Collection Costs of a Non-Discharged Debt Also Are Non-Discharged

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Bankruptcy offers debtors an opportunity for a "fresh start," the primary draw for many individuals seeking to unburden themselves of their debt.  

A bankruptcy discharge relieves a debtor of their legal obligation to repay most debts.  The Bankruptcy Code begins with a presumption of dischargeability for the honest but unfortunate debtor, but there are exceptions.  If, for example, a debt was incurred through fraud, larceny, or embezzlement, the debt may be deemed non-dischargeable, and the debtor will remain liable to repay it.  But what if you have a non-discharged debt, but you incur new expenses to collect on it.  Are those new expenses collectible and non-dischargeable? 

According to a 2024 decision from the Fourth Circuit Court of Appeals, the answer is "Yes." 

In Yagi v. Hilgartner, Hilgartner physically assaulted and injured Yagi.  The parties reached an out-of-court settlement agreement to compensate Yagi for her injuries.  Hilgartner was to make payments to Yagi over time.  The settlement agreement included an attorneys' fees provision if Yagi had to enforce the agreement in court.  All this occurred before Hilgartner filed for bankruptcy.  Yagi, as a creditor in the bankruptcy, wanted all amounts owed under the settlement agreement declared non-dischargeable, including interest and attorneys' fees incurred in collecting under the agreement.  

The Fourth Circuit had to decide if sums incurred to enforce the breach of an agreement should be considered non-dischargeable like the underlying debt. 

Hilgartner argued that by signing the settlement agreement, his non-dischargeable debt was converted into a dischargeable debt.  Any claim arising from a breach of the agreement was a simple breach of contract claim -- which is dischargeable.  The Fourth Circuit rejected the debtor's argument, holding that a court must look beyond the legal instrument to the underlying debt. 

Because the settlement agreement established that the debt was derived from a "willful and malicious injury," a discharge exception not limited to physical harm, the Court held the non-dischargeable exception should apply. 

Hilgartner also argued that even if the principal debt is non-dischargeable, any collection costs associated with enforcing the agreement are separate and should be discharged.  The Fourth Circuit also rejected this argument, holding that the ancillary costs (e.g., late fees, interest, and attorneys' fees) were also incurred "as a result of" the same malicious (and non-dischargeable) injuries that gave rise to the agreement.  Recovery of the interest, late fees, and attorneys' fees incurred in collecting on the debt, were all bargained-for in exchange for the release of the "willful and malicious injury" claim, causing them to be inextricably linked.  The settlement memorialized a bargain, which envisioned compensation for injury and collection. 

Therefore, Hilgartner was prohibited from discharging the compensation for the harm suffered and Yagi's costs to collect under that agreement. Bankruptcy courts in North Carolina are bound to follow this decision. 

This case exemplifies the value of drafting agreements with the end-game in mind to ensure a hard-fought settlement is not wiped out in bankruptcy.  Bankruptcy implications should be considered in any settlement agreement. 

And while it may be impossible to eliminate all risk of loss if a bankruptcy filing occurs, careful drafting of settlement agreements, consent judgments, and workout documents will help to preserve your rights and maximize recovery.

© 2024 Ward and Smith, P.A. For further information regarding the issues described above, please contact Jameson A. Doub or Thomas C. Wolff.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

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