Discharge of Debt: A Seller Relying on a Buyer’s Assumption of Debt May Be Out of Luck If the Buyer Files Bankruptcy

Recanati v. Roberts (In re Roberts), 594 B.R. 484 (Bankr. N.D. Fla. 2018) –

In connection with acquisition of a restaurant the debtor agreed to assume debts of the business. After the debtor filed a chapter 7 bankruptcy, the former owners sought to except this obligation from discharge.

The sellers contended that the debt was nondischargeable under (1) section 523(a)(4) – obtained by “fraud or defalcation while acting in a fiduciary capacity, or (2) section 523(a)(6) – intended to cause “willful or malicious injury” to another. In the court’s view the pleadings were more consistent with section 523(a)(2)(A) – incurred under “false pretenses, a false representation, or actual fraud.” So, it considered all three subsections.

To put the facts in context, the court started by noting that the debtor retired from the US Postal Service where her annual salary had been ~$65,000-$70,000. Prior to retirement she patronized a restaurant and formed a relationship with one of the owners (Tony). She loaned Tony ~$8000 to help improve the restaurant and became what she characterized as a “silent investor.” She paid rent, shopped for and purchased equipment, used personal funds to make payroll and help relocate the restaurant to a new location. The loans totaled ~$60,000.

During this time, she also became responsible for navigating the BP oil spill claims process which eventually resulted in two payments to the company. The first payment of $84,000 was incorrectly released to the debtor in her personal checking account as opposed to the company’s business account. However, as soon as the mistake was discovered, the money was transferred to the business account.

Eventually the debtor agreed to purchase the restaurant through a stock purchase. As consideration the debtor agreed to assume all debts, liabilities, and obligations of the business, to forgive the personal debts of Tony, and to have all personal guarantees, loans, and vendor agreements paid off or assumed by the debtor within 30 days after the sale closed.

The debts included a bank line of credit and note, an oil spill bridge loan with a credit union, a balance due to the US Food Service, and back tax payments. The liabilities totaled ~$155,700 and the company had ~$35,000 in assets. The parties agreed that the second BP claim payment of $25,000 would be used to pay back rent, vendor accounts, taxes and other debts.

At some point the debtor signed an undated writing acknowledging that the debts were her sole responsibility. In another undated writing she asked for an extension of time to obtain financing so that she could meet her obligations.

The debtor was able to keep the business open for about a year, but closed when the liquor license expired and she no longer had any income to keep the restaurant open.

After the restaurant closed the sellers sued the debtor in state court alleging breach of contract, fraud in the inducement, and unjust enrichment. They obtained a judgment on the breach of contract claim and eventually a judgment establishing payment terms. When they had problems enforcing the judgment, they recommenced the state court action. After the debtor filed bankruptcy, the sellers filed an adversary proceeding seeking a determination that the debt owed by the debtor was nondischargeable.

Turning first to the section 523(a)(2)(A) discharge exception for debt obtained by false pretenses, false representation, or actual fraud, the court outlined the elements as follows: (1) the debtor had an intent to deceive, (2) the other party relied on the misrepresentation/deceptive conduct, (3) reliance was reasonably justified, and (4) the other party sustained a loss as a result of the fraud/deception. The court further noted that fraud involving unfilled promises required showing that when the debtor made promises she either knew that she could not fulfill them or had no intention of fulfilling them.

The court found that as a threshold matter the sellers failed to prove that the debtor engaged in deceptive conduct intended to deceive. Rather, given the facts described above the court found the debtor “to be generous; not deceptive.” The court further noted that there was no requirement in the purchase agreement that the debtor have funding in place. Her inability to obtain financing might result in a breach of contract, but was not evidence of fraud.

With respect to section 523(a)(4), the sellers contended that handling the BP oil spill claim proceeds placed the debtor in a fiduciary position which was violated when the debtor used the proceeds for her own benefit. The elements of this discharge exception were: (1) the debt resulted from a fiduciary defalcation under an express or technical trust, (2) the debtor was acting in a fiduciary capacity, and (3) the transaction was a defalcation.

The court explained that the meaning of “fiduciary” was a matter of federal law, and did not mean the traditional concept of a relationship involving confidence, trust, and good faith. Rather it is a narrow concept that requires an express or technical trust. This in turn requires a segregated trust res, identifiable beneficiary, and affirmative trust duties established by statute or contract. The court found that the sellers failed on all counts. They did not establish, or even plead, the existence of an express or technical trust. Further, even if there was a fiduciary relationship the debtor did not violate that relationship.

Finally, section 523(a)(6) regarding willful and malicious injury required proof that the injury was both willful – meaning an intentional or deliberate act, and malicious – meaning the debtor’s action was “wrongful and without just cause or excessive even in the absence of personal hatred, spite or ill-will.” The court found that the sellers did not present any evidence that the debtor intended to act in a way that she knew would injure the sellers.

Accordingly, the court found for the debtor on all counts.

This case highlights the difficult position of a seller when a significant portion of the consideration for the sale involves assumption of debt and the buyer is unable to handle the debt. If feasible, perhaps the seller could require an affirmative release of the seller’s liability in connection with the buyer’s assumption of a debt. If not, perhaps the seller can negotiate terms designed to provide assurance that the buyer will be able to perform (such as requiring the buyer to demonstrate adequate funding as a condition of closing). In any event, the seller should recognize that an individual buyer will probably be able to obtain a discharge in bankruptcy absent really egregious conduct.

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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