Tag Archives: fraud

June 21, 2016

Supreme Court Expands Creditors’ by Allowing Denial of a Discharge Under Sec. 523(a)(2)(A) if Debtor Transfers Assets in Violation of State Fraudulent Transfer Statute

Section 523(a)(2)(A) of the Bankruptcy Code allows a creditor to obtain a judgment denying its debtor a discharge of debts incurred by false pretenses or actual fraud. However, if the debt itself was not incurred by actual fraud, but the debtor subsequently transfers his assets with the intent prevent its creditors from obtaining payment, may the creditor still obtain a judgment denying the debtor’s discharge under § 523(a)(2)(A)? The United States Supreme Court answered that question in the affirmative in its recent decision in Husky International Electronics, Inc. v. Ritz, 2016 WL 2842452 (2016).

Chrysalis Manufacturing Corp. incurred a debt to Husky International arising from Chrysalis’s purchase from Husky of components used in electronic devices. Over a period of four years, Chrysalis incurred a debt to Husky totaling over $160,000. There was no contention that this debt was incurred as the result of false representations or actual fraud. However, during the latter part of this same period, Daniel Ritz, a director and owner of Chrysalis, caused Chrysalis to transfer virtually all its assets to other companies Ritz also controlled. Husky sued Ritz under a Texas statute which allows creditors to hold shareholders responsible for corporate debts under circumstances involving actual fraud. After Ritz filed a personal bankruptcy petition under chapter 7, Husky brought an adversary proceeding against him seeking denial of the dischargeability of its debt under § 523(a)(2)(A). The District Court concluded the Ritz was liable under the Texas statute but also concluded that the debt was not obtained by actual fraud could be discharged. The Fifth Circuit affirmed, agreeing the debt could be discharged since it was not incurred by actual fraud as required by § 523(a)(2)(A).

The Supreme Court reversed, holding the term “actual fraud” in § 523(a)(2)(A) “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.”

The Court commenced its analysis by first looking to the prior Bankruptcy Act, which prohibiting debtors from discharging debts obtained by false pretenses or false representations, but contained no provisions relating to situations which might constitute “actual fraud” but not fall within the meaning of false pretenses or false representations. Congress added the term “actual fraud” when it enacted the Bankruptcy Code in 1978. The addition of the words “actual fraud” were presumed by the Court to have “real and substantial effect.” The Court believed the words “actual fraud” were intended to mean something other than “false representation.” The Court then analyzed the historical meaning of the terms “actual fraud” and concluded the words have long included the type of fraudulent transfer scheme in which Ritz engaged. First, the Court noted the word “actual” has a simple meaning in the common law, and denotes any fraud that “involves moral turpitude or intentional wrong,” and stands in contrast to implied fraud or fraud in law. The Court stated “Thus, anything that counts as ‘fraud’ and is done with wrongful intent is ‘actual fraud.’”

The Court found analyzing the history of the word “fraud” to be more challenging, and although it “connotes deception or trickery generally,” was more difficult to precisely define. However, the Court noted the term “fraud” had long been used by courts to describe a debtor’s transfer of assets which impairs a creditor’s ability to collect a debt. The Court further noted that fraudulent conveyances at common law did not require a misrepresentation by a debtor to his creditor. The fraudulent conduct was not in inducing the creditor to extend credit but rather was in the act of concealment and hindrance. As a result, the Court determined the actual fraud need not be present at the inception of a credit transaction.

March 1, 2016

Tenth Circuit Holds Default Judgments for Violations of Securities Laws Must be Given Preclusive Effect in Non-dischargeability Actions Under Section 523(a)(19)

The Tenth Circuit has in the past refused to give preclusive effect in bankruptcy non-dischargeability actions brought under § 523(a)(2) to pre-petition default judgments arising from claims of actual fraud. In re Jordana, 216 F.3d 1087 (10th Cir. 2000). However, the Tenth Circuit recently held that this refusal does not extend to pre-petition default judgments based on violations of securities laws where the claim for non-dischargeability is brought under § 523(a)(19), and that such judgments must be given preclusive effect for purposes of denying the dischargeability of the debt. Tripoldi v. Welch et al, 810 F.3d 761 (10th Cir. 2016).

