What is Fraud? And how does it affect bankruptcy? The James vs. West case

As a bankruptcy attorney in Mount Vernon, IL for over 20 years, I read through and analyze court rulings throughout the country. I was lucky to find this wonderful case from the Western District of Missouri (whence lay Kansas City, Independence, Branson, etc.). James v. West, 16-40358.

What a wonderful case this is: an excellently written opinion dealing with fraud, the means test and other topics important in bankruptcy.

This isn’t an opinion, this is a text book. It should be on the curriculum of anyone teaching bankruptcy law. It is that good!

Click on the links to read Part One, Two, Three, Four, Five and Six of this case for the facts and other issues.

 

Conclusions of Law

Section 523(a)(2)(A) & (B)

Section 523(a)(2) reads in pertinent part:

(a) A discharge under section 727 . . . of this title does not discharge an individual debtor from any debt—

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by–

(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition; [or]

(B) use of a statement in writing–

(i) that is materially false;

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

(iii) on which the creditor to whom the debtor is liable for such money, property, services, or credit reasonably relied;

and

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

The two grounds for nondischargeability under subsections (2)(A) and (2)(B) are mutually exclusive. In re Long, 774 F.2d 875, 877 n.1 (8th Cir. 1985).

Before Reaching Counts I and II, Threshold Issues of Law

There are three threshold issues of law under § 523(a)(2) applicable to both Counts I and II. First, is the Jameses’ debt a debt for money, property or services “obtained by” fraud under either § 523(a)(2)(A) or (a)(2)(B)? Second, should misrepresentations made by someone other than the Debtor be imputed to her under § 523(a)(2)(A) or (a)(2)(B)? Third, do the alleged misrepresentations fall under § 523(a)(2)(A) or (a)(2)(B)?

Threshold Issue No. 1 – What “Money, Property or Services” Did the Debtor Obtain From the Jameses?

The first issue is whether the complaint states a plausible claim for relief under §523(a)(2); that is, whether the Debtor obtained “money, property or services” from the Jameses.

The Debtor moved to dismiss the Jameses’ complaint for failure to state a claim in her answer and moved for judgment on the pleadings at the close of the Jameses’ evidence. The issue is a real one; the majority of § 523(a)(2) cases involve someone misrepresenting something to someone else to obtain something: a vehicle, a loan, or a business interest, for example. Here, the Debtor arguably obtained nothing from the Jameses. In fact, the Jameses later sold the Property to an unknown party for $735,000. The Court must therefore delve into what “obtained by” means in the context of § 523(a)(2)(A) and (B) before reaching the merits.

The case law is convoluted. Before the Supreme Court’s decision in Cohen v. de la Cruz, 523 U.S. 213 (1998), there were three lines of cases: (1) those requiring debtors to receive a personal and direct benefit from their fraud; (2) those requiring debtors to at least receive an indirect benefit from their fraud (known as the “receipt of benefits” theory); and (3) those not requiring the plaintiff to show any benefit to the debtor, whether direct or indirect. See, e.g., In re Bilzerian, 100 F.3d 886, 890 (11th Cir. 1996) (describing the three approaches). This Court did not find any Eighth Circuit cases addressing this split before the Cohen case, and the parties did not cite any.

It is now clear after the Cohen decision, however, that “[t]o the extent obtained by” qualifies “money,” and not “any debt.” Cohen, 523 U.S. at 218–19. Following Cohen, at least three circuits have done away with the requirement that the debtor receive at least some benefit. In re Yelverton, No. 09-00414, 2009 WL 3823187, at *2–*3 (Bankr. D.D.C. Nov. 16, 2009) (citing post-Cohen cases from the Fourth, Fifth, and Ninth Circuits, rejecting the receipt-ofbenefits test); see also In re Reuter, 427 B.R. 727, 746 (Bankr. W.D. Mo. 2010). What is still unclear is whether a benefit to at least a third party is required. See, e.g., Yelverton, 2009 WL 3823187, at *2–3 (requiring at minimum that “someone or something received property”).

Again, there is no controlling Eighth Circuit law post-Cohen. Cohen certainly liberalized the “obtained by” language in § 523(a)(2). However, the cases adopting this approach generally analyze the “obtained by” language where the real issue is whether a third party’s receipt of benefits is sufficient. This Court is not aware of any other Courts, even after Cohen, finding nondischargeability where no one, not even a third party, obtained some kind of benefit from the alleged misrepresentation.

As explained above, the Jameses argue the Debtor obtained bare equitable title to the Property when they accepted the Contract and that she obtained their services to maintain the Property. There is no evidence that any third party received a benefit here, so the Jameses essentially ask this Court to either find that (1) the Debtor received a benefit under one of their theories, or (2) Cohen expanded the scope of § 523(a)(2) such that it is not necessary that any party receive a benefit.

