Bankruptcy Court Refuses to Allow Creditor a Nondischargeable Claim Despite Fraudulent Financial Statement

by Andrew K. Alper July/August 2008
In this edition of Legal Watch, Andrew Alper reminds us that there are always lessons to be learned from adverse court decisions. Lessons include the necessity for lenders and lessors in making sure their lending and leasing guidelines make sense and the importance of digging deeper into credit information received from a borrower or lessee.

The leasing and financing industries have suffered as a result of fraudulent debtors and lessees in recent years. The infamous names of Norvergence, Inc., Cyberco Holdings Inc. and Allserve bring chills to lenders and lessors in the financial services industry. But besides the well-known fraud cases, fraudulent representations are made to lenders and lessors alike in everyday situations. A lender or lessor can only hope that when a debtor submits financial information to obtain an extension of credit, it will not be able to discharge the claim once the fraudulent borrower or lessee files the bankruptcy petition. Unfortunately, for one lender, this was not the case. In the case, In re Hill (2008 WL 2227359 & 2008 Bankr Lexis 1668), decided in the Northern District of California on May 28, 2008, the borrowers clearly made fraudulent representations to the lender, which enabled the borrowers to obtain a loan but nevertheless was able to avoid having the debt declared nondischargeable in their bankruptcy.

The Facts
In this case, National City Bank made a loan to the Hills secured by a second deed of trust on the debtors’ house in the sum of $200,000. After purchasing the house for $220,000, 20 years ago, the value went up and the debtors scheduled the value of the house at $683,000 in their bankruptcy, which was filed in April 2007. Mr. Hill was an auto parts manager and earned $39,000 a year. Mrs. Hill was self employed and earned about $25,000 a year. When they applied to get the equity line of credit with the bank in April 2006 for $200,000, they represented to the bank that Mr. Hill made $98,112 and Mrs. Hill made $47,604. Collectively, they represented to the bank in their credit application that they made $145,716, which only inflated their true annual income by around $81,716.

In October 2006, the Hills decided they wanted an increase in their equity line of credit to $250,000 so in this application to the bank, Mr. Hill’s annual income was stated to be $67,200 and Mrs. Hill’s annual income was stated to be $123,600 for a total of $190,800, inflating their true annual income by about $109,084. The bank had appraised the house at $785,000 for the April 2006 loan and at $856,000 in October 2006.

Shortly after the Hills filed bankruptcy in April 2007, the holder of the first deed of trust, which was owed $450,000, obtained relief from the stay and purchased the house by credit bidding its debt at the foreclosure sale (the case did not state what the true value of the property was, only the scheduled value. If the house was really worth $683,000 or anywhere close to that amount, it was curious why the bank did not acquire the house and recover a substantial amount of its debt by selling the house). After the foreclosure sale, the bank then brought its complaint to determine that the debt be deemed nondischareable based on the fraudulent financial information submitted by the debtors to the bank with respect to their income in obtaining the loan in both financial statements.

The loan made by the bank to the debtors was a “stated income” loan, which did not require verification of income. The bank had certain guidelines that it had to comply with in making a “stated income” loan. The guidelines stated that for a borrower who was employed, the bank only needed verification of employment and not verification of income and the bank obtained verification of employment as to Mr. Hill. The guidelines further stated that a third-party vendor would evaluate whether the income stated in the credit application to the bank by the debtors was reasonable based on the job type, tenure and geographical location of the employment.

In this case, there was no evidence presented that the bank had such a third-party vendor evaluate whether Mr. Hill’s income was reasonable for his position. As to Mrs. Hill, who was self-employed, the bank could choose one of three ways to obtain verification of the employment. One of those ways was to get a signed letter from her CPA verifying the existence and ownership of her business. The bank received such a letter but did not verify the qualifications of the person who signed the letter at the CPA’s office.

The Law
A creditor seeking to determine a debt to be nondischargeable based on receipt of fraudulent financial information under 11 U.S.C. §523(a)(2)(B) must demonstrate: 1.) the debtor made a written representation respecting the debtor’s financial condition; 2.) the representation was material; 3.) the debtor knew, at the time, the representation that was made was false; 4.) the representation was made with the intent to deceive the creditor; 5.) the creditor relied on the representation; 6.) the reliance was reasonable; and 7.) the damage suffered by the creditor proximately resulted from the representation [See In re Candland 90 F.3d. 1466. 1470 (9th Cir. 1996); In re Sirani 967 F.2d. 302,304 (9th Cir. 1002)]. The creditor must prove each of these elements by a preponderance of evidence.

