Accountant's Mistake on Financial Statement Leads to Non-Dischargeable Debt

A recent opinion from the Fifth Circuit demonstrates that non-dischargeable claims for false financial statements can extend beyond the traditional lender-borrower relationship and that a third party's error can create liability when it is knowingly adopted by the debtor. Matter of Morrison, No. 07-51118 (5th Cir. 1/16/09).

David Morrison was president of Morrison Excavation. Like many construction contractors, the firm was short of cash and looking for new work. On February 6, 2002, the company's CPA informed David that the company's financial condition was dire. To make things worse, on February 15, the company's bookkeeper found an accounting error which inflated the company's accounts receivable by $857,000. When the inflated receivables were removed, the company was insolvent. The previous day, the company had submitted a bid for a subcontract with Western Builders. After reviewing the company's work at several job sites and performing a credit check, Western requested a financial statement. On February 22, David faxed the financial statement containing the inflated receiveables to Western. On March 6, Morrison Excavation entered into a subcontract with Western and started taking draws on March 28. During that time, the company used the draws from Western to pay off lienholders who they said had previously been paid. David also gave himself a raise and paid off a personal home equity loan from company funds. By mid-August, Morrison Excavation abandoned the job. Western hired another contractor to finish the job at and additional cost of over half a million dollars. David Morrison filed chapter 7 on March 13, 2004.

Western filed a non-dischargeability action against David based upon submitting a false financial statement. At trial, two company employees testified that David was informed about the error in the financial statement somewhere around February 15, which was prior to the time that he provided the statement to Western. The bankruptcy court found that the subcontract created a debt which could be nondischargeable under Sec. 523(a)(2)(B) because Morrison could be held liable for the misrepresentation which benefited Morrison Excavation. The bankruptcy court also entered a money judgment against David in the amount of $549,773.63. On appeal, the Fifth Circuit affirmed, finding that the Bankruptcy Court had the jurisdiction to enter a money judgment in a dischargeability action (agreeing with five other circuits) and affirming the Bankruptcy Court's conclusions on liability and non-dischargeability.

While the result in this case is not particularly remarkable, it demonstrates how personal liability for a non-dischargeable debt can arise in a business setting.

1. While false financial statement cases often arise from a loan application, the Morrison case shows that they can arise in any context. What is interesting about this case is the fact that Western Builders did a substantial amount of due diligence before entering into the contract with Morrison Excavation. It observed job sites, ran a credit check and requested a financial statement. Although reliance was not discussed in the Fifth Circuit opinion, it seems clear that Western was trying to protect itself from doing business with a financially shaky subcontractor who would not be able to complete the job.

2. It did not matter that the financial statement was for Morrison Excavation or that David Morrison was not the person responsible for preparing the financial statement. When David Morrison faxed the financial statement to Western for the purpose of being awarded the subcontract and after being informed that it erroneously showed a positive net worth instead of a negative one, he fell within the statutory language of receiving money or property based upon "use of a statement in writing:

(i) that is materially false;

(ii) respecting the debtor's or an insider's financial condition;

(iii) on which the creditor to whom the debtor is liable . . . reasonably relied; and

(iv) that the debtor caused to be made or published with intent to deceive."

The financial statement was materially false because it showed the company as solvent rather than insolvent. It depicted the financial condition of an insider. The creditor reasonably relied on the statement as shown by the fact that it conducted several types of due diligence before entering into the contract. Finally, the debtor's intent to deceive was shown by the fact that he had been told that the statement was inaccurate but faxed it anyway.

3. It was not necessary to pierce the corporate veil to impose liability on the corporate officer. Under Texas tort law, an individual may be held liable for "fraudulent or tortious acts commited while in the service of his corporation."

4. The creditor was allowed to obtain both a judgment of non-dischargeability and a money judgment in the same proceeding. This allowed the creditor to obtain all of the necessary relief in one action.

Judge to Secured Creditor: The Loan has been PAID!!!!!