Robert Tripoldi brought an action in the U.S. District Court for the District of Utah against Nathan Welch and others alleging violations of state and federal securities laws. Welch answered the complaint, but during the course of the litigation, his attorneys withdrew and Welch never retained new counsel. Eventually, the trial court issued a default judgment against Welch. Welch subsequently filed a chapter 7 bankruptcy petition, and then filed motions with the district court to set aside the default judgment and grant judgment on the pleadings in Welch’s favor. Tripoldi filed a motion with the district court to declare the pre-petition default judgment non-dischargeable under § 523(a)(19). The district court denied Welch’s motions and granted Tripoldi’s.

On appeal, after determining the district court did not abuse its discretion in entering the default judgment or in denying the motion to vacate it, the Tenth Circuit then turned to the issue of whether the default judgment could be the basis for a denial of discharge under § 523(a)(19). Welch argued that a default judgment should not be the basis for the denial of a discharge, relying on the Tenth Circuit’s prior opinion in Jordana. The Tenth Circuit disagreed, and noted what it considered to be significant differences between § 523(a)(2) and § 523(a)(19). The court stated that it declined to extend its reasoning in Jordana to default judgments based on violations of securities laws because § 523(a)(2) and § 523(a)(19) “have different requirements and different purposes.” The court placed great importance on the fact that § 523(a)(19) contains the specific requirement that the debt be memorialized in a “judgment, order, decree or settlement agreement” stemming from a violation of securities laws, whereas § 523(a)(2) contains no such requirement. The court also that Congress, in enacting § 523(a)(19) to include the requirement of a judgment, intended to close what it perceived to be a “loophole in the law.” The noted its decision was consistent with those of two other courts to rule on the issue: In re Pujdak, 462 B.R. 560 (Bankr. D. S.C. 2011) and Meyer v. Rigdon, 36 F.3d 1375 (7th Cir. 1994) (interpreting § 523(a)(11) which contained a similar requirement).

February 16, 2016

Seventh Circuit Finds Suspicion, Negligence and Ineptitude Sufficient to Defeat a Claim that a Transferee Received a Fraudulent Transfer in Good Faith, but Insufficient to Equitably Subordinate the Transferee’s Claim

Section 548(c) of the Bankruptcy Code entitles the recipient of a fraudulent transfer in certain circumstances to retain a lien on the property received through the debtor’s fraud if the transferee took the property in good faith and for value. The Seventh Circuit recently, In addressing a case where the bankruptcy trustee asserted the recipient of a fraudulent lien did not take in good faith and its claim should be equitably subordinated to unsecured claims, held suspicion, negligence and ineptitude on the part of the claimant to be sufficient to defeat the recipient’s claim that it acted in good faith but insufficient to equitably subordinate the claim. Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), 809 F.3d 958 (7th Cir. 2016).

In Sentinel, the debtor was a cash management firm which borrowed money from BNYM to funds its operations. Sentinel received money from its customers, which it used to purchase securities for its customers and which it was required by law to maintain in segregated accounts separate from the accts which Sentinel used for its own trading. Sentinel had a capitalization of less than $3 million, but also had securities it had purchased for its customers’ accounts which exceeded $300 million. When securities markets became shaky in the summer of 2007, Sentinel found itself unable to meet both its collateral levels with the bank and its customers’ requests to redeem their securities. Sentinel embarked on a scheme under which it borrowed on its line of credit with the bank to meet its customers’ redemption demands, and transferred its customers’ securities from their segregated accounts into Sentinel’s personal accounts on which the bank held a lien. By transferring customer securities to accounts on which the bank held a lien, Sentinel violated federal law. When Sentinel filed bankruptcy, a dispute arose between the bank and the trustee over whether the bank received its lien in good faith or whether the trustee could avoid the lien under § 548. The district court ruled in favor of the bank, finding the bank’s actual belief that Sentinel had not pledged the securities in question without its customers’ consent, was sufficient to establish it acted in good faith. The Seventh Circuit reversed.

