Bankruptcy Court Predicts Fifth Circuit Will Adopt Broad View of Statement of Financial Condition

Section 523(a)(2) is a Code section which is very familiar to most experienced practitioners, but still can be tricky. In particular, the distinction between statements regarding financial condition and all other fraudulent statements has prompted disagreement among the courts. A new opinion from Judge Craig Gargotta predicts that the Fifth Circuit would join the minority position on this issue. Material Products International, Ltd. v. Ortiz, No. 09-1062 (Bankr. W.D. Tex. 8/27/10). You can find the opinion here.

There are three types of fraudulent statements under 11 U.S.C. Sec. 523(a)(2):

1. Statements which are not made "respecting the debtor's or an insider's financial condition" which are actionable under Sec. 523(a)(2)(A);

2. Written statements "respecting the debtor's or an insider's financial condition" which are actionable under Sec. 523(a)(2)(B) and have a higher reliance standard; and

3. Verbal statements "respecting the debtor's or an insider's financial condition" which cannot form the basis for a non-dischargeability complaint based on fraud.

Because the distinction between statements about the debtor or an insider's financial condition and all other statements is significant, it is important to know what a "statement respecting the debtor's or an insider's financial condition" means.

The majority opinion, as represented by the Tenth Circuit's opinion in In re Joelson, 427 F.3d 700 (10th Cir. 2005), holds that only statements which concern a debtor's overall financial condition, that is, are the equivalent of a financial statement, will be subject to the restriction. The minority position holds that "financial condition" is broader than simply a financial statement and that statements regarding an individual asset may qualify.

In the Ortiz case, the creditor alleged that the Debtor had lied about whether equipment at a restaurant was free of liens. (The restaurant was located in my neighborhood and I ate there once. There was nothing about the food which indicated that it was or was not subject to prior liens). The creditor's complaint alleged the elements of Section 523(a)(2)(A) and quoted the statute. The complaint did not reference Section 523(a)(2)(B). The debtor filed a motion for judgment on the pleadings under Rule 12(c).

The court ruled that whether the equipment was subject to prior liens was a statement regarding financial condition. Thus, it could not be brought under Sec. 523(a)(2)(A). Although the Fifth Circuit has not ruled on this issue, the Court found the Fifth Circuit's opinion in In re Mercer, 246 F.3d 391 (5th Cir. 2001) to be instructive. Judge Gargotta wrote:

The parties readily agree that the Fifth Circuit has not addressed this issue. That said, the Court agrees with the Defendants that the Fifth Circuit’s opinion in AT&T Universal Card Svcs. v. Mercer (In re Mercer), 246 F.3d 391, 405 (5th Cir. 2001) is suggestive of how the Fifth Circuit might rule.

The Court agrees with the Defendants’ assertion that while it has not expressly addressed the scope of a “statement respecting a debtor’s or insider’s financial condition,” the Fifth Circuit Court of Appeals’s decision regarding the applicability of § 523(a)(2) to credit card use is consistent with the broad interpretation of that phrase. Under that approach, courts have included statements that reflect on the debtor’s ability to pay as statements respecting a debtor’s financial condition. See Mercer, 246 F.3d at 405 (5th Cir. 2001) (noting that “if [credit] card-use could be understood as a representation not only of intent, but also ability, to pay, the latter is not actionable under § 523(a)(2)(A); as noted, it excludes from its scope ‘a statement respecting the debtor’s . . . financial condition.’”) (emphasis and footnote omitted); (additional citations omitted).

Therefore, as a matter of law, taking all Plaintiff’s allegations in the Complaint as true, Plaintiff cannot show that the claim is non-dischargeable under § 523(a)(2)(A) as it alleges, and the Defendants are entitled to judgment on the pleadings denying the Plaintiff’s cause of action requesting that the claim be declared non-dischargeable.

Ortiz, slip op. at 15-16.

This opinion is significant because Judge Gargotta adopted the minority position. By taking a broad view of what constitutes a statement of financial condition, the Court has given creditors a higher burden of both pleading and proof. When in doubt about whether a representation is a statement of financial condition, it is better to plead both subsections (A) and (B) in the alternative.