In the latest opinion from a single asset real estate case which has taken on the ferocity of a cage match brawl, the bankruptcy court has told a secured lender that it must treat its credit bid under Section 363(k) the same as if it had received a cash payment. The audacious secured creditor had asserted that its credit bid applied to reduce its bankruptcy claim but not its debt, so that it was still free to pursue guarantors and other collateral. Spillman Investment Group, Ltd. v. American Bank of Texas, Adv. No. 08-1018 (Bankr. W.D. Tex. 1/29/09).

In a fact pattern which is showing up more frequently these days, the case started off with a golf course development. The debtor borrowed money from American Bank of Texas and Fire Eagle, LLC. American Bank held the first lien and also held a CD and limited guaranties. Fire Eagle held a junior lien and did not have personal guaranties. After the loans went into default and the debtor filed chapter 11, Fire Eagle bought the American bank debt so that it held both the senior and junior liens. After a bidding process in which a group lead by insiders of the debtor offered $9.2 million in cash, Fire Eagle made a credit bid in the amount of $9.3 million and acquired the property. Fire Eagle also received cash collateral in the amount of $500,000, increasing its total amount credited and paid to $9.8 million. At the time, the amount of the first lien debt was approximately $9,250,000. Thus, the combination of the credit bid and the cash collateral clearly exceeded the amount of the first lien debt.

Notwithstanding the math, Fire Eagle asserted that the senior debt (and with it the right to collect against the CD collateral and the guarantors) remained alive because the credit bid under Section 363(k) reduced its bankruptcy claim, but not the underlying debt. The Bankruptcy Court did not have any trouble rejecting the distinction between debt and claim.

Fire Eagle's claim is also its debt. "Debt" is defined as liability on a claim. 11 U.S.C. Sec. 101(12). "Claim" means "right to payment, whether or not such right is reduced to jdugment, liquidated, unliquidated, fixed, contingent, matured, unmatued, disputed, undisputed, legal, equitable, secured or unsecured." 11 U.S.C. Sec. 101(5A). Payment against the claim necessarily reduces the debt. It cannot reduce one and not the other. This is the bankruptcy court; not fantasy land.

Memorandum Opinion, p. 27.

The Bankruptcy Court also rejected arguments that language in the guaranty agreements which provided that setoffs or defenses of other parties and discharge in bankruptcy would not impair the guarantees allowed continued pursuit of the guarantors. The Court noted that payment of the debt was neither a setoff nor a discharge, so that the guarantees were extinguished when the debt was paid.

To make sure that there was no room for confusion, the Court added the following conclusion:

Fire Eagle's Senior Loan was paid in full. As such Fire Eagle has no claim against the SIG CD or the Guarantors under their respective Guarantees. Fire Eagle's feigned ability to not understand the Court's reasoning falls on deaf ears. This is not rocket science. The Senior Loan has been PAID!!!!!

Memorandum Opinion, p. 34.

First Post-Script:

Judge Monroe will be retiring this year after nearly twenty years on the bench. While Spillman is an example of his rather direct writing style, it is not the only time that he has used all capitals to make a point. In an opinion discussing allowance of late filed claims in chapter 11, he quoted from the then-recent Supreme Court opinion in Pioneer Investments v. Brunswick, followed by the exclamation: "WRONG." Judge Monroe has never had trouble telling us what he really thinks.

Second Post-Script:

This marks the 100th posting to A Texas Bankruptcy Lawyer's Blog.

Individual Involuntary Petitions Remain Viable Under BAPCPA

The Bankruptcy Abuse Prevention and Consumer Protection Act requires that an individual filing for relief under Title 11 obtain credit counseling within 180 days prior to filing bankruptcy. 11 U.S.C. Sec. 109(h). Some commentators have questioned whether this requirement would spell the end of involuntary bankruptcy cases against individuals (since they would not have completed credit counseling). Judge Monroe has recently held that involuntary cases are not subject to the credit counseling mandate. In re Sadler, No. 06-10091 (Bankr. W.D. Tex. 10/18/06).