The Seventh Circuit stated the district court’s conclusion was wrong. The court held that inquiry notice, which it defined as “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing,” prevents the recipient of a fraudulent transfer from the protections afforded a good faith transferee. The court further stated “inquiry notice is not knowledge of fraud or other wrongdoing but merely knowledge that would lead a reasonable, law-abiding person to inquire further—would make him in other words suspicious enough to conduct a diligent search for possible dirt.” As a result, an actual belief that the transfer is not fraudulent is insufficient if the recipient has knowledge of facts which place him on notice that further investigation is warranted. In this instance, the fact that the debtor’s capital was less than $3 million yet it had the ability to post $300 million of collateral to secure its debt to the bank, were sufficient to place the bank on notice that the debtor was using someone else’s property to collateralize the loan. A memo from a bank employee who worked on the Sentinel account to the bank evidencing “puzzlement” at the source of the collateral and a suspicion that the collateral was owned by parties other than the debtor, was sufficient to require additional investigation on the bank’s part. As a result, the court held the bank did not qualify as a good faith transferee with respect to its lien on securities owned by the debtor’s customers.

The next question before the court was whether the bank’s conduct was sufficient to warrant equitable subordination of its unsecured claim to claims of general unsecured creditors. The trustee argued that the same conduct which prevented the bank from being considered a good faith transferee was sufficient to warrant equitable subordination of its claim. The court disagreed, stating that, while mere negligence or ineptitude may be sufficient to place a transferee on inquiry notice for purposes of a good faith defense, they are insufficient to warrant equitable subordination under § 510(c)(1). In order to warrant equitable subordination, the court held the transferee’s conduct must not only be inequitable but “seriously so,” using the words “egregious,” “tantamount to fraud” and “willful” as the type of conduct required. The bank should have suspected something was amiss, and that was sufficient to eliminate its good faith defense, but because the trustee did not establish the bank knew Sentinel had pledged its customers’ securities without their consent, the court found there was insufficient evidence to equitably subordinate the bank’s unsecured claim.

June 9, 2015

Seventh Circuit Holds that a Debt Created by Fraud may be Discharged if the Fraud was Perpetrated by the Debtor’s Agent, so long as the Debtor was not Complicit in the Fraud

In the case of Sullivan v. Glenn (In re Glenn), No 14-3213 (7th Cir. 2015), the Seventh Circuit Court of Appeals held that a debt which was incurred as a result of fraud perpetrated by the debtor’s agent is dischargeable, so long as the debtor was not complicit in the agent’s fraudulent conduct.  The facts involved a loan made by Brian Sullivan to the Glenns through the actions of a loan broker by the name of Karen Chung.  Chung and Sullivan knew each other.  In fact, Sullivan, an attorney, had represented Chung on more than one occasion.  In this transaction, however, Chung acted as the agent of the Glenns in seeking a bridge loan of $250,000 pending the closing of a bank loan for $1,000,000.  Chung convinced Sullivan to loan the Glenns $250,000 on a short-term basis at a high interest rate, representing to Sullivan that a bank had agreed to give the Glenns a loan of $1,000,000.  Chung represented to the Glenns that she had negotiated the bank loan and that it had been approved.  Based on Chung’s representations, Sullivan made the loan to the Glenns, and the Glenns signed promissory notes to Sullivan.  As it turned out, there was no bank loan at all.  After the Glenns filed bankruptcy, Sullivan filed an adversary proceeding seeking denial of the discharge of his loan based on fraud.

