Fifth Circuit Sets Its Standard for Credit Card Non-dischargeability

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Oct 2001

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Earlier this year, the Fifth Circuit Court of Appeals took the unusual step of
granting a rehearing en banc to determine the standard for non-dischargeability of
credit card debt in <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Mercer, 246 F.3d 391 (Miss. 2001)</a>. The
rehearing followed a circuit court opinion that was not exactly unanimous. Of the three
circuit judges hearing the initial appeal, one wrote for the majority, one wrote a
concurring opinion and one dissented.

The facts of the case are not at all unique. Mercer opened a credit card account
with AT&T in November 1995 as a result of receiving a pre-approved solicitation
in late September. The account had a credit limit of $3,000. Within 31 days
of the opening of the account, Mercer had exhausted her credit limit. In January,
Mercer made a payment of $25, the only payment AT&T ever received. At the time
the payment was made, the minimum amount due was $253.82. She filed chapter
7 in April.

Mercer had been a paralegal for 20 years, earning approximately $24,000 a
year. She also had a gambling problem, having already lost $25,000 that year.
She had lost considerably more in the prior two years. In total, she had more than
$31,000 in credit card debt at the time she filed.

The opinions of the bankruptcy court, the three-judge panel of the Fifth Circuit
and the full Fifth Circuit<a href="#1" name="1a">1</a> are as much reflections of their views on the credit
card industry as they are a scholarly review of the elements of non-dischargeability
under §523(a)(2) (A). As is typical in bankruptcy law, there is usually
a case to support every point of view. Here, the majority opinion could have easily
gone another way before a different court.

<h3>The Bankruptcy Court: Focus on Reliance</h3>

The bankruptcy court, finding the debt dischargeable,<a href="#2" name="2a">2</a> based much of its decision
not on Mercer's actions, but on those of AT&T. Although there are typically five
elements that a creditor must prove to have a debt declared non-dischargeable,<a href="#3" name="3a">3</a> the
bankruptcy judge disregarded the majority of those elements, throwing the case out on
just one: reliance. Specifically, the court ruled that Mercer made no representations
on which AT&T relied at the time the account was opened because of AT&T's
pre-approval process. Although the debtor was required to fill out an "application,"
the information requested by AT&T was so sparse, in the court's opinion, that it
could not constitute a "representation." Even AT&T's representative testified that the
information requested on the credit form was merely a reinforcement of the information
they had obtained through their screening process. Rather, AT&T's decision to extend
credit to Mercer was based on credit screenings made prior to the offer.

The bankruptcy court was extremely critical of AT&T (and presumably any other
similarly situated creditors) because:

<blockquote>
In their eagerness to capture market share, banks spend little time gathering
financial information about their potential credit card customers... In instances
where pre-approved cards are issued...card issuers apparently desire to avoid
the considerable expense of determining credit-worthiness prior to issuance of the
card, and spew the cards out basically upon getting the party's name, address
and some scant information about employment (if any is obtained at all).
Issuers have obviously made a business decision regarding credit inquiries at the
inception of the relationship... [T]he court believes issuers will continue to
issue pre-approved cards without any inquiry into the cardholder's ability to repay
the charges to be incurred by use of the card... In other words, a creditor
cannot justifiably rely on any representation...made by a cardholder if the
card was pre-approved... [T]o hold otherwise only encourages creditors to
continue to act irresponsibly.<a href="#4" name="4a">4</a>
</blockquote>

As a result of the pre-approval process, the court ruled that there was no actual
reliance on any representation made by the debtor, mainly because the debtor made no
representations at all. The court also noted that even if there were actual reliance,
it would not have been considered justifiable because of the sparse financial information
AT&T obtained. The court suggested that AT&T could have asked the debtor where she
worked, her financial condition, how many children she had or whether she was
married.<a href="#5" name="5a">5</a> At trial, the bankruptcy judge apparently further suggested that issuers
could ask questions prior to issuing cards such as whether the debtor had any problem
with gambling, owed any gambling debts, or had any gambling losses or winnings over
the past several years.<a href="#6" name="6a">6</a>

In short, the bankruptcy court found that the element of reliance attaches when
the decision to offer credit is made and therefore could not be proven in a case
where a card was pre-approved. This is because, in completing the solicitation form,
the debtor does not make any representations of intent to repay upon which the creditor
relies in extending credit.<a href="#7" name="7a">7</a>

The bankruptcy court also found that AT&T was "fully aware" that the debtor was
using the card to obtain cash at an ATM machine located in a casino and thus could
not now complain about the card's usage. The court reasoned that AT&T knew this
because the debtor's billing statement showed that the transactions were made at the
Isle of Capri Casino. The court suggested that if AT&T did not want its card
to be used for gambling, they could put such a restriction in the cardholder
agreement.<a href="#8" name="8a">8</a>