All About Emails, Texts, Blogs and Non-Dischargeability

On February 3, 2010, Judge Jeff Bohm released his opinion in Wallace v. Perry, 423 B.R. 215 (Bankr. S.D. Tex. 2/3/10), opinion available with PACER access here. Following a twelve day trial, the court penned a 118 page opinion. The opinion is an interesting study in how to try a dischargeability case and just how bizarre relations between partners can get. I was going to do several short posts on this opinion. However, the subject matter is so inter-related that I am going to do it in one long article. The topics that I will be focusing on are getting the right parties, creative use of Sec. 523(a)(6) and dischargeability in the electronic age.

Background

Judge Bohm made extensive fact findings, some of which are summarized here.

Will Perry, Costa Bajjali and the Wallace Trusts became partners in W.C. Perry Partners, L.P. in 2004 and 2005. The Wallace Trusts were two trusts formed for the daughters of David Wallace. Perry, Bajjali and Wallace all worked in different aspects of the partnership. Wallace also served as mayor of Sugar Land. The partnership received substantial investments from third parties, including the clients of a talk radio host.

The relationship between the partners did not go well. Bajjali and Wallace were unhappy that Perry would spend his afternoons at the movies instead of working and that he often made decisions without consulting them. Perry complained that Wallace's political activities had become a liability to the partnership and accused Bajjali of lurching at him in the office kitchen. Perry decided that he needed a bodyguard to protect him from his partner. Perry sent an email canceling all partnership meetings.

In an attempt to smoke out his partners, who he thought were secretly reading his emails, he sent his assistant an email stating that he intended to file bankruptcy and leave them with nothing.

Subsequently, he agreed to buy out his partners and indemnify them from any liabilities. He also agreed to a liquidated damages clause if he did not use his best efforts to get them released from their guarantees.

Having parted ways with his partners, Mr. Perry started a smear campaign against them. He told others that he had removed them from the partnership because they were dishonest and incompetent. He also asserted that they were receiving kickbacks and stealing funds from the partnership. Perry sent a mass email to the Sugarland Rotary Club telling them not to associate with Bajjali or Wallace. Perry also had his assistant print out copies of a blog accusing Wallace of unethical conduct and distribute them anonymously.

The allegations took a toll on Wallace who was then running for Congress. The Fort Bend Republican Party returned a contribution he made and forbade him from introducing the speaker at the Lincoln-Reagan Dinner. He was also asked not to speak at the Gathering of Men, a faith-based men's group. Wallace was unsuccessful in his Congressional race.

After Perry Properties crashed and burned, Bajjali and Wallace spent $3.78 million to restructure the debts they had guaranteed.

Perry filed for chapter 11 bankruptcy and a non-dischargeability action ensued.

It's Hard to Party Without the Right Parties

David Wallace, Costa Bajjali and the Wallace Trusts each brought non-dischargeability claims based upon failure to honor the indemnification and non-disparagement clauses of the Purchase Agreement. However, Wallace and the Trusts found themselves in a catch-22 situation.

The Trusts were parties to the Purchase Agreement. However, Judge Bohm ruled that under Texas law, a trust lacks capacity to sue or be sued. Instead, only the trustee may sue or be sued on behalf of the trust. If the trustee abrogates his duty, a beneficiary may sue. However, David Wallace, the only natural person named was neither the trustee of the trusts nor a beneficiary. Thus, he could not sue on behalf of the trusts and the trusts could not sue on their own behalf.

Wallace also was unable to recover under the non-disparagement clause. The clause applied to the parties to the agreement and their "affiliates." The Court found that an affiliate was a person who controlled or was controlled by a party or an officer, director, partner, employee or relative of a party. Wallace did not control the trusts nor was he controlled by them. While he was a relative of the beneficiaries of the trusts, he was not a relative of the trusts themselves. Therefore, he was not an affiliate and could not recover.

