In recent opinions relating to creditors’ objections to dischargeability of their debts under 11 U.S.C. §523(a)(2)(B), bankruptcy courts in the Northern District of Illinois have analyzed the sophistication of the debtor to determine if they possess the intent to defraud.
For a debtor to possess the requisite intent, either he must have knowingly intended to defraud, or he must have “engaged in such reckless behavior as to justify the finding of fraud.
In re: Hansen, 325 B.R. 746, 759, (Bankr. N.D. Ill. 2005).
Conversely, section §523(a)(2)(B) of the Bankruptcy Code provides that a debtor is not discharged from any debt for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by:
a statement made 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.
11 U.S.C. §523(a)(2)(B). In such cases, a creditor bears the burden of proving by a preponderance of the evidence that a debt meets the statutory requirements for an exception to discharge. Grogan v. Garner, 498 U.S. 279, 286 (1991).
However, in a recent Northern District of Illinois bankruptcy case (as the matter remains pending, names are withheld from this article), a creditor lost $700,000.00 after it extended credit on a patently false financial statement. Suit arose out of a business relationship between a creditor corrugated supplier (“Supplier”) and a debtor packaging broker, (“Broker”). The brokerage business was a one-man shop brokering deals for corrugated boxing/packing materials with its customers. After it procured orders from its customers, it would call in the orders to the Supplier, which would then manufacture, warehouse, and direct ship the product to the Broker’s customers.
Despite operating on a credit system, wherein Supplier would make and ship product and wait for the Broker to receive payment from its customers, the Supplier never required assurances of Broker’s credit worthiness. As a result of the delay in Broker’s customers remitting payment to him, often Broker’s payments to Supplier were late. In fact, Supplier modified the payment terms to accommodate Broker’s slow paying customers.
Broker’s business boomed for twenty-seven years. In the late 1990’s, after Broker’s son spent “a semester or two” at a local college, and then obtained a two-year electronic technician degree from a local community college, the Broker hired his son (“Son”) to work for him. Son had no corrugated box sales experience.
After 27 years of business and no credit assurances, in 2000 the Supplier requested Broker and Son to execute a guarantee and financial statement. At that time, Broker’s business owed Supplier over half of a million dollars. Broker and Son complied with Supplier’s request and submitted their respective financial statements, which they prepared without assistance.
Supplier reviewed the 2000 personal financial statements from Broker and Son but never tested their veracity. The credit line did not change after the 2000 financial statement. The financial statements were not relied upon to change Broker’s business credit.
In 2003, Broker retired and sold his interest in the business to Son, who admittedly could not say that he “knew it (the business) inside and out” as represented on the financial statement. Because of the change in ownership, Supplier requested an updated financial statement from Son, who then ran the business out of his basement, since he had become the sole owner. Son again complied with Supplier’s request and submitted a statement attesting to his financial status in 2003. The line of credit in 2003 remained the same.
The business did not do so well after the sale to Son, who had received complaints about Supplier’s products from all of his customers, which he did not track. Despite the failing brokerage business, the Supplier continued to ship out product and invoice Son. Supplier did so knowing that Son’s customers were not paying on time to keep the brokerage business. The brokerage business then closed its doors in June 2005.
In October 2005, Son sought protection under Chapter 7 of the United States Bankruptcy Code. Supplier filed a complaint seeking to have the debt owed by Son to be non-dischargeable on the basis of 11 U.S.C. §523(a)(2)(B). After a trial on the matter, the court held that Supplier failed to meet its burden of proving that it extended credit to the brokerage business based upon written financial statements submitted by Son that were: (1) materially false, (2) respecting his financial condition; (3) upon which Supplier reasonably relied; and (4) were made with the intent to deceive the Supplier.
The Seventh Circuit has cautioned courts not to “sit as an after-the-fact loan committee, second guessing lending decisions” and that “a creditor need not ‘view each representation with incredulity requiring verification,’ unless there are facts which reasonably indicate verification was necessary.” Matter of Garman, 643 F. 2d 1252, 1260 (7th Cir. 1980). However, in this case, the court held that - despite the existence of falsities on the financial statement relative to Son’s financial condition - there was no evidence that Supplier relied on the statements in its decision to extend credit. Moreover, the court found that Supplier failed to establish that Son intended to deceive it by his financial representations. On this, the court stated:
After hearing [Son’s] testimony, the court was left with the definite and firm impression that he was somewhat careless, even negligent, in completing his financial statement. He testified that he believed what he wrote was the truth, and the court has little trouble accepting the idea that [Son] did not keep a close eye on his account balances. In hindsight, [Son] should have carefully reviewed his bank records before completing the 2003 Financial Statement. That he failed to do so comes as no surprise and, based on everything the court heard from [Son], is not evidence of intent to deceive. Although Broker was able to successfully run the brokerage business for many years, Son ran [the business] into the ground in two years. Son was not a sophisticated businessman.” (citation omitted)
In comparison, in Hansen the court denied the debtor a discharge, finding that the debtor knew certain statements were false and made with fraudulent intent. Hansen, 325 B.R. at 759. As its basis for denial, the court determined that “Hansen is an intelligent and educated businessman, a lawyer, and a corporate officer sophisticated in financial matters.” Id. Apparently, a semester or two of college, two-years at a community college and experience in a lumberyard does not a businessman make.
When requesting financial statements, creditors should be very clear as to the reasons for which they are seeking the statements and ensure that the disclosures are delivered and reviewed by everyone who makes credit decisions. If the debtor’s statement contains a questionable representation, the creditor should undertake efforts to verify the information. As far as debtors, despite education or sophistication, financial representations should be based on records, not on memory.
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Eileen Madda, an associate in our Chicago office, concentrates her practice in litigation, insurance coverage, bankruptcy and creditor's rights. She is admitted to practice in Illinois and the US District Court for the Northern Districts of Illinois and Indiana and the US Court of Appeals for the Seventh Circuit. Eileen previously gained experience in banking litigation with another Chicago law firm, clerked for the Attorney Regulatory and Discipline Commission and the Cook County State’s Attorney’s Office.
Prior to completing her BA in Political Science at Providence College in Rhode Island, Ms. Madda studied international law at L’Universite de Fribourg in Switzerland.