The issue has been further muddied by the Supreme Court’s recent ruling in Husky International Electronics, Inc. v. Ritz, 136 S. Ct. 1581 (2016), which some commentators have read to mean that a fraudulent scheme is all that is sufficient for nondischargeability under § 523(a)(2)(A). But see In re Vanwinkle, Adv. No. 16-5030, 2016 WL 7443168 (Bankr. E.D. Ky. Jan. 31, 2017) (reading Husky to say that only a debt obtained by actual fraud is nondischargeable under § 523(a)(2)(A) on the basis of fraud, and rejecting the creditor’s argument that the judgment debt that was not based on fraud should be actionable under § 523(a)(2)(A) because the debtor engaged in a post-judgment fraudulent conveyance scheme that had nothing to do with the creation of the debt itself).

Given this convoluted state of the law and the facts of this case, the Court believes it is a far stretch to say that the Debtor “obtained” utility or maintenance services from the Jameses when the Jameses would have incurred them regardless of whether or not they entered the Contract with the Debtor. Certainly, the moving costs and other damages were not obtained by the Debtor. Any property “obtained” under the Contract would have expired once the sale did not close. Nonetheless, a right to close such as the Debtor obtained once the Jameses accepted her offer to purchase is in the nature of an equitable property interest under applicable Missouri law.

The Court will therefore conclude that the Debtor obtained a property interest from the Jameses, such that the Jameses have pleaded a plausible claim for relief under § 523(a)(2)(A) and (B), and deny the Debtor’s motion for judgment on the pleadings on this ground.

Threshold Issue No. 2: Should Fraudulent Statements of Knowles or Strong Be Imputed to the Debtor on the Grounds of Agency?

The second threshold issue is that of agency. The weight of the evidence shows that many of the alleged misrepresentations to the Jameses were not made by the Debtor herself, but by either her boyfriend Knowles or by her agent Strong based on communications from Knowles.

The Supreme Court has recognized that a court may impute fraud to a debtor-principal in a nondischargeability proceeding. In re Miller, 276 F.3d 424, 429 (8th Cir. 2002) (citing Strang v. Bradner, 114 U.S. 555, 561 (1885)). The imputation is based on agency principles. The Eighth Circuit has likewise recognized that a bankruptcy court may impute an agent’s fraud to his debtor-principal. See Matter of Walker, 726 F.2d 452, 454 (8th Cir. 1984); In re Treadwell, 637 F.3d 855, 860 (8th Cir. 2011).

Two prerequisites must exist, however, before imputing an agent’s fraud to a principal: an agency relationship and knowledge of the fraud.

Prerequisite No. 1 to Imputation: Agency Relationship

Generally, to establish a principal-agent relationship under Missouri law, the principal must have a “right to control” the agent. Bach v. Winfield-Foley Fire Protection Dist., 257 S.W.3d 605, 608 (Mo. 2008). The mere existence of a marital relationship – and presumably that of boyfriend/girlfriend – is insufficient to establish a principal-agent relationship. See, e.g., Missouri Farmers Ass’n, Inc. v. Busse, 767 S.W.2d 108, 110 (Mo. Ct. App. 1989). An implied agency can exist, however, where the significant other’s activity amounts to “joint participation.” Kenny’s Tile & Floor Covering, Inc. v. Curry, 681 S.W.2d 461, 466–67 (Mo. Ct. App. 1984); Busse, 767 S.W.2d at 110. “Joint participation has been demonstrated by knowledge and active involvement in the project undertaken.” Turner v. Hoffmeier, 690 S.W.2d 188, 189 (Mo. Ct. App. 1985) (citing Robinson Lumber Co. v. Lowrey, 276 S.W.2d 636, 640–41 (Mo. Ct. App. 1955)).

Whether an agency relationship exists is a matter of state law. In re Reuter, 686 F.3d 511, 517 (8th Cir. 2012).

Here, both the Debtor and Knowles testified that they were in the B&B project together, intending to each have specific duties and sharing any profits. The Debtor also testified that she left the details of the Property purchase and the financing to Knowles. The Court concludes that the Debtor and Knowles had, at a minimum, a joint venture, such that Knowles was her agent for purposes of imputing his representations to her.

With respect to Strong’s agency, the relationship between a homebuyer and a buyer’s agent is addressed by statute. In Missouri, buyer’s real estate agents are licensed under state law. See § 339.710 RSMo et seq. Section 339.740 clearly states that a buyer’s agent is a limited agent.

