Mother-Daughter Debacle Plays Out in Waco; Family Debts Determined to Be Dischargeable

“Traditionally, trials of family conflicts often involve emotion and controversy, yet are short on reason, logic and admissible evidence. These adversary proceedings share these traits.” Thus, began Judge Larry Kelly’s Memorandum Opinion in which he sought to sort out the tangled mother-daughter disputes in Rose Douso Petro v. Irene E. Holland, et al, Adv. No. 06-6001, 06-6002 and 06-6004 (Bankr. W.D. Tex. 1/12/07). This opinion is significant both because it was one of Judge Kelly’s final opinions prior to retirement (after 20+ years on the bench) and because it offers an object lesson in the difficulty in translating informal family dealings into legal proceedings.

Some Background

In better times, Irene Holland was married to Scottie Holland and Irene’s parents advanced money to her. These borrowings were later documented in a promissory note in the amount of $305,000 in 1988. The debt was evidenced by a note which was payable on November 1, 1993 or when the Hollands sold a piece of property they owned in San Antonio. Seven years later, the Hollands sold the San Antonio property but neglected to pay off the note. According to Irene’s mother Rose Petro, they also failed to inform her of the sale. Rose contended that she did not learn of the sale until spring 2002, some 14 years after the date of the loan and seven years after the sale.

In the spring of 2003, the Hollands sold a residence they owned in Hawaii for $1.6 million. Around the same time, they divorced. In connection with the divorce, the Hollands agreed that Rose would receive $286,568.53 out of the sales proceeds to be paid on her note. Judge Kelly noted that there is no explanation for why they chose this amount rather than the full face amount of the note (although apparently this is what Irene believed was owing). The Title Company issued the check payable to Rose, but wrote it in care of Irene. It is not explained why the check went to Irene. However, a lot of subsequent litigation could have been avoided if the check had gone straight to Rose. In apparent violation of the divorce agreement, Irene returned the check to the title company and requested that it be voided. In its place, she requested that four new checks be issued. One of the four checks was issued to Rose in the amount of $110,000 and was received by Rose. In a development which would become important later, Irene contended that Rose gave her permission to do this.

Rose was not happy when she found out what had happened. In June 2004, she sued Irene, Scottie and the title company in District Court in Bell County. The state court found that it lacked jurisdiction over the title company and dismissed all claims against it. Irene engaged Waco attorney John Montez and filed bankruptcy during the October 2005 bankruptcy rush. At this point, adversary proceedings began to get filed left and right. Rose removed the state court litigation to bankruptcy court where it was assigned Adv. No. 06-6001. She then filed a complaint against Irene seeking to except her debt from discharge under Sec. 523(a)(2), (4) and (6) and objecting to Irene’s general discharge under Sec. 727(a)(2)-(5). This became Adv. No. 06-6002. Scottie filed his own adversary proceeding based on breach of the Agreement Incident to Divorce, which was docketed as Adv. No. 06-6004. Prior to trial, Scottie settled his claims against Irene as well as Rose’s claims against him. Thus, the sole issues which remained for trial were Rose’s claims against Irene.

The Trial

Prior to trial, it appeared as though Irene had not gone out of her way to repay the note to her parents. However, it was unclear whether this would translate into a non-dischargeable debt.

Before determining whether the debt was non-dischargeable, the court had to decide whether there was even an enforceable debt. The promissory note was due within four years after the property sold. Since the property was sold on March 29, 2000, the deadline to file suit would have expired on March 29, 2004, approximately three months before suit was actually filed. The court found that Irene had not fraudulently concealed the sale of the property from her mother and that her mother knew about the sale by 2002. As a result, the court concluded that the original debt was barred by limitations. However, under Texas law, a debt barred by limitations can be revived by a written agreement signed by the obligor. Even though Rose was apparently unaware of the terms of the Agreement Incident to Divorce, the Court found that Rose was a third party beneficiary of this agreement and that it was sufficient to revive the debt. Thus, but for Irene and Scottie’s agreement to provide for Rose in their divorce, the debt would have been unenforceable and the court’s opinion would have been much shorter.

Having overcome the limitations defense, Rose still needed to prove one of the grounds for non-dischargeability which she alleged.

