Filing for bankruptcy does not eliminate a secured creditor’s lien against any property used as collateral. For example, if a homeowner with a mortgage files for Chapter 7 bankruptcy, the mortgage lender can still foreclose on the property if the loan is ultimately not repaid. A bankruptcy discharge only eliminates the debtor’s legal obligation to repay the lender.

So what happens when a bankruptcy debtor sells the secured property but doesn’t use the proceeds to repay the lien holder? A number of bankruptcy courts in the United States have held that is a form of embezzlement. And it can prevent a debtor from receiving a discharge of the underlying loan.

This issue came up in a recent Illinois bankruptcy proceeding, In re Daddosio. The debtor in this case owned and operated a company that served as a concrete sub-contractor for various construction projects. In 2017, the company started having cash flow problems. The debtor, acting on behalf of the company, signed a financing agreement with a lender. In exchange for a $71,300 in financing, the debtor agreed to make weekly payments until the loan was repaid with interest. The agreement included a voluntary lien on all of the company’s assets.

Unfortunately, the debtor’s financial situation continued to decline after his largest contractor stopped paying for their concrete and filed for bankruptcy. The debtor then stopped making payments on the financing agreement, even though he still owed about $70,000. The lender then filed a lawsuit in Virginia state court to enforce the agreement. The lender subsequently obtained a civil judgment, which was recorded in Cook County, Illinois, where the debtor conducted business.

The debtor then filed a series of bankruptcy cases. The case at issue here started out as a Chapter 11 filing later converted to Chapter 7. While that case was pending, the debtor started a new company that effectively continued his prior, pre-bankruptcy concrete business. He also started “selling or giving away” assets that belonged to the prior company without regard for the lender’s lien or civil judgment. More to the point, the debtor used the proceeds from the sale of those assets for his own personal expenses and not to pay back the $70,000 he owed.

Failure to Read (or Understand) Financing Agreement Is No Excuse

Not surprisingly, the lender was unhappy about the situation and filed a lawsuit in bankruptcy court against the debtor. The lender sought an order denying a discharge of the $70,000 still owed by the debtor. U.S. Bankruptcy Judge Donald R. Cassling agreed with the lender and issued a judgment against the debtor on August 21, 2023.

The judge described the debtor’s actions as a clear-cut case of “embezzlement.” The debtor “did not dispute that he sold assets that were subject to the [lender’s] blanket lien and failed to use those proceeds to repay his debt.” Notwithstanding that admission, the debtor nevertheless claimed he lacked a “fraudulent state of mind” because he did not understand the terms of the financing agreement that he signed. Judge Cassling was not sympathetic. He noted that under Virginia law, which governed the agreement, a person who signs a contract without taking the time to read or understand it is still bound by its terms.

Judge Cassling also rejected the debtor’s claim that his actions were not embezzlement since he was simply trying to keep his business afloat. As described above, the debtor did not keep his bankrupt company going. Rather, he liquidated the assets of that company–without approval from the court or the lender–and then used the proceeds to start his new business. The debtor had no excuse for not using that money to repay a secured creditor. As such, the court said the debtor could not discharge his remaining debt to the lender under federal bankruptcy law.

Speak with a Qualified Bankruptcy Attorney

If you are struggling with a failing business and are not sure of how to deal with your creditors–secured or unsecured–it is in your best interest to seek out legal advice from a qualified Chapter 7 bankruptcy attorney in your area.

Disclaimer: This post is provided for informational purposes only. The author is not an attorney and nothing in this post should be construed as legal advice. You should always consult a licensed and qualified attorney in your state about any legal matter.