The problems with parties here raise several important points. When the Purchase Agreement was drafted, it referred to the "Sellers," being Bajjali and the Trusts. However, despite the fact that the trusts were the partners, Wallace had a very direct involvement in the partnership. Careful drafting could have prevented this problem.

The difficulty with the trusts is more baffling. While the capacity of a trust to sue or be sued is not obvious, it must have been raised in the pleadings in order for the court to have addressed it in the opinion. If the issue was raised prior to trial, it should have been possible to substitute the trustee in as the real party in interest.

Creative Use of Section 523(a)(6)

Section 523(a)(6) allows non-dischargeability of debts for willful and malicious injury. While the language used suggests physical injury or at least tort claims, the statute is much broader and can be applied to a wide variety of injuries, including injuries arising from breach of contract.

In this case, the plaintiffs brought suit under Sec. 523(a)(2), (a)(4) and (a)(6). However, the court struck the claims under 523(a)(2) and (4) based on misconduct of the plaintiff's original counsel, leaving them to proceed solely under Sec. 523(a)(6).* The plaintiffs had two types of claims: claims for failure to honor the indemnification clause and claims for defamation. While it is easy to see how defamation can fall under Sec. 523(a)(6), a claim for willful and malicious breach of a contractual obligation to indemnify seems like more of a reach.

*Note: The Court was quick to point out that Plaintiff's trial counsel Johnnie Patterson was not responsible for the conduct that led to the pleadings being struck. The court stated, "Mr. Patterson's conduct throughout his representation of the plaintiffs was exemplary, as was the conduct of counsel for the defendant, John W. Wauson."

In this case, the plaintiff provided the defendants with evidence that his breach of contract was not just inadvertent, but was intended to harm the defendants.

In the "trick" email which Perry sent to his administrative assistant prior to execution of the Purchase Agreement, he stated:

I wanted to let you know that I am going filing bankruptcy per my attorneys advice. Please do not worry as this is part ofmy big plan I am going to be hatching this week. Dave [Wallace] and Costa [Bajjali] think they can pull the wool over my eyes they have no idea what is about to happen and I just love it. They [Wallace and Bajjali] will walk away with nothing after this week and oh Dave [Wallace] can kiss his political career goodbye. Costa [Bajjali] will be getting all the blame plus a hell of a lot of debt. The master is at work and I have them by there balls. Costa should have never sided with Dave.

While Perry later claimed that he sent this email in order to catch his partners reading his email, the court found that it betrayed his true intentions.

He also told another business associate "don't **** with me, I will destroy you like I did David Wallace."

He also stated that he wanted to cause Bajjali to incur a lot of debt and did not intend to pay him a dime.

Based on this evidence, the court found that Perry had actual subjective intent to harm Bajjali and knew with substantial certainty that his actions would cause harm. As a result, Bajjali was entitled to recover $3.78 million in damages incurred with regard to the indemnification clause.

The plaintiffs also brought defamation claims which were a more traditional use of Sec. 523(a)(6). The most interesting facet of the defamation claims concerned Perry's distribution of a blog written by someone else. The Rhymes With Right blog (www.rhymeswithright.mu.nu) wrote a post about Wallace which described him as "unethical, corrupt and not fit to represent the GOP." The blog post amounted to disorganized ramblings which imputed that Wallace was involved in arms dealing and attempts to overthrow governments. The Court found that the blog posting was defamatory. However, the Court also found that Perry did not write the blog or contribute to it.

However, the Court found that under Texas law, a person is liable for defamation if he "publishes" the defamatory statement. A statement in an email constitutes a publication. The Court found that emailing a link to the blog to a third party and instructing his assistant to print out the blog and distribute it constituted publication.

The court also found that statements with regard to kickbacks, "gross fraud," "serious crimes" and extortion were defamatory.

The Court found that the statements constituted defamation per se. As a result, the plaintiffs were able to recover without proof of specific damages. The Court awarded both actual and exemplary damages.