The statute also lays out the agent’s duties and obligations. Most importantly, “[a] licensee acting as a buyer’s agent . . . owes no duty or obligation to a customer” except to disclose all adverse material facts.” § 339.740.3 RSMo. Further, “[a] buyer’s agent owes no duty to conduct an independent investigation of the client’s financial condition for the benefit of the customer and owes no duty to independently verify the accuracy or completeness of statements made by the client or any independent inspector.” Id. Here, “customer” refers to the Jameses, and “client” refers to the Debtor. See § 339.710(5), (6), (10) RSMo. Thus, Strong may have been an agent of the Debtor’s, but only for limited purposes as reflected by the statute and his contract.

Prerequisite No. 2 to Imputation: Actual or Constructive Knowledge of the Agent’s Fraud

Once an agency relationship is established, as it has been here, the second prerequisite for imputation is that the debtor as principal had actual or constructive knowledge of the agent’s fraud. This means the debtor knew or should have known of the agent’s fraud. Treadwell, 637 B.R. at 860 (citation omitted). Reckless indifference is sufficient to show constructive knowledge of the fraud. Id. Actual or constructive knowledge of the fraud is a question of fact. Walker, 726 F.2d at 454.

Here, five of the nine alleged representations come from the Debtor’s mere act of signing the Contract. Because the Debtor was the sole buyer on the Contract, the alleged representations, if made, came from her, and not from her agent. Thus, imputation is unnecessary as to these five representations. With the remaining representations, the Court must decide as it addresses each representation whether it was made with the intent to deceive, and after determining so, will then address whether that intent should be imputed to the Debtor. So, further imputation issues will be addressed below.

Threshold Issue No. 3: Which Representations Relate to Financial Condition?

The Jameses pleaded many of the alleged misrepresentations as constituting both fraudulent representations under § 523(a)(2)(A) and fraudulent representations under §523(a)(2)(B). Since the subsections are mutually exclusive, the Court must address which of the nine alleged representations fall within which section.

Some bankruptcy courts have confined the term “statements” to formal financial statements. But in the Eighth Circuit, “statements regarding financial condition” are construed more broadly. See In re McCleary, 284 B.R. 876, 883 (Bankr. N.D. Iowa 2002).

In the Eighth Circuit, a statement regarding the debtor’s financial condition is “sufficiently broad enough to include any statement made by the Debtor, not just formal financial statements and documents in a bank or commercial setting.” In re Kerbaugh, 162 B.R. 255, 261 (Bankr. D.N.D. 1993) (citation omitted). A statement is about the debtor’s “financial condition” if it “concern[s] the debtor’s or insider’s overall financial health, net worth, or ability to generate income.” Kloven v. Ramsey, No. 4-92-CV-1249, 1993 WL 181309, at *2 (D. Minn. April 22, 1993). Thus, even misrepresentations about the value of inventory may qualify as statements regarding financial condition. See Long, 774 F.2d at 877 n.1.

Here, the Jameses allege nine misrepresentations. Five of them are completely unrelated to the Debtor’s overall financial condition, and will be analyzed exclusively under section 523(a)(2)(A). These statements are: (1) the Debtor’s representation that she intended to purchase the Property; (2) the Debtor’s representation that she would comply with the entirety of the Contract; (3) the Debtor’s representation that she would close on the dates in the Contract; (4) the Debtor’s representation that she would take possession on May 3, 2013; and (5) the Debtor’s representation that she was married to Knowles.

The remaining four statements arguably relate to the Debtor’s financial condition under the Eighth Circuit’s comparatively liberal standard. The statements are: (1) the Debtor’s representation that she had $999,500 in cash to purchase the property; (2) the Debtor’s representation that she was approved by Tailwind Funding for $999,500; (3) the Debtor’s representation that she had $989,500 available from Banner Bank to purchase the Property; and (4) the Debtor’s representation that she had a large estate sufficient to pay the purchase price.

These statements will be analyzed under both § 523(a)(2)(A) and (a)(2)(B), given the uncertainty with respect to which they are pled and which subsection they fall within.

 

About the blogger:

Michael Curry of Curry Law Office in Mount Vernon, Illinois (http://michaelcurrylawoffice.com/) has helped thousands of individuals, family and small businesses in southern Illinois find protection under the Bankruptcy Code for almost twenty-five years. He is also available to help individuals and families with their estate planning (wills, power-of-attorney) and real estate and other sales transactions.

He is also the author of books on finance and bankruptcy available on Kindle through Amazon!

Whether you live in Mount Vernon, Sparta, Olney, Mount Carmel and throughout Southern Illinois call Curry Law Office today at (618) 246-0993 and Finally Be Financially Free!

 

 

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3 thoughts on “What is Fraud? And how does it affect bankruptcy? The James vs. West case

  1. Pingback: A primer on the elements of fraud | Curry Law Office

  2. Pingback: The James vs. West case, part nine: More analysis on the Elements of Fraud | Curry Law Office

  3. Pingback: A primer on Willfull and Malicious: the final review of the James vs. West case | Curry Law Office

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