Fraud

The court had no trouble dispatching the fraud ground under Sec. 523(a)(2). There was simply no evidence that Irene had made a false representation at the time that the note was executed or that Rose had relied upon any false representation. Since Rose did not know about the Agreement Incident to Divorce, it was not possible for her to rely upon this agreement as a false representation. While Irene very likely made a false representation to Scottie, she wisely resolved her dispute with him.

This illustrates an important distinction between “fraud” in the popular sense and the legal sense. If I make a promise to pay you with the best of intentions and then later make a capricious and whimsical decision not to pay, even though I had the ability to do so, you would feel defrauded. However, legally this constitutes nothing more than a breach of contract. The essence of fraud is a false representation made with bad intent which is relied upon by the other party to their detriment. If the representation is originally made with good intent, all the subsequent bad faith in the world will not transform the original representation into fraud. Thus, where the original promise is made honestly and there is subsequent bad conduct, the plaintiff must be able to show a subsequent false representation which they relied upon.

In a series of informal dealings over a lengthy period of time, such as in this case, proving anyone’s intent at the outset is nearly impossible.

Fraud or Defalcation in a Fiduciary Capacity

Fraud or defalcation in a fiduciary capacity under Sec. 523(a)(4) did not present much difficulty either. A fiduciary under federal law requires a much higher standard than under state law. A federal fiduciary must be akin to a trustee. The mother-daughter bond simply does not rise to this level. Judge Kelly found that there were no other factors, such as control over Rose’s finances, which would give rise to a fiduciary relationship. An argument could have been made that the Agreement Incident to Divorce imposed trustee-like duties upon Irene with respect to the cashiers check which was later voided. However, this claim would have likely failed based on Irene’s unrebutted testimony that Rose gave her permission to use the funds.

Embezzlement

The claim for embezzlement failed for the reason that the funds from the real estate closing were never property of Rose. In order for embezzlement to take place, there must be an appropriation of another person’s property for the debtor’s benefit with fraudulent intent. Here, Irene exercised control over a cashiers check made payable to Rose. However, once again, the popular wisdom parts company with the legal test. Under Texas law, a cashier’s check remains the property of the person who purchased it until it is delivered. Judge Kelly found that because the check for $286,568.53 was never delivered to Rose, it was never her property. Thus, while it looks bad that Irene canceled out the check and didn’t give the funds to Rose, it didn’t constitute embezzlement.


Willful and Malicious Injury

Finally, Judge Kelly found that the claim for willful and malicious injury under Sec. 523(a)(6) failed. Of all the claims, this one appeared to have the greatest chance of success. If the court had believed that Irene had voided the cashiers check from the real estate closing for the purpose of harming Rose, then the court might have been able to find willful and malicious injury. However, Irene testified at trial that she had oral permission from Rose to void the check. This testimony came out on direct examination from Rose’s attorney and was not rebutted. As a result, the testimony stood without contradiction and was accepted by the court. The result might have been different on a claim by Scottie, since he was certainly harmed by the failure to pay Rose. However, he had already settled with Rose and Irene prior to trial.

Conclusion

This case shows why the bankruptcy discharge is an imperfect screen for unethical or immoral behavior. Some observers would probably conclude that Irene behaved badly, or at least selfishly. Despite the fact that she had received a huge sum of money from her parents and signed a written promise to pay, she always found other things to spend her money on when she had the opportunity. Her conduct in agreeing to repay her mom out of the Hawaii sales proceeds and then voiding the check appears to constitute double dealing. Thus, it could be argued that good lawyering and weak laws helped Irene escape her just desserts.

However, a counter argument can be made that this was much ado about nothing. Irene’s parents did not treat the “loan” like a business transaction. They apparently advanced funds first and documented the transaction later. According to Irene, the note was never intended to be collected, but would be used to adjust the sisters’ share of the inheritance later. As found by Judge Kelly, the note would have been barred by limitations and become unenforceable were it not for Irene and Scottie’s decision to include it in the Agreement Incident to Divorce. While the decision to void the cashier’s check looks bad, the unrebutted testimony about verbal consent supports an inference that the mother may have initially approved the transaction and then changed her mind.

