Burr & Forman

11.22.2017   |   Blog Articles, Consumer Finance Litigation

The So-Called “Innocent Spouse” Defense to Denial of Discharge Under 11 U.S.C. § 727(a)(3)

Under § 727(a)(3) of the Bankruptcy Code, a court shall not grant a debtor’s discharge if “the debtor has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor’s financial condition or business transactions might be ascertained, unless such act or failure to act was justified under all of the circumstances of the case.” To prevail under § 727(a)(3) an objecting party must establish that the debtor has failed to maintain or preserve records. Once this is established, the burden shifts to the debtor to explain the deficiencies in the documentation and justify the failure. One example of when a court found that a debtor’s failure to keep and preserve records was justified involved an individual debtor who relied on her debtor spouse to maintain records. In analyzing this factual scenario, the Ninth Circuit in In re Cox carved out a so-called “innocent spouse” defense to § 727(a)(3). However, this “innocent spouse” defense directly conflicts with a debtor’s general duties under bankruptcy to provide accurate financial information.

In re Cox
In In re Cox, the Ninth Circuit defined the so-called “innocent spouse” defense providing that a debtor’s reliance on his or her spouse justifies the debtor’s failure to maintain or preserve records. In In re Cox, the wife delegated her responsibility to maintain financial records to her spouse and she relied on her husband without verifying that he was actually maintaining records. The Ninth Circuit identified six factors in determining whether the reliance was justified: (1) the debtor’s intelligence and educational background; (2) the debtor’s experience in business matters; (3) the extent of the debtor’s involvement in the business; (4) the debtor’s reliance on her spouse to keep records, including what the debtor was told or knew about such records or the keeping of the records; (5) the nature of the marital relationship; and (6) any recordkeeping or inquiry duties imposed upon the debtor by state law.[6]  The Ninth Circuit found that because there were no warning signs for the debtor to doubt that her husband was properly maintaining the business records and because the debtor lacked training to “make a reasonable inquiry into the adequacy of the record keeping,” she was justified in relying on her husband and was granted a discharge.

No other circuit court has opined on the Ninth Circuit’s analysis in In re Cox and there are few reported opinions discussing a similar factual scenario. The lack of case law may be the result of the potential conflict between the “innocent spouse” defense and a debtor’s duties under the Code.

Debtor’s Duty under the Bankruptcy Code
In bankruptcy, a debtor has “an affirmative duty . . . to create books and records accurately documenting [his or her] affairs. A debtor also has an independent duty under the Code to verify the accuracy of the information listed on his or her schedules. A bankruptcy court must deny a debtor’s discharge if they fail to comply with these duties. If a debtor has an independent duty to keep records and verify the accuracy of the financial information provided to the court or the trustee, then it does not follow that a debtor’s blind reliance on his or her spouse to accurately maintain financial records justifies a failure to perform these duties.

The only possible way the “innocent spouse” defense can coexist with the duties created by the Code is if the “innocent spouse” defense is limited to the narrow situation where the debtor fails to list information because of the spouse’s failure to maintain records but not in the case where the debtor actively lists false financial information on his or her schedules as a result of the failure to maintain records. Applying In re Cox  to permit a debtor to list false financial information would only deincentivize a debtor to verify the accuracy of the information contained in his or her schedules. Even worse, it could enable a debtor to benefit from misleading the court or the trustee by presentation of false financial information, either through mistake of the non-debtor spouse keeping the records or, in the extreme case, from a fraudulent scheme perpetuated by the non-debtor spouse.

The Bankruptcy Court for the Central District of Illinois, in In re Wilson applied this limitation when it denied a debtor’s discharge because he relied on his spouse who falsely filled out his schedules and statement of financial affairs. In In re Wilson, the debtor allowed his wife to list information even though he knew it was false. The court found that the debtor could not delegate his responsibilities under the Code to his wife and later deny responsibility for false information because “[debtors have the ultimate responsibility for the accuracy of the information contained in their schedules, which cannot be avoided by playing ostrich.”

The Ninth Circuit in In re Cox appears to agree with this application. Even though the Ninth Circuit found that delegating the responsibility to maintain records might be justified in some circumstances, it did not find the reliance to be justified in those circumstances where reliance on third parties resulted “in the filing of false information.”  Not only is this distinction supported through case law, this distinction directly aligns with the bankruptcy principle that bankruptcy is for the honest but unfortunate debtor. If a debtor truly relies on his or her spouse and does everything in his or her power to provide accurate financial information, then the debtor is honest and should not be punished for the failures of his or her spouse. However, a debtor should not be able to stick his or her head in the sand while providing false information to the court and expect a get out of jail free card by merely asserting that he or she was relying on a spouse.

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