In Sadler, the Cadle Company filed an involuntary petition against the debtor without the joinder of any other creditors. The alleged debtor moved to dismiss the case claiming that he was not eligible for chapter 7 relief because he had not completed credit counseling, that he was generally paying his debts as they came due and that he had more than 11 creditors requiring three petitioning creditors.

Judge Monroe parsed the statutory language of Sec. 109(h) and found that it referred to completing credit counseling within 180 days "preceding the filing of the petition by such individual." Since an involuntary case is not filed by the debtor, then the eligibility provision does not apply. This result seems to be consistent with both the statutory language and congressional intent. BAPCPA is all about shifting control from debtors to creditors. While some have questioned the benefits of credit counseling (See Opinions Regarding Failure to Seek Credit Counseling Underscore Dissatisfaction With Law, 7/18/06), its only efficacy would be in the case of a voluntary filing. If a creditor takes the unusual step of initiating a petition, it is unlikely that credit counseling by the debtor would change the creditor's mind about the need to seek relief.

The rest of the opinion is devoted to creditor counting for purposes of Sec. 303(b). Cadle took the gutsy step of filing the involuntary petition without the joinder of any other creditors. If the debtor could show that he had at least 12 creditors, then the petition would be required to be dismissed unless additional joining creditors could be found. The debtor, who clearly did not want to be in bankruptcy, came up with a list of 24 creditors. However, this was not sufficient to keep him out of bankruptcy.

After an initial pass, Judge Monroe eliminated 11 potential creditors from the calculus, allowed 10 and saved three for further scrutiny. The debts excluded on the first pass included several that were owed by other parties, one which was time barred and eight which were for current, recurring expenses. Judge Monroe excluded the recurring expenses, which included such items as the electric bill and insurance based on an old Fifth Circuit case, Denham v. Shellman Grain Elevator, Inc., 444 F.2d 1375 (5th Cir. 1971).

The court's initial ruling created high drama. If the debtor could include two out of the three remaining debts, then the case could be dismissed and the creditor would face potential sanctions. If the creditor could exclude at least two of the three debts, then the case would proceed. The Court excluded all three remaining debts for three different reasons.

First. the debtor claimed that he owed a judgment to First Financial Resolution for $156,000. Unfotunately, the debtor could not provide a copy of the judgment or even an address for the creditor. Bankruptcy Rule 1003(b) requires that a debtor claiming to owe more than 12 debts file a list of the names and addresses of his creditors. Because the debtor could not provide an address for the creditor or otherwise prove that the debt existed, it did not count.

Second, the debtor relied on a debt owed to company controlled by his wife and brother-in-law. This company loaned him $65,000 to settle a $3 million debt. Judge Monroe classified this creditor as an insider so that they did not count toward the number of creditors.

Finally, the debtor claimed that he owed money to the IRS. Since the debtor had not filed tax returns for several years, it was very likely that he did owe taxes. However, because he could not prove any specific liability, Judge Monroe did not count the debt.

Thus, the creditor count stalled out at 10 and the involuntary was allowed to stand with a single petitioning creditor.

The Other Shoe Drops on Pro-Snax

Here is an article which I wrote that was recently published in the Bankruptcy Law Section Newsletter published by the Bankruptcy Law Section of the State Bar of Texas.

When the Fifth Circuit decided Matter of Pro-Snax Distributors, Inc[1].,the court devoted most of its analysis to the issue of whether debtor’s counsel could be compensated from the estate after appointment of a chapter 11 trustee. The Fifth Circuit ruled that the statutory language of 11 U.S.C. §330(a) prohibited such compensation and the Supreme Court subsequently adopted the same position.[2] However, the Fifth Circuit also addressed the broader issue of the proper standard to be used in awarding compensation. In a few short paragraphs, the Fifth Circuit rejected a standard of objective reasonableness and required that legal services result in “an identifiable, tangible and material benefit to the bankruptcy estate.”[3] Courts are only just now starting to focus on the meaning of this second holding.