<h3>The Fifth Circuit Panel—Three Different Conclusions</h3>

The majority panel opinion of the Fifth Circuit<a href="#9" name="9a">9</a> also found no reliance, but its
focus was on the element of Mercer's representation of intent to repay. "The
information Mercer returned to AT&T with her acceptance does not amount to any false
representation regarding her intent to pay."<a href="#10" name="10a">10</a> Also dismissed was the "implied
representation" theory adopted by many courts, which finds that with each use of the
account, the debtor makes an "implied" promise to pay upon which the creditor relies
in extending credit. The panel declined to adopt this theory in the context of
pre-approved credit cards on two bases: First, the decision to extend credit was
made not when the debtor used the account, but previously when the account was
issued. Second, this theory, according to the court, shifts the burden of proof to
the debtor to show his failure to pay was not fraudulent, rather than leaving it with
the creditor to show that there was fraud, as intended by the Code.<a href="#11" name="11a">11</a>

Like the bankruptcy court, the panel was also critical of AT&T's business
practices:

<blockquote>
The credit card issuers' irresponsible lending practices are another part of this
problem... If AT&T had merely had asked Mercer for information regarding her
credit card usage, AT&T may have been more prudent in its lending practices,
but AT&T did not... This holding properly places a greater responsibility on
credit card issuers for their lending practices, which have become increasingly
irresponsible...[and] properly favors the debtor instead of the creditor, and
will hopefully encourage more responsible lending practices by credit card
issuers.<a href="#12" name="12a">12</a>
</blockquote>

The concurrence to the panel opinion did find an implied promise to repay when a
debtor uses a credit card. But where a creditor issues a card without a "reasonably
adequate assessment" of the debtor's creditworthiness, the creditor cannot justifiably rely
on the debtor's implied representation. The judge agreed with the majority opinion that
AT&T did not make a reasonably adequate assessment of Mercer's financial condition to
be able to justifiably rely on her implied promise to pay. This judge added that a
creditor's reliance may become justified if, after the card is issued, the debtor
establishes a good payment history with the creditor—that is, justifiable reliance can
develop over time.<a href="#13" name="13a">13</a> Here, however, since the debtor ran the card up to its limit
within a month, there was no possibility that reliance could have developed.

The dissenting judge began by stressing the importance of the analysis of the
dischargeability of credit card debt:

<blockquote>
The analysis for determining whether credit card debt is dischargeable in bankruptcy
has enormous implications, not only for credit card issuers, but also for
millions of credit card users. Moreover, neither the card's being pre-approved,
nor its use in large part for gambling, should alter the standards for
representations and justifiable reliance vel non... Accordingly, rehearing en
banc is necessary and appropriate for this exceptionally important issue.<a href="#14" name="14a">14</a>
</blockquote>

<h3>The Fifth Circuit: Still No Consensus</h3>

The dissent formed the basis for the majority opinion of the full Fifth Circuit.
In that opinion, the majority reiterates the significance of this issue:

<blockquote>
Cards play a major role in, and promote, modern commerce... Cards are a
convenient—if not necessary—substitute for cash and checks, especially where they
are not a viable medium, such as telephone and Internet purchases. They help
small retailers compete with larger ones... Finally, cash advances, the focus
of the case at hand, are a prompt, simple and extremely convenient alternative
to bank loans.<a href="#15" name="15a">15</a>
</blockquote>

The court also took note of the other side of that argument:

<blockquote>
Readily available cards tempt consumers, hard-pressed by loss of work, illness
or family difficulties, to attempt to tide themselves over and to postpone
financial collapse or bankruptcy with little or no realistic prospect of
success.<a href="#16" name="16a">16</a>
</blockquote>

The court recognized that the difficulty in credit card cases is for the creditor
to prove the elements of misrepresentation and reliance, since the creditor does not
deal face-to-face with the debtor. This court disagreed with the bankruptcy court and
majority panel opinions and adopted the implied representation theory, holding that the
debtor makes a promise to pay each time she uses the card. The fact that the card
was pre-approved does not discount this theory because these promises to pay occur at
card use, not when a card is issued. Merely by accepting the card, the debtor was
not obligated to use it. But by using it, the debtor is requesting a loan, which
implies a promise to repay it.

Although the falsity of Mercer's representation of intent to pay was not decided,
the opinion did discuss how intent is to be determined, considering the fact that most
debtors will rarely admit that they did not intend to repay. The court found that
the commonly cited "12 factors"<a href="#17" name="17a">17</a> are helpful in determining a debtor's intent. The
court further concluded that when a debtor testifies as to her intent to repay, the
bankruptcy judge must ultimately make a credibility decision after considering the
testimony as well as the objective circumstances.<a href="#18" name="18a">18</a>

When gambling is involved, this determination becomes more complicated because often,
a debtor will claim that she intended to repay with winnings from gambling. The court
would not find this argument persuasive however, pointing out that gamblers only hope
to win. But, hoping to win is not synonymous with intending to pay. Relevant to
the inquiry of intent under these circumstances is whether the debtor has other sources
of income, and whether she intended to pay her debt with her winnings, or use those
winnings to continue gambling. In this context, the court suggested the proper inquiry
is whether the debtor has ever gambled and won, and, if so, what she did with the
winnings.<a href="#19" name="19a">19</a>