Sullivan raised two arguments to justify denial of the debtors’ discharge, both of which were rejected by the Seventh Circuit.  First, Sullivan argued that a debtor’s complete innocence in connection with the fraud should not be a defense to nondischargeability.  The court rejected this “debt not the debtor” theory for denying a discharge, even though it agreed the theory was consistent with the language of § 523, stating this argument “just illustrates the limitations of literal interpretation of statutory language.”  The court illustrated this limitation by taking Sullivan’s argument to its logical conclusion:  if Chung, who was jointly liable with the Glenns on the loan, had assigned the debt to an innocent third party who agreed to assume it, and that third party later filed bankruptcy, Sullivan under his theory could obtain a judgment denying the discharge of the debt in that innocent third party’s bankruptcy case.  The court concluded the intent of § 523 did not go that far, and rejected the “debt not the debtor” argument advanced by Sullivan.

The court then addressed Sullivan’s agency argument, contending that Chung’s fraud should be charged to the Glenns.  Sullivan contended that an agent’s fraudulent conduct must always be binding on his principal, even if the principal had not knowledge of the fraud.  The court rejected this argument, and agreed with the Eighth Circuit’s opinion in In re Walker, 726 F.2d 452, 454 (8th Cir. 1984) that denial of a discharge of a debt based on an agent’s fraudulent conduct requires “proof which demonstrates or justifies an inference that the debtor knew or should have known of the fraud.”  On the facts before it, the Seventh Circuit determined that, as between the Glenns and Sullivan, the Glenns were the more innocent party, and Sullivan was in the better position to protect himself.  As a result, the court affirmed the judgment in favor of the Glenns.

May 9, 2014

Montana Supreme Court Rules That Mortgage Company May be Liable in Tort on Homeowner Claims Arising from Modification Applications Under HAMP

On May 7, 2014, the Montana Supreme Court rendered its decision in Morrow v. Bank of America, ushering in what could be a new era of tort liability for lenders and servicers. 

The Morrows had retired to Montana in 2006 and built a home financed by Countrywide.  They lost their source of income in the downturn in 2009, and – while still current on their loan – reached out to their lender to discuss a modification of their loan.  First, the Morrows’ claim they were told by Bank of America to skip a loan payment so that they would be eligible for a modification.  Then, they were informed by a representative of Bank of America that “they were ‘locked’ for a modification with trial payments of $1,239.99” per month which the Morrows started paying in December 2009.  A few months later Bank of America sent the Morrows a notice of acceleration.  Another employee of Bank of America advised them that their account was “under review”.  They continued to make payments through February of 2011.  The Morrows were invited to apply for the Federal Home Affordable Modification Program or HAMP but the notices of acceleration continued.  On January 11, 2011, the Morrows were advised that modification of their loan under HAMP had been denied.  Their final payment was rejected by Bank of America, and a sale of the property was scheduled.

The Morrows then sued Bank of America in state district court, asserting claims of breach of contract, negligence, negligent misrepresentation, and fraud, among others.  The district court eventually granted the Bank’s motion for summary judgment on all counts.  The Morrows appealed to the Montana Supreme Court.  The Supreme Court has now held that the district court erred in granting summary judgment to the Bank on several of the claims.