A Few Thoughts About Evidence in the Electronic Age


In this case, Will Perry got into trouble by shooting off his mouth. However, the evidence included texts, emails and blogs. The risk posed by electronic communications is that (i) the speaker will unleash his raw, unvarnished thoughts without any self-censorship and (ii) there will be a tangible record of those statements.

The "trick" email was probably the most damaging piece of evidence against Perry. This was an act of macho boasting to his administrative assistant. If it hadn't been sent in email form, there would not have been any record of it. The Court's extensive discussion of the credibility of the witnesses (discussed here) illustrates the fallibility of human memory. However, by incriminating himself in an email, Perry placed himself in the position of having to invent an unbelievable rationalization for his words.

The blog also deserves some discussion. Rhymes With Right is written by "Greg," a 40-something teacher from Seabrook, Texas according to his profile. Much of it consists of right-wing rants. However, for some reason, "Greg" developed a deep dislike for Dave Wallace. According to Judge Bohm, his writings were defamatory. When Perry distributed it, he probably didn't think that he was making a defamatory statement. Instead, he was merely providing third party confirmation. The irony here is that the anonymous blog poster escaped liability while the passer-on did not. However, Perry would not have been held liable were it not for the raft of other evidence concerning his irrational hatred toward his former partner. The lesson here is that just because you read something on the internet doesn't make it safe for publication.

Final Thoughts

It is said that the most dangerous cases are those with Exes, ex-spouses, ex-partners and so on. A bad break-up triggers enough negative emotions to overwhelm rational thought. That is not a good thing when the person on the other side knows where the bodies are buried. This was just such a case. Despite the other side's failure to name the right parties and failure to cooperate in discovery, the defendant still ended up with a non-dischargeable judgment for $4 million give or take. The debtor's self-righteous anger fueled by excessive testosterone ultimately proved to be destructive for him.

Tchaikovsky's Overture: How an Unremarkable Case Took on a Life of Its Own

Peter Tchaikovsky's 1812 Overture ends with a cannonade. Some commentators have viewed a recent opinion from Bankruptcy Judge Leslie Tchaikovsky as a cannon shot aimed at the irresponsible practices of the home mortgage industry. However, what is most remarkable about National City Mortgage vs. Hill, No. 07-4106 (Bankr. N.D. Cal. 5/28/08) is how unremarkable the opinion is.

The Opinion

In the Hill case, the debtors purchased a home for $220,000 twenty years ago. By the time that they filed bankruptcy, they had incurred debt of $683,000 against the house, including a second lien debt to National City Mortgage for $250,000. However, the debtors' combined income never exceeded $65,000.

When the debtors first applied for a loan with National City Mortgage in April 2006, they stated that their combined income was $145,716 on an annual basis. Six months later, they asked the bank to increase their Home Equity Line of Credit from $200,000 to $250,000. This time they stated their income as $190,800 on an annual basis. The bank either did not notice or did not care that the debtors were asserting that their income had increased by $45,000 per year in the span of just six months.

After the debtors filed for chapter 7 bankruptcy in April 2007, the first lienholder foreclosed and the second lien to National City Mortgage was wiped out. National City Mortgage brought a dischargeability action based on submitting a false financial statement under 11 U.S.C. Sec. 523(a)(2)(B). The court had little trouble finding that the first five elements of the claim were established. The debtors had made knowingly made a false financial statement with intent to deceive the lender. However, the court found that the element of reasonable reliance was missing.

Section 523(a)(2)(B) is unusual in that the statutory language expressly requires that reliance on a false financial statement be reasonable. This contrasts with Section 523(a)(2)(A) which states that debts based upon fraud are non-dischargeable but does not spell out the standard for reliance. The Supreme Court has said that reliance must be "justifiable" under Sec. 523(a)(2)(A), which is a lesser standard than "reasonable." Field v. Mans, 516 U.S. 59 (1995)("While the Court of Appeals followed a rule requiring reasonable reliance on the statement, we hold the standard to be the less demanding one of justifiable reliance, and accordingly vacate and remand."). Thus, Congress required a higher level of reliance on written statements of financial condition.