This case is a good example of why informal dealings based on trust make for bad legal cases. Rose could have protected herself if she had tried to enforce the note when it matured or when she found out about the sale of the San Antonio property. She did not do so, perhaps hoping that her daughter would eventually do the right thing. Or perhaps she never intended to enforce the note at the time it came due and only changed her mind after the fact. The Court had an unenviable job in trying to sort all the sort out the mother-daughter brawl. However, the resulting opinion provides a good primer on the law of dischargeability.

Judge Kelly Finds 401k Loans Deductible Under Means Test

Judge Larry Kelly has recently held that 401k loans may be deducted in performing the chapter 7 means test. In re Otero, 06-30691 (Bankr. W.D. Tex. 11/2/06). BAPCPA expressly designates 401k loans as allowable expenses in chapter 13 cases. 11 U.S.C. Sec. 1322(f). However, there is not a similar provision with respect to the chapter 7 means test. Judge Kelly's ruling differs from a recent decision on this issue out of the Northern District. In re Barraza, 346 B.R. 724 (Bankr. N.D. Tex. 2006).

BAPCPA generally gives favorable treatment to retirement plans. Retirement plans loans have an exception from the automatic stay under Sec. 362(b)(19). Retirement plans are exempt up to $1 million under the federal exemptions pursuant to Sec. 522(d)(12). Retirement plan loans are non dischargeable under Sec. 523(a)(18). Finally, amounts withheld from the debtor's wages to be contributed to retirement plans are not property of the estate under Sec. 541(b)(7). However, while chapter 13 expressly allowed the deduction from disposable income, the chapter 7 means test under Sec. 707(b) was silent.

When this issue was argued to Judge Russell Nelms, the parties apparently framed the issue as to whether the payments could be deducted as "other necessary expenses." Judge Nelms found that they could not, but asked "why would Congress presume under section 707(b)(2)(A) that this amount of money could be used to pay unsecured creditors, and then deny unsecured creditors access to that money in chapter 13?"

However, Judge Kelly was asked to decide whether 401k loan payments could be deducted from the means test income as secured debts. While the U.S. Trustee argued that these "loans" were really just advances against the debtor's entitlement to receive retirement plan assets later, Judge Kelly concluded that they met the statutory definitions of secured debts.

Judge Kelly stated:

"The parties do not dispute that funds were advanced to the Debtors, that there exists documentation giving the plan administrator a 'lien claim' against the funds in the Debtors' 401K accounts, and that such accounts represent property of the Debtors. Each loan is therefore certainly a 'claim against property of the debtor' and so also a 'claim against the debtor,' which makes the interest of the plan administrator a 'security interest' against property of these Debtors. This court thus concludes that each loan is a 'secured claim' within the intendment of 11 U.S.C. Sec. 707(b)(2)(A)(iii)."

Judge Kelly's ruling follows an impeccable trail of statutory construction and harmonizes the Code's treatment of retirement plan loans. Not only is Judge Kelly's result right, but it is also the same argument made by this blog at the time that Barraza came out. http://stevesathersbankruptcynews.blogspot.com/2006/08/means-testing-opinions-strictly.html

Update:

The U.S. Trustee appealed Judge Kelly's decision and obtained an opinion from the U.S. District Court reversing it. McVay vs. Otero, 371 B.R. 190 (W.D. Tex. 4/26/07). The District Court looked at the same language as Judge Kelly and concluded that a loan against a 401k plan was NOT a debt, so that it could not be a secured debt deductible under the means test. In making this ruling,the District Court followed the majority position.

The Debtors did not further appeal the District Court ruling. Instead,they converted to Chapter 13 and proposed a plan which allowed them to deduct the 401k payments from disposable income. The Debtor's plan was confirmed on November 19, 2007. Under the confirmed plan, unsecured creditors will receive approximately 3% on their claims.

Interesting Opinion on Dischargeability of Student Loans

Judge Larry Kelly of the Western District of Texas has just written an opinion on dischargeability of student loans. This is must reading for anyone trying a case under Sec. 523(a)(8) because it is very comprehensive. A few interesting points.