  • The Court found that a bank that goes “beyond the ordinary role of lender of money and actively advises customers in the conduct of their affairs” may owe a fiduciary duty to a borrower.  Going “beyond the ordinary role of lender” might include activities like advising a borrower to stop making payments, or to make lower payments and ignore foreclosure notices. 
  • The Supreme Court held the Bank could be negligent for the way it handled the Morrows’ request for a modification of their loan.  The Court stated that Bank of America had no duty to avoid foreclosure or to actually grant the modification of the loan.  Instead, the Bank “owed a duty to manage the modification process in a manner that would not cause the Morrows to suffer loss or injury by reason of its negligence.”  A jury trial on this issue will be required.
  • The Court also held that summary judgment on the Morrows’ claim of negligent misrepresentation was granted in error.  The Morrows allege that Bank of America made several false statements regarding the servicing of their existing loan and the status of the application for modification.  The Court noted that “the allegations by the Morrows raise questions of fact regarding whether Bank of America ‘exercise[d] reasonable care or competence’ in obtaining or communicating the information” regarding their request for modification.  A jury trial on that issue will be required.
  • A jury trial will also be required on the Morrows’ claims of fraud, constructive fraud, and violation of the Montana Consumer Protection Act (a statute that provides for treble damages).
  • Bank of America pointed out to the Court that the Morrows have not been damaged – the mortgage has not yet been foreclosed.  The Court refused to visit that question leaving it, instead, to the trial court and, presumably, the jury.

The case includes a fairly detailed recitation of lender liability case law.  Many of the cases date to the 1980s and will cause some lenders to remember the days when lender liability was alleged by every disgruntled borrower.  In Morrow v. Bank of America, the Supreme Court did little to undercut the decisions that ended the so-called “bad faith” era.  Instead, it signaled to lenders and servicers that the way they service distressed loans will be scrutinized and may be the subject of negligence and fraud claims.

The opinion can be accessed through the following link: http://tinyurl.com/kfwgho6 or from Holland & Hart upon request.

March 14, 2014

Ninth Circuit B.A.P. Holds That Principal Can Discharge Debts Caused By His Agent’s Fraud

The BAP held that “more than a principal/agent relationship is required to establish a fraud exception to discharge . . . The creditor must show that the debtor knew, or should have known, of the agent’s fraud.”

A central purpose of bankruptcy is to grant debtors a fresh start – in bankruptcy terms, a “discharge” of existing debts.  But not all debts are dischargeable.  Bankruptcy Code § 523(a)(2)(A), for example, prevents the discharge of debts resulting from “false pretenses, a false representation, or actual fraud . . . .”  What if a principal incurs a large debt based not on his own fraud, but on the fraud of his agent?  Is that debt dischargeable?  That was the question addressed recently by the Ninth Circuit Bankruptcy Appellate Panel in In re Huh, BAP No. CC-12-1633, 2014 WL 936803 (9th Cir. B.A.P. March 11, 2014). Download In re Huh 2014 WL 936803 9th Cir BAP 2014.

Benjamin Huh was a real estate broker who ran a real estate and business brokerage business as a sole proprietor.  He hired an agent, Jay Kim, who did not hold a brokerage license of his own and so relied on Huh’s brokerage license.  Kim sold a shopping market (the “Market”) to an out-of-country investor looking for a profitable investment that required minimal personal involvement.  It turned out that the Market was quite unprofitable and required substantial personal involvement.  Its gross sales were significantly lower than Kim represented, and it was subject to so many code violations that its business license was revoked. 

The investor sued Kim for fraud in state court and prevailed.  The investor then successfully moved the state court to add Huh to the judgment.  Huh thereby became jointly and severally liable on the judgment of approximately $1 million, based upon his agent’s fraud.

Huh filed for chapter 7 bankruptcy relief.  The investor filed a complaint under Bankruptcy Code § 523(a)(2)(A), asking the court to except his state court judgment from discharge.  The investor argued that under basic agency principals, a principal is liable for the torts of his agents, and therefore Kim’s liability should be imputed to Huh for purpose of discharge.  Notably, the state court findings of fact were not binding on the bankruptcy court, which made its own findings.  It found that Huh had no involvement with Kim’s sale of the Market, and was totally unaware of the Market until after the sale closed.  In short, he had not personally engaged in any culpable conduct.  Thus, the judgment debt would be dischargeable in Huh’s bankruptcy unless Kim’s fraud was imputed to Huh for purposes of § 523(a)(2)(A). 