Judge Tchaikovsky set out the standad for reasonable reliance as follows:

Whether the creditor reasonably relied on the materially false statement under Sec. 523(a)(2)(B) is measured objectively by the degree of care exercised by a reasonably cautious person in the same transaction under similar circumstances. (citation omitted). Absent other factors, a creditor's reliance on a statement of financial condition is reasonable if it followed it normal business practices. (citation omitted). Other factors that may affect whether the creditor's reliance on its own standard lending practices is reasonable include the standards of the creditor's industry in evaluating creditworthiness, and the existence of any "red flags" that would alert the reasonably prudent lender of the possibility that the information was inaccurate. (citation omitted).

Memorandum of Decision at 8.

This was what is known as a stated income loan. According to the creditor's own guidelines, it did not require verification of income. However, it did require that an independent contractor verify that the amount stated was reasonable and that for a self-employed person that the borrower provide a copy of the borrower's business license, a copy of a bank statement showing a balance equal to 1/10 of the stated annual income or a letter from a CPA verifying the existence and ownership of the business. The Court found that the lender did not follow its own guidelines. There was no evidence that a third party contractor had verified that it was reasonable for an auto parts manager in the San Francisco Bay area (the husband) to earn $98,112 on an annual basis. While the wife submitted a letter on a CPA's letterhead with regard to her sole proprietorship, the person who signed the letter was not the CPA. Thus, the bank failed to follow its own guidelines. The Court also found that the bank ignored obvious red flags. In April 2006, the debtors claimed that Mr.Hill's income was $98,112 and that Mrs.Hill's income was $47,604. However, in October 2006, the debtors claimed that Mr. Hill's income was $67,200 (a 33% drop) and that Mrs. Hill's income was $123,600 (a 300% increase). Reasonable minds would have wondered about such a dramatic fluctuation in income, but the bank apparently did not.

In denying the complaint, the court concluded:

Based on the foregoing, the Court concludes that either the Bank did not rely on the Debtors representations concerning their income or that its relaiance was not reasonable based on an objective standard. In fact, the minimal verification required by an 'income stated' loan, as established by the Guidelines, suggestes that this type of loan is essentially an 'asset-based' loan. In other words, the Court surmises that the Bank made the loan principally in reliance on the value of the collateral: i.e., the House. If so, the Bank obtained the appraisal upon which it principally relied in making the loan. Subsequent events strongly suggest that the appraisal was inflated. However, under these circumstances, the Debtors cannot be blamed for the Bank's loss, and the Bank's claim should be discharged.

Memorandum of Decision at 13.

The Response

While the opinion was rather unremarkable, one line in it drew a lot of attention. Near the beginning of the opinion, the Court stated, "This adversary proceeding is a poster child for some of hte practices that have led to the current crisis in the housing market." Memorandum of Decision at 2. According to one blogger who wrote the day after the opinion was released, "This is a big deal, and will no doubt strike real fear in the hearts of stated-income lenders everwhere." BK Judge Rules Stated Income HELOC Debt Dischargeable, http://calculatedrisk.blogspot.com/2008/05/bk-judge-rules-stated-income-heloc-debt.html. This comment was picked up on and repeated by dozens of bloggers. The Wall Street Journal ran a story with the headine "Are borrowers free to lie?" Amir Efrati, "Are Borowers Free to Lie?," Wall Street Journal, May 31, 2008, p. B2. An article on MSN Money on June 30, 2008 amplified the story, claiming that, "In a little-noticed decision, U.S. Bankruptcy Judge Leslie J. Tchaikovsky let a California couple off the hook for debt they owed their home-equity lender because the incomes they had listed on their applications were obvious "red flags" that the lender had ignored." Liz Pulliam Webster, "Lenders create a bankruptcy monster," http://articles.moneycentral.msn.com/Banking/BankruptcyGuide/
LendersCreateABankruptcyMonster.aspx?page=1.

