By Lisa M. Goolik, J.D.
A couple that provided a loan to an individual debtor and his business could not avoid the discharge of their claim against the debtor’s bankruptcy estate under the theory that the debtor’s offer of a UCC-1 financing statement as security for the loan was fraudulent in light of the subsequent termination of the filing without the couple’s consent. However, the evidence substantiated the couple’s claim that the debtor misrepresented his financial condition in order to induce the couple to extend the loan. As a result, the U.S. Bankruptcy Court for the District of Oregon concluded that the couple was entitled to an exception to the debtor’s discharge of claims under the Bankruptcy Code, and the debtor was prevented from discharging the debt (In re Holman, Sept. 8, 2015, Dunn, R.).
Background. In early 2011, the couple was introduced to the debtor through a mutual friend. The couple had funds that they wished to invest, and the debtor's business was in a "cash crunch." The couple agreed to loan the debtor $300,000, which was secured by a trust deed on the debtor's home, an assignment of the debtor's $300,000 business life insurance, and a UCC filing on business assets. Although the couple had some experience in the banking industry, they were unfamiliar with a UCC financing statement.
During the negotiations, the debtor presented the couple with an unsigned personal financial statement, stating that the debtor had assets with a total value of $6.8 million and liabilities totaling $866,000, for a net worth of almost $6 million. The debtor's business was valued as an asset worth $5 million, and the debtor’s home was valued at $775,000, with a mortgage balance of $450,000, reflecting equity of $325,000. The couple testified that they reviewed the financial statement before deciding to make the loan and relied on the financial statement in making their decision.
The loan closed on or about the end of February 2011 and was documented by a promissory note, a deed of trust the debtor’s home, a UCC-1 filing with the Oregon Secretary of State’s office, and an assignment of the debtor’s life insurance policy.
The debtor made at least six payments prior to requesting a deferral in August 2011. After the 60-day deferral period passed, the debtor made only a few sporadic payments and the last interest check received by the couple was in October 2012.
In the meantime, unbeknownst to the couple, on Aug. 18, 2011, around the same time as the debtor’s request for a deferral, the UCC-1 was terminated. Although the termination statement indicated that it was authorized by the couple, the couple testified that they knew nothing about the termination. At the same time, the debtor’s business received secured loans from two other creditors. While the debtor denied any knowledge as to who authorized the UCC-1 to be terminated, the court noted that the evidence indicated that the UCC-1 was terminated by counsel for the debtor’s business.
After the debtor followed his business into chapter 7 bankruptcy, the couple sought an exemption under the Bankruptcy Code that would prevent the debtor from discharging the couple’s claim.
Exemption for fraud. Section 523(a)(2)(A) of the Bankruptcy Code excepts from a debtor’s discharge debts for money obtained by “false pretenses, a false representation or actual fraud.” The couple argued the offer of the UCC-1 as security was fraudulent or illusory in light of the subsequent termination of the UCC-1 without the couple’s authorization or consent.
However, the court concluded the evidence did not support the couple’s claim. “However suspicious the circumstances of the unauthorized termination of the UCC-1, the evidence does not establish that [the debtor] intended to terminate the UCC-1 and default on the Loan payments at the outset of the Loan transaction,” wrote the court. In fact, the court characterized the initial negotiations regarding the UCC-1 as “the blind leading the blind.”
In particular, the court noted that there was no evidence that the couple relied on the offer of the UCC-1 as partial security because “they had no idea what a UCC-1 was or how it worked.” The couple admittedly took no steps to ascertain whether the filing of the UCC-1 provided them with any real security for repayment of the loan.
False financial statement. Although the couple was not able to demonstrate they relied on the debtor’s offer of the UCC-1, they were not without recourse. Section 523(a)(2)(B) excepts from discharge debts arising from the debtor’s intentional use of a false financial statement on which the creditor reasonably relied. A creditor must establish that the debtor knew the representations in the financial statement were false, or that the representations were so recklessly made as to satisfy that standard, and that the representations were made with the intent to deceive.
The court concluded that the evidence showed that the financial statement prepared and submitted to the couple by the debtor included net worth and home equity values that were “grossly and recklessly inflated” to induce the couple to make the loan. Not only were the liabilities on the debtor’s home understated by almost $100,000, but the debtor did not list any liabilities for his business. The court determined that based on his experience as a business owner, the debtor had to know that including the value for his business without including its corresponding liabilities grossly overstated the net value of his business.
Moreover, the circumstances surrounding the loan supported the conclusion that the debtor intended to deceive the couple in order to quickly close on the loan. “The circumstances supporting that finding include that [the debtor] apparently had exhausted his possibilities for obtaining more conventional financing for [his business]. If he had not, why would he be approaching private lenders like the [couple] and offering them “hard money” rates of interest?” The court also stated that it was reasonable to assume that the debtor had already borrowed what it could from more conventional sources, none of which were reflected on the financial statement.
As a result, the debtor was prevented from discharging the debt owed to the couple.
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