The Pro-Snax Holding

In addressing the proper standard for awarding compensation, the court stated:

The other task to which this appeal commends us it deciding which standard we must apply to A & K’s services rendered before the appointment of the trustee. A & K argues that a reasonableness test is appropriate—whether the services were objectively beneficial toward the completion of the case at the time they were performed. The Petitioning Creditors, by contrast, advocate a more stringent test—whether A & K’s services resulted in an identifiable, tangible and material benefit to the bankruptcy estate. We determine today that the stricter test is the appropriate measure.[4]

The court went on to state that “we are disinclined to hold that any service performed at any time need only be reasonable to be compensable[5]” and added that “we believe it is important to stress that any work performed by legal counsel on behalf of a debtor must be of material benefit to the estate.[6]”

Thus, the court appears to have held that:

1. Services must result in an identifiable, tangible and material benefit to the estate to be compensable; and
2. Services which were objectively reasonable at the time they were performed, but did not result in an identifiable, tangible and material benefit are not compensable.

These holdings are problematic because they appear to contradict the language of 11 U.S.C. §330(a). The statute provides that courts shall not allow compensation for “services that were not … reasonably likely to benefit the debtor’s estate or …necessary to the administration of the estate.[7]” Because Congress prohibited payment for services not “reasonably likely to benefit the debtor’s estate,” it seems that they approved payment for services which were reasonably likely to benefit the estate. However, Pro-Snax would amend the statute to require that the services rendered an actual, material benefit as judged in hindsight. Congress also stated that courts should consider “whether the services were necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of a case under this title.”[8] How can Pro-Snax be reconciled with a requirement to look at whether services necessary or beneficial at the time at which they were rendered?

The Pro-Snax ruling is also difficult because it fails to address services, which are necessary to the administration of the case, but do not result in an identifiable, tangible and material benefit. For example, the bankruptcy estate does not receive a direct benefit from filing schedules, attending the first meeting of creditors or filing monthly operating report. However, each of these functions is required by Title 11. While these services do not render a direct benefit, they avoid a direct detriment, that is, having the case dismissed or converted.

Applying Pro-Snax in Chapter 11

While the Pro-Snax material benefit standard has been rejected by some courts in other circuits,[9] it has been applied in a handful of cases within the Fifth Circuit.[10] The most extensive discussion is found in the recent Evans Weaver [11]case from the Western District of Texas. Weaver involved representation of an individual in a failed chapter 11 case described by the judge as “one of the most contentious cases that the Court has involved with since being licensed as a lawyer in 1969.[12]” The case was precarious for debtor’s counsel due to the nastiness of the case, the ultimate conversion to chapter 7 and the inherent conflict present in representing an individual as both debtor and debtor-in-possession.[13]

The Court followed Pro-Snax despite an argument that it was contrary to clear statutory authority.[14] The court separately analyzed each project that the debtor’s counsel and special counsel worked upon to see whether it was compensable.[15] The Court generally divided the fee requests into several categories: those which represented mandatory duties for Debtor’s counsel, which would be allowed subject to reasonableness; those which were for the benefit of the individual debtor, which would not be allowed; those which were not mandatory and did not benefit the estate, for which no compensation would be allowed; and those which were not mandatory but did benefit the estate, for which compensation would be allowed based on reasonableness and the results obtained.

Mandatory Services

The Court found that benefit must be presumed on those matters “necessary to the administration of the case.[16]” Judge Monroe stated that, “The Court believes that is the only exception to the Pro-Snax pronouncement that all services rendered by persons representing the estate have the ability to show the identifiable, tangible and material benefit that has come from their efforts. With regard to ‘mandatory’ work, the benefit must be presumed and the inquiry is one of the reasonableness of the fees charged on such mandatory matters.[17]” Mandatory services were found to include such items as preparing the initial filing, matters related to case administration such as filing schedules and attending the creditors’ meeting[18] and “investigating whether property of the estate has value.[19]” There were also a number of small items which arguably fell into this category.