The bankruptcy court dismissed the investor’s nondischargeability complaint, and the BAP, sitting en banc, affirmed.  The BAP held that “more than a principal/agent relationship is required to establish a fraud exception to discharge . . .  The creditor must show that the debtor knew, or should have known, of the agent’s fraud.”  In reaching this result, the BAP examined various approaches taken by circuit courts, and a recent United States Supreme Court case that granted a discharge exception under another subsection only if the creditor could establish a debtor’s “culpable state of mind.”  See  Bullock v. BankChampaign, N.A., 133 S.Ct. 526 (2013). 

Because Huh was not aware of the Market sale or of his agent’s false representations until after the sale closed, Huh’s liability on the state court judgment was dischargeable in his chapter 7 case.

September 14, 2012

Ninth Circuit Holds that Non-Dischargeability Actions are not Subject to Arbitration

The Ninth Circuit Court of Appeals recently rejected two creditors’ creative contention that he was entitled to have his claim that the debtor’s debt to him should be denied a discharge under § 523 for fraud in connection with a contract containing an arbitration clause resolved through arbitration
proceedings.  In Matter of Eber, 2012 WL 2690744 (9th Cir. 2012), the creditors and the debtor entered into an agreement relating to the construction and operation of the debtor’s beauty salon in Las Vegas.  The agreement required that all disputes arising under the agreement would be arbitrated in New York.  After disputes arose, the creditors commenced an arbitration proceeding against the debtor asserting claims for breach of contract, fraud and breach of fiduciary duty.

After the debtor filed bankruptcy, the creditors filed a complaint seeking a denial of the debtor’s discharge of the claims alleged against him under § 523.  The creditors filed a motion to compel
arbitration of the issues of liability and damages, but agreed that the bankruptcy court could determine the issue of dischargeability.  The creditors argued that liability and damages were non-core matters which were arbitrable.  The Circuit Court agreed with the bankruptcy court and the district court that the fraud claims asserted by the creditors could not be so finely parsed.  First,
any finding by the arbitration panel adverse to the debtor on liability and damages would be binding on the debtor under the doctrine of collateral estoppel.  Consequently, although the issue of dischargeabilty would technically be decided by the bankruptcy court, for all intents and purposes, dischargeability would be determined by the findings and conclusions of the arbitration panel, in abrogation of the bankruptcy court’s exclusive jurisdiction over dischargeability actions under § 523(a)(2).

The Circuit Court then addressed the issue of how to reconcile the Federal Arbitration Act with the Bankruptcy Code.  The court noted that disputes involving the Bankruptcy Code and the FAA often “present a conflict of near polar extremes; bankruptcy policy exerts an inexorable pull towards centralization while arbitration policy advocates a decentralize approach towards dispute
resolution.”  Looking to the U.S. Supreme Court’s decision in Shearson/Am. Express, Inc. v. McMahon, 482 U.S. 220, 226 (1987), the Ninth Circuit noted that, in determining if Congress intended to override the FAA’s policy favoring arbitration in a particular case, a court must examine: (1) the text of the statute, (2) its legislative history, and (3) whether an inherent conflict between arbitration and the underlying purposes of the statute exist.

The Ninth Circuit went on to state that it had previously found no evidence in the text of the Bankruptcy Code or in the legislative history suggesting that Congress intended to create an exception to the FAA in the Bankruptcy Code. Determining that whether a dispute is core or non-core is
not dispositive of the issue, the Ninth Circuit went on to hold that a bankruptcy court has discretion to decline to enforce an otherwise applicable arbitration provision only if arbitration would conflict with the underlying purposes of the Bankruptcy Code.  The Circuit Court agreed with the bankruptcy and district courts in holding that allowing arbitration of issues of liability and damages on the fraud claims in question would result in the arbitrator’s deciding issues that are so closely intertwined with dischargebility and, therefore, would conflict with the underlying purposes of the Bankruptcy Code.