Addressing the dissent's view that a creditor must first establish reliance at the
time the credit card was issued in order to establish reliance on subsequent card use,
the court found this to be erroneous. Actual reliance is established by the fact that
credit is extended, and whether or not that reliance is justifiable is a question of
fact. Dismissing the lower court's criticism of the "minimal" information obtained on
and by Mercer, the Ninth Circuit's justifiable reliance standard for credit
dischargeablility was adopted: An issuer justifiably relies on a representation of intent
to pay as long as the account is not in default and any initial investigations into
a credit report do not raise red flags that would make reliance unjustifiable.
Further, the nature and extent of the credit investigation is not determinative. In
fact, an investigation is not even required. However, if undertaken, only obvious
falsities would make reliance unjustifiable.<a href="#20" name="20a">20</a>

As related to Mercer, the information obtained by AT&T prior to issuing the card,
according to the court, appeared not to have raised any red flags that would have
required further investigation. "For justifiable reliance, the focus should be on whether
[AT&T], based on its credit screening and its relationship with Mercer during her brief
card use, had reason to believe she would not carry out her representation of intent
to pay."<a href="#21" name="21a">21</a>

The court also addressed the issue of cash advances taken at a casino, which seemed
to be an important factor in the bankruptcy court's decision.

Not everyone [accesses cash at a casino] to obtain gambling funds...for
example, if given a choice, some might consider it safer, or more convenient,
to enter a casino to obtain cash, rather than to do so at an ATM outside
a bank, where there is no security and far greater potential for being robbed.
Or, some might be in a casino hotel for a convention or musical entertainment
and obtain a cash advance at an ATM there for non-gambling uses.<a href="#22" name="22a">22</a>
</blockquote>

Ultimately, the case was remanded back to the bankruptcy court for a determination
of whether Mercer's representation of intent to repay was knowingly false, and if so,
whether AT&T justifiably relied on that representation. However, Mercer does more
than clarify the issues for credit card cases in the Fifth Circuit. It is a case
study on how different views on non-bankruptcy matters affect the outcome of a case
that is governed by bankruptcy law. Judges with obviously divergent views on the credit
card industry came to very different conclusions on the same set of facts. While this
is to some extent a necessary and healthy way to resolve disputes, it also keeps the
waters muddy for practitioners. To a great degree, the legal system depends on
litigants and their attorneys having an idea of what to expect in a given case. In
credit card cases, until all circuits clarify the standards, debtors won't be the only
ones gambling.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The chief judge was recused from participating. <a href="#1a">Return to article</a>

<a name="2">2</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. 315 (Bankr. S.D. Miss. 1998)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> (1) That the debtor made a representation (2) that was false, (3) made with the intent to deceive (4) that was relied on
by the creditor and (5) that was the proximate cause of a loss to the creditor. <a href="#3a">Return to article</a>

<a name="4">4</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 325-326</a>. <a href="#4a">Return to article</a>

<a name="5">5</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 319</a>. The court did not discuss the legality of such questions. <a href="#5a">Return to article</a>

<a name="6">6</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d at 422</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> The district court affirmed. <a href="#7a">Return to article</a>

<a name="8">8</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… B.R. at 328</a>. <a href="#8a">Return to article</a>

<a name="9">9</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 214 (5th Cir. 2000)</a>. <a href="#9a">Return to article</a>

<a name="10">10</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 217</a>. <a href="#10a">Return to article</a>

<a name="11">11</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 217-218</a>. <a href="#11a">Return to article</a>

<a name="12">12</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 218</a>. <a href="#12a">Return to article</a>

<a name="13">13</a> This was also suggested by the bankruptcy court in a footnote. <a href="#13a">Return to article</a>

<a name="14">14</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 222-223</a>. <a href="#14a">Return to article</a>

<a name="15">15</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d 391, 401 (5th Cir. 2001)</a>. <a href="#15a">Return to article</a>

<a name="16">16</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; <a href="#16a">Return to article</a>

<a name="17">17</a> See <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… re Dougherty, 84 B.R. 653, 657 (9th Cir. BAP 1988)</a>. <a href="#17a">Return to article</a>

<a name="18">18</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=… F.3d at 409</a>. <a href="#18a">Return to article</a>

<a name="19">19</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 410</a>. <a href="#19a">Return to article</a>

<a name="20">20</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 421-422</a>. <a href="#20a">Return to article</a>

<a name="21">21</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 423</a>. <a href="#21a">Return to article</a>

<a name="22">22</a> <a href="http://www.westlaw.com/find/default.asp?rs=CLWP2.1&vr=1.0&cite=…; at 424</a>. <a href="#22a">Return to article</a>

<hr>

Journal Date

Monday, October 1, 2001 - 12:00

Bankruptcy Rule

2001

none