Services for Debtor’s Benefit

This category illustrates the perils of representing an individual debtor. While the debtor was in chapter 11, he was a party to a pending divorce action and was sued by several creditors to determine dischargeability of debts. These are both areas where the debtor required counsel and which could impact the reorganization case. For example, the divorce action could create new obligations for maintenance or support which would limit the debtor’s funds to pay creditors and could attempt to divide or dispose of property of the estate. Similarly, it would be difficult to negotiate a plan with a creditor without addressing the dischargeability of that creditor’s claim.

However, the court denied or substantially reduced fees in this area reasoning that they were for the benefit of the individual debtor and not the estate. The court completely denied fees with regard to the dischargeability actions. The court was more generous with regard to the divorce action. The court allowed a small portion of special counsel’s fees which brought an asset into the estate which was later bought back from the chapter 7 trustee by the individual debtor. The court also allowed bankruptcy counsel to recover for fees incurred in connection with the motion to lift stay to allow the divorce to go forward and allowed reduced fees for matters relating to coordination between the divorce and bankruptcy.

These rulings, while true to Pro-Snax, raise difficult practical problems. If debtor must have counsel for a dispute, but is not allowed to pay counsel out of the estate, how will debtor obtain qualified counsel? The choices are limited. A debtor can liquidate exempt property, can use funds which are not property of the estate or can borrow funds from outside the estate. However, under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, the debtor’s post-petition earnings in a chapter 11 case are now property of the estate.[20] Therefore, these funds are no longer available to pay counsel for matters which can’t be paid out of the estate.

Non-Mandatory Services Without Benefit

This category resulted in denial of a substantial amount of fees. A non-mandatory service is one that debtor’s counsel is not required to perform under the code. Debtor’s counsel does not have to propose a plan or respond to respond to a motion to dismiss or convert the case. As a practical matter, counsel must perform these duties if the debtor is to emerge from bankruptcy with a confirmed plan. However, these are areas which might not be appropriate in a specific case. As a result, counsel is subject to being second-guessed at fee application time.

The two main areas where the court denied fees for this reason related to the plan and the motion to convert. The court found that the facts relating to the plan were very close to those of Pro Snax in that the debtor was attempting to propose a plan over the vehement objection of his main creditors. However, the court also stated that it could not understand why the creditors would prefer trying to seek a non-dischargeable judgment in chapter 7 to the debtor’s plan. Thus, even though the debtor was objectively trying to benefit his creditors, the fact that they did not want to be benefited meant that these services were not compensable.[21] With regard to the motion to convert, the court found that the debtor’s resistance was simply an attempt to keep the debtor in control at a point where the case had become hopeless.[22]

Non-Mandatory Services With Benefit

In an unsuccessful case, this category is likely to be slim. However, in the Weaver case, the debtor’s counsel pursued a preference claim against the major creditor in the case which the trustee successfully settled for a large sum. The court allowed these fees after noting that it had to prod the debtor to pursue the action in the first place.

Applying Pro-Snax Beyond Chapter 11 Debtor’s Counsel

Nearly all of the cases applying Pro-Snax have involved compensation of debtor’s counsel in a chapter 11 case. However, the statute being interpreted, 11 U.S.C. §330(a), also applies to compensation of a chapter 11 trustee, an ombudsman, an examiner and counsel for a trustee. If the identifiable, tangible material benefit standard is part of the statute, then it must apply to these parties as well. How exactly does an examiner benefit the estate? If an examiner is appointed to investigate the debtor’s transactions with insiders and concludes that no wrongdoing occurred, should compensation be denied on the basis that no benefit was received? If trustee’s counsel investigates 100 potential preference actions, chooses to pursue ten and is successful on five, should compensation be limited to the time spent on the five successful actions or should compensation be allowed for the entire project on the theory that it was necessary to wade through 95 potential claims to find the five meritorious ones?

