtor after the commencement of the case does not bind the estate.

Been there since 1984.  But what does that apply to? – seems to be the estate only.

As to proofs of claim, Section 502(b) states that the claim is allowed “unless it would not be allowed under state law.”

What about as a defense to a non-dischargeability action.    Suppose the complaint says the debtor defrauded me.  He responds, No I didn’t (and I don’t have any money anyway – which is about half the mediations I have done).  There is a statute of limitations for fraud under state law, can that be asserted as a defense to a 523(a)(2) complaint?  I have never seen it which is what causes me to think of it.  The statute of limitations for breach of a written contract is a little longer than fraud.

So the debtor cheats a lender five years ago – files chapter 7 today.  Can the lender bring a 523 complaint against the debtor alleging fraud even though he could not under state law?  I put that question to 10 or 12 of my knowedgeable friends.  The answers were all over the place.  At least I can say there were two themes to the responses.  The first, led by the creditor attorney, is that 558 doesn’t apply to the debtor.  But there are cases that suggest that is not true.  The second theme, led by Mike Avanesian,  is there is no “debt” to be not discharged if the statute has run.  Sounds good but it seems to me to beg the question.

So I am researching the issue on a Saturday morning and ignoring the weeds in my rose garden that need pulling.    Mike is right!

In Banks v. Gill Distribution Centers, Inc., 263 F.3d 862 (9th Cir. 2001) the 9th Circuit said,

“[The debtor] contends the bankruptcy court erred in holding that Lee-Benner v. Gergely (In re Gergely), 110 F.3d 1448 (9th Cir.1997), and Resolution Trust Corp. v. McKendry (In re McKendry), 40 F.3d 331 (10th Cir.1994), compelled it to ignore state statutes of limitations entirely in determining the dischargeability of a debt.”

Huh?  The bankruptcy court ignored “state statute of limitations”?  The 9th Circuit ruled:

“We hold, as did McKendry, that there are two distinct issues to consider in the dischargeability analysis: first, the establishment of the debt itself, which is subject to the applicable state statute of limitations; and, second, a determination as to the nature of that debt, an issue within the exclusive jurisdiction of the bankruptcy court and thus governed by Bankruptcy Rule 4007. See id. at 337.”

In Banks, the creditor filed a timely breach of contract action in state court which was pending on the petition date.  The complaint did not allege fraud.  The fraud statute had run by the time the bankruptcy petition was filed.  The 9th Circuit said that under Brown v. Felson, a creditor can bring a fraud cause of action in bankruptcy court even though it got a judgment for breach of contract in state court, thereby waiving forever the right to get a fraud judgment in state court.   The Banks court here then said that since the state court complaint for breach of contract had been timely filed, the right to bring an action for fraud was still alive.

So the rule?  The moral of the story? (remembering Jim Healy – “Get to the point, will you Jim?”)

If the time to bring a breach of contract action has not run when the petition is filed, fraud is still alive even if the time ran prepetition.  But if the statute for breach of contract ran prepetition, the fraud action is dead.

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