A statement is materially false if it is substantially inaccurate and affects the creditors’ decision-making process (See Candland 90 F.3d. at 1470). Significant misrepresentations of financial information are generally considered to be material. A debtor’s intent to deceive for nondischargeability purposes requires either a finding that the debtor actually knew the statements were false or it can be inferred from the totality of the circumstances, including the debtor’s reckless disregard for the truth, that the debtor had an intent to deceive the creditor. [See In re Gertsch 237 B.R. 160, 167-68 (Bankr. 9th Cir. 1999)]. Also a debtor’s failure to check the accuracy of their financial condition in reckless disregard of the truth of their financial condition justifies a finding of fraudulent intent [See In re Oh 278 B.R. 844, 858-60 (Bankr. CD. Cal 2002)].

With respect to the first four elements of a nondischargeability claim based on fraud, the court had no trouble finding that the bank satisfied those elements and the debtors submitted fraudulent financial information to the bank.

However, with respect to the aspects of the bank’s reasonable and justifiable reliance on the financial statements, the court had a problem. Whether a creditor reasonably relied on the materially false statement is measured objectively by the degree of care exercised by a reasonably cautious person in the same transaction under similar circumstances. [See In re Gertsch 237 B.R. at 170 citing In re Cohn 54 F. 3d. 1108, 1117 (3d Cir. 1995)]. Absent other factors, a creditor’s reliance on its own standard lending practices is reasonable if it followed its normal business practices. However, a creditor must also look for obvious “red flags” regardless of following its normal business practices.

The Analysis
The court found that the bank failed to carry its burden on whether it reasonably and justifiably relied on the fraudulent financial statements. The court questioned whether the bank’s own guidelines were reasonable and further questioned whether the bank followed its own guidelines. The bank presented no evidence as to any evaluation done as to the reasonableness of Mr. Hill’s income set forth in the credit application because the bank never had it evaluated by a third-party vendor. In addition, the bank was unable to produce a letter signed by a CPA verifying the existence and ownership of Mrs. Hill’s business. The letter the bank received was not signed by a CPA but someone in the CPA’s office. Therefore, the lack of such evidence suggested that the bank did not follow its own guidelines.

More important to the court was the court’s belief that the bank did not reasonably rely on the income stated by the Hills in the two applications because the income varied so much from the April 2006 loan application to the October 2006 loan application given that there was an annual income difference during the six months between the applications of more than $45,000 for no apparent reason. Based on this analysis, the court concluded that either the bank did not rely on the debtors’ representations concerning their income or its reliance was not reasonable based on the “objective” standard.

The court surmised that the bank really made the loan based on the value of the house and that the value of the house was inflated because, if it was not inflated and the house had that value, the bank would have purchased it at the foreclosure sale. Therefore, the court reasoned it was probably the real estate appraisal and not the income that the bank relied on in making the loan. As a result, despite the fraudulent financial statements submitted by the Hills to the bank, the debt was discharged and the bank was stung with a loss.

As always there are lessons to be learned from adverse decisions. First, lenders and lessors need to make certain that their lending or leasing guidelines make sense and internal guidelines are followed. Guidelines for small-ticket transactions should not be the same as large-ticket transactions where more due diligence will typically be conducted by a lender or lessor because of the potential loss that could be incurred.

Second, dig into the credit information received from the borrower or lessee and see if it makes sense under the circumstances. The income information that the bank had from the Hills did not make sense where the income varied so much in six months. Whether this income was or was not properly verified in accordance with the bank’s guidelines, or whether an auto parts manager could make the level of income stated is one thing, but the lender should have questioned the variance of the income during that six-month period.

Long ago former Bankruptcy Judge Lisa Hill Fenning in a frequently quoted passage from the case of In re Figge 94 B.R. 654,666 (Bankr. C.D. Cal 1988) stated, “Lenders do not have to hire detectives before relying on borrowers financial statements.” Whether a different judge hearing this case may have rendered a different result is not necessarily the issue. The issue for lenders and lessors alike is that nothing replaces their own diligence in reviewing credit information before approving and entering into loans and leases.

Andrew K. Alper is a partner with the law firm of Frandzel Robins Bloom & Csato, LC in Los Angeles. Alper has been representing equipment lessors, funding sources and other financial institutions since 1978. Alper obtained his Bachelor of Arts degree in Political Science, magna cum laude, from the University of California at Santa Barbara, and received his Juris Doctor from Loyola Marymount University School of Law making the Dean’s List.

Alper’s practice emphasizes the representation of equipment lessors and funding sources in all aspects of equipment leasing including litigation, documentation, bankruptcy and transactional matters. Besides representing equipment lessors and funding sources, Alper represents banks and other financial institutions in the area of commercial litigation, insolvency, secured transactions, banking law, real estate and business litigation.

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