By this point, the focus on the legal definition of reasonable reliance had been lost. From the comments being circulated, it appeared that a crazy bankruptcy judge had declared war on the stated-income lenders, was countenancing lying by debtors and was letting borrowers off the hook for their misdeeds. One email which I received from a colleague asked me if I had heard about a case “in which the good judge held that despite the mendacity of the debtors, Mr. and Mrs. Hill (In Re Hill), National City Bank could not enforce, post petition, a home equity type of loan against the debtors post discharge.” He asked “Is this a case that you are aware of?” However, the debtors were not let off the hook. They lost their home of 20 years. What they did get was a discharge, something that debtors are entitled to if their creditors do not object or do not prove an exception to discharge.

We have been through this before. During the 1990s and early years of the 2000s, credit card lenders made a concerted effort to object to dischargeability in cases where debtors irresponsibly ran up their credit card debt. Many of these decisions focused on reliance or the lack thereof. E.g., In re Mercer, 246 F.3d 391 (5th Cir. 2001)(no reliance where creditor sent debtor pre-approved credit card);In re Eashai, 87 F.3d 1082 (9th Cir. 1996)(reliance justifiable where no red flags appeared).

In one noteworthy case, the court stated:

There is no reliance in this case. There is not even a scintilla of reliance in this case. . . .

The Plaintiff's extension of credit to the Defendant in this case was a result of their own negligent lending practices and the industry's negligent use of a faulty FICO score system which has been engineered to create the greatest amount of credit for the greatest number of working people in this country with artificially low monthly repayment requirements so that credit card companies can make the greatest amount of interest and profits possible. Losses such as this are simply a cost of doing business in such a greedy manner.

In re Akins, 235 B.R. 866, 874 (Bankr. W.D. Tex. 1999).

As long as lenders continue to make high risk loans, it is inevitable that some borrowers will default and file bankruptcy. If the loss results from the lender's own negligence, the debt will be dischargeable. This is nothing remarkable.

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.

Don't Mess With Judge Jernigan

Stacey Jernigan is both the newest and the youngest bankruptcy judge in the State of Texas. However, in a recent opinion she made it clear that she is not one to be fooled by clever lawyers.

In Baker v. Sharpe, Adv. No. 06-3208 (Bankr. N.D. Tex. 9/28/06), a male debtor dressed to impress as he persuaded a recent divorcee to loan him large amounts of money. Having run through her money, he then filed chapter 7. She then sued to establish a non-dischargeable debt under Sec. 523(a)(2)(A) and 523(a)(6). The only problem was that most of her case revolved around verbal and implied statements concerning his solvency (including his statement that he could pay her out of the money he was hiding from his current wife).

Section 523(a)(2) draws a careful dichotomy between fraudulent statements of financial condition and other fraudulent representations. Section 523(a)(2)(A) expressly excludes statements of financial condition from its scope, while Section 523(a)(2)(B) only applies to written statements of financial condition. Thus, verbal statements of financial condition can never form the basis for a dischargeability action (at least not under Sec. 523(a)(2)).

The clever plaintiff's attorney tried to conceal this distinction from Judge Jernigan by omitting a few words when quoting the statute.

Judge Jernigan was not fooled. In a footnote, she stated:

"Indeed, Ms. Baker--or at least her attorney--knew there was this very large flaw in her argument, for in the Plaintiff's Brief in Support of Non-Dischargeability of Indebtedness Under Sec. 523(a)(2)(A) and (a)(6) filed with this court in advance of trial, the plaintiff quoted Section 523(a)(2)(A), but left out, with the convenient use of an ellipsis, the critical phrase 'other than a statement regarding the debtor's or an insider's financial condition.' Thankfully, the court has several copies of the Bankruptcy Code handy so it could consult the entire statutory provision in addressing this this question."

Memorandum Opinion, p. 26, n. 13 (emphasis added).

It is good to know that in these days of budgetary shortfalls that bankruptcy judges have not just one but several copies of the Bankruptcy Code available for use.

With the vigilant eye of the judge to protect him, the pro se defendant prevailed.

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).