Individual Debtor Discharge: Does “See No Evil, Hear No Evil” Work?

Sullivan v. Glenn, 782 F.3d 378 (7th Cir. 2015) –

A creditor sought to have its debt excepted from discharge because he advanced funds to the debtors in reliance on fraudulent misrepresentations. The bankruptcy court found in favor of the debtors, the district court affirmed, and the creditor appealed to the 7th Circuit.

The debtors were real estate developers. They asked a loan broker to try to arrange a short term loan of $250,000. The broker asked a friend and occasional client, who agreed to make a loan of $250,000 to be due in two to three weeks with interest of $5,000 per week.

However the debtors needed the money for more than two weeks. The broker told everyone that a bank had agreed to give the debtors a $1M line of credit, but there was a need for a “bridge” loan since it would take a few weeks to put the line of credit in place.

During a meeting to discuss these arrangements, one of the broker’s employees stepped out of the room supposedly to call the bank. When he returned he told the creditor that the bank had approved the line of credit. However, the employee did not call the bank and the loan had not been (and never was) approved. In fact it had never been applied for. The creditor left the meeting with promissory notes from the debtors and the broker making them all personally liable to pay the loan if it was not repaid from the line of credit.

Surprise, surprise – the loan was not repaid.

The broker filed bankruptcy. The creditor was successful in claiming that the broker was not entitled to a discharge of the $250,000 loan since it was induced by her fraudulent assurance that the line of credit had been approved. The debtors also filed bankruptcy, and the creditor filed a similar complaint in their bankruptcy. However, the bankruptcy judge concluded that neither of the debtors committed fraud, which meant that the creditor’s nondischargeability claim failed.

Section 523(a)(2)(A) of the Bankruptcy Code bars discharge of an individual debtor if the debt is “obtained by… false pretenses, a false representation, or actual fraud…” The creditor argued that this meant that a debt is nondischargeable if it is the result of fraud, even if the debtor is innocent.

The 7th Circuit acknowledged that the “debt not the debtor” theory could be supported under a literal reading of the statute. However, taken to its logical conclusion, a loan induced by fraud of the original borrower and subsequently assigned by the borrower to an innocent third party would mean that the innocent third party could not obtain discharge of the debt simply because it originated in fraud. “That would make no sense. It would be a form of attainder: an innocent person punished for the misdeed of an ancestor, or in this case an assignor.”

Alternatively the creditor argued that the broker was an agent of the debtors, and her fraud should be imputed to them as the principal. Although the debtors disputed that the broker was their agent, the court disagreed with their position since they hired the broker to negotiate a bridge loan subject to their approval.

The court also noted that “the principal is liable for a misrepresentation made by its agent if the person to whom the misrepresentation was made would have no reason to doubt that it was a true statement, authorized by the principal.” However, the issue was not liability of the debtors to the creditor, but rather whether the fraud was grounds for denying a discharge under the Bankruptcy Code. And in the context of denying a discharge, the court concluded that the test was whether the debtor knew or should have known about the fraud. In this case the test was not met.

Further, the court noted that the creditor was in just as good a position as the debtors to detect a fraud. He could have checked with the bank. In the case of the broker, this did not affect the dischargeability of the broker’s debt because “as between fraudulent and careless, careless wins.” But as between the debtors and the creditor, the court came out on the side of the debtors.

In reaching its conclusions the court commented on the fact that this was an extremely lucrative opportunity for the creditor – with $5,000 per week interest, which was an interest rate of 104%. Further, the creditor was relying on the broker in part based on his friendship with her – initially characterized as “good friends,” and then later as “very good friends.” The court thought that this tarnished his agency argument. He was relying more on the fact that the broker was a friend than that she was the debtor’s agent. (The court further commented on creditor dealings with the broker that “bordered on the irrational.”)

Even taking into account public policy considerations – such as whether debtors should have an incentive to police their agents on the one hand, and increased complexity and cost of transactions on the other, the court could find no “net social benefit” from adopting the creditor’s arguments.

While noting several circuit court decisions that “lean the other way,” none of them actually rejected the standard that discharge should be denied only if the debtor “knew or should have known of the agent’s fraud” or “was recklessly indifferent to acts of its agent.” In considering whether there was any indication that the debtors were guilty of fraud, the court noted the debtor’s testimony that “his usual method of obtaining bank loans was just to email a loan request to a bank, rather than to submit a formal loan application, and that he would receive informal notice of approval of his application before receiving documentary confirmation.” Given that context, the debtors saw no reason to doubt what they were told by the broker.

As a final argument, the creditor contended that the monies were not used for construction as he was led to believe, but to pay off creditors. He claimed that if he knew this was the reason for the loan, he would have suggested that the debtors simply wait for the bank line of credit. The court didn’t buy that argument. In its assessment, the creditor wanted to make $10,000 to $15,000 in interest for a short term loan regardless of the use.

Thus the 7th Circuit agreed that the lower courts were correct in rejecting the argument that the creditor’s debt should be nondischargeable.

For many individual debtors a primary purpose in filing chapter 7 is to obtain a discharge of debts. It is worth remembering that this is not an absolute right. Some debts are nondischargeable due to the nature of the debt (such as domestic support obligations and certain taxes) and some debts are nondischargeable due to the circumstances (such as fraud).

For those of you who are fans, note that this is a Posner opinion – which means that it is not your typical dry prose. For example:

  • “As [the creditor] nostalgically remarks, ‘Contrary to popular belief, bankruptcy was initially created for the benefit and protection of creditors, not debtors.’ Yes, and debtors used to be sent to prison.”
  • “And by the way, there is no keeping [the broker] down. [Citing web articles about the broker being a leader in autism and special needs training, as well as a serial entrepreneur] (both websites were visited on April 1, 2015).” (NB: I was suspicious given the April Fool’s date, but the websites actually exist.)
  • Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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