Burden of Proof:

The conventional wisdom has been that the Debtor has the burden of proof on all issues in a student loan discharge case. However, in Ford v. Texas Higher Education Coordinating Board, Judge Kelly held that it is the creditor’s burden to prove (1) the existence of a debt (2) made for an educational loan and (3) made, insured or guaranteed by a governmental unit or made under any program funded in whole or in party by a governmental unit or nonprofit institution. If the creditor meets its burden, then the debtor must prove that excepting the debt from discharge will impose an undue hardship. This poses an interesting conundrum. What happens if neither side offers any evidence? Does it mean that the debtor automatically wins, since the creditor did not meet its burden? I think that Judge Kelly has it right. There are two different ways that a student loan might be dischargeable. The first is if one of the elements of non-dischargeability is not present. For example, if the debtor ran up a big tab to Starbucks for coffee which enabled her to study, his would arguably an educational loan (or at least a loan for educational purposes). However, since it was not made, insured or guaranteed by a governmental unit or non-profit it does not meet the first test. The second way for it to be dischargeable would be if undue hardship was shown. This raises a pleading issue. If the debtor alleges that the first part of the test is met, then the debtor would be judicially estopped from denying that the creditor had met its burden. However, if the debtor disputes it in a clear case, debtor’s counsel may violate Rule 9011.

The Bruner Test

Judge Kelly found that Bruner v. New York Higher Education Services Corp., 831 F.2d 395 (2nd Cir. 1987) applies. Several years ago in In re Speer, 272 B.R. 186 (Bankr. W.D. Tex. 2001) Judge Monroe had questioned whether Bruner was good law in the Fifth Circuit. Since that time, the Fifth Circuit has adopted Bruner, which is a shame because it imposes a very high standard. The Fifth Circuit opinion is In re Gerhardt, 348 F.3d 89 (5th Cir. 2003).

Applying Bruner

Bruner has three prongs: (1) that the debtor cannot maintain a minimal lifestyle if forced to repay the loans; (2) that additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period and (3) that the debtor has made good faith efforts to repay the loans.

In this case, the Debtor ran up $250,000 in loans attending Texas Lutheran College (my alma mater) and St. Mary’s Law School. Apparently St. Mary’s is very expensive. Unfortunately, she was not able to pass the bar. She worked at a series of progressively better jobs but capped out at $45,000.

Judge Kelly found that the third prong was satisfied despite the fact that the debtor had never made a payment and had not applied to the Ford Federal Direct Loan Program. The court found that it is not bad faith to fail to make payments if you don’t have any money to make them with. Further, the debtor had explored avenues to receive help from elected officials and charitable organizations.

However, Judge Kelly found that the second prong was not present. According to the Fifth Circuit, this prong requires proof that the debtor has a total incapacity in the future to pay his debts for reasons not within his control. The additional factors that the Fifth Circuit said could apply would be psychiatric problems, lack of usable job skills and severely limited education. It would appear that some of these factors were arguably present. The debtor had gotten depressed and attempted suicide in 2002 and she was not able to use her education for its intended purpose. However, the pro se plaintiff showed herself to be highly educated and well-spoken; she presented her claims in an organized manner with supporting documentation and made a good presentation of her position. Normally, this would be high praise. However, here it spelled defeat when combined with her continuous employment.

The message here is that Bruner requires something much more than persistent inability to pay. To paraphrase the old Saturday Night Live sketch, the person has to end up living in a van down by the river (which was very close to the facts in Judge Monroe’s Speer case).

Because the Court found that the second prong was not satisfied, it never reached the first prong.

Constitutionality

At trial, the Debtor tried to argue that Sec. 523(a)(8) was unconstitutional. If you are going to make this request, be sure to include it in your pleadings and also be sure to join the Attorney General of the United States as a party. Trying to make a trial amendment on a constitutional issue is not a good idea and was not successful here.

The judgment in this case is located at http://www.txwb.uscourts.gov/opinions/opdf/05-06023-lek_Ford%20v.%20Sallie%20Mae%20Servicing%20et%20al.pdf. However, to get the opinion, you will need to go on to PACER at https://ecf.txwb.uscourts.gov/cgi-bin/login.pl?315066890217586-L_786_0-1 (PACER registration required).