The second Pro-Snax holding is difficult to reconcile with the statute it sought to interpret. Perhaps the Fifth Circuit was reacting to the specific facts before it and would not apply the same standard to a consumer privacy ombudsman (a position which did not exist at the time of the opinion) or an examiner. It also may be that the Fifth Circuit, like Judge Monroe, would find an exception for “mandatory” services which would mitigate the potential harshness of its ruling. In the alternative, all professionals employed by bankruptcy estates may find themselves under a one-sided contingent fee arrangement[23] and should negotiate their fees accordingly.

End-Notes:
[1] 125 F.3d 414 (5th Cir. 1998).
[2] Lamie v. United States Trustee, 540 U.S. 526, 124 S.Ct. 1023, 157 L.Ed.2d 1024 (2004).
[3] 157 F.3d at 426.
[4] Id.
[5] Id.
[6] Id.
[7] 11 U.S.C. §330(a)(4)(A).
[8] 11 U.S.C. §330(a)(3)(C).
[9] In re Ames Department Stores, Inc., 76 F.3d 66 (2nd Cir. 1996)(while this opinion pre-dates Pro-Snax, it adopts the position rejected by the Fifth Circuit); In re Mednet, 251 B.R. 103 (9th Cir. BAP 2000).
[10] In re Condit, 2003 Bankr. LEXIS 601 (Bankr. N.D. Tex. 2003); In re Needham, 279 B.R. 519 (Bankr. W.D. La. 2001).
[11] In re Evans Weaver, 336 B.R. 115 (Bankr. W.D. Tex. 2005).
[12] In re Evans Weaver, 336 B.R. at 118.
[13] Representation of an individual chapter 11 debtor requires counsel to represent a single individual who is both the individual debtor and the representative of the estate. Some matters, such as exemption disputes, place counsel in a conflict between duties to the debtor and to the estate. Other areas, such as objections to discharge and determination of dischargeability, benefit the debtor without affecting the estate. The state disciplinary rules require counsel to sealously represent both interests. This is less of a problem in chapter 12 and 13 cases because the statute allows compensation for services reasonably benefiting the debtor. 11 U.S.C. §330(a)(4)(B).
[14] “Applicant Borsheim argues that Pro-Snax is at odds with the statute and misinterprets it since the statute plainly authorizes fees ‘for actual, necessary services” (citation omitted) as well as services that are ‘reasonably likely to benefit the debtor’s estate.” (citation omitted). Even if such be true, this Court is constrained to follow the 5th Circuit’s interpretation.” 336 B.R. at 119.
[15] The Local Rules of the Western District require that fee applications contain a description of the categories of services rendered stating the nature and purpose of each category and the results obtained. W. D. Tex. Local Bankr. R. 2016(a)(1).
[16] 11 U.S.C. §330(a)(4)(A)(ii)(II).
[17] In re Evans Weaver, 336 B.R. at 122.
[18] The Condit court approached this area somewhat differently, finding that items such as preparation of schedules and attendance at the first meeting of creditors “inures to the estate’s benefit” and “may confer an actual benefit on the estate” and were therefore compensable. In re Condit, at 8.
[19] “(I)t is mandatory that counsel should spend some time investigating whether property of the estate has value. He should not be required to simply roll over.” 336 B.R. at 123.
[20] 11 U.S.C. §1115.
[21] Other courts have fudged on this issue and have allowed partial compensation for unsuccessful attempts to propose a plan. In re Condit, supra (50% of requested fees allowed); In re Needham, supra (20 hours out of 98.25 allowed).
[22] In contrast, the court allowed fees for resisting a motion to appoint trustee which was “wholly without merit.” It is unclear whether this was allowed as a mandatory item or whether preventing something bad from happening counts as an identifiable, tangible and material benefit.
[23] A one-sided contingent fee arrangement is one where the hourly rate is paid if counsel is successful and no compensation is paid if counsel is unsuccessful. It lacks the upside potential of a traditional contingent fee contract.