Holding that “the reasonable reliance requirement is a low hurdle for creditors to satisfy,” the Fifth Circuit decided that the bankruptcy court’s findings of fact were clearly erroneous, and directed entry of judgment declaring that a debt was not discharged under Section 523(a)(2)(B) for issuing a fraudulent written statement about the debtor’s financial condition.
In addition, the opinion provides a safe harbor for a lender who extends the maturity of an existing sour loan when the debtor’s financial condition is deteriorating. In other words, extending maturity of a loan to a debtor known to be failing will not in itself result in discharging the debt if the debtor has issued a false financial statement in connection with negotiations to renew the loan.
The Doctor-Debtor
The debtor was a cardiologist. Along with his wife, they personally guaranteed a $500,000 loan to finance his corporate medical practice. The loan application required the doctor to notify the lender of any change in financial condition.
Two days before the loan closed, the corporation leased $1 million of medical equipment. The doctor and his wife personally guaranteed the lease. They did not notify the lender on the $500,000 loan that they had incurred the additional contingent lease liability.
A year later, the corporation defaulted on the lease. The state court entered judgment against the couple for more than $2.1 million. The couple did not inform the lender about the judgment.
In fact, a month before the judgment, the doctor began negotiating with the lender to extend the $500,000 loan for another year. In connection with the negotiations, the wife gave the lender a statement showing the couple with a net worth of $1.5 million. Again, the couple did not disclose the judgment. The financial statement did not list the couple’s liability on either the loan or the lease.
As part of its due diligence on the loan renewal, the lender obtained a new credit report showing the doctor with a credit score of 712, which had risen by two points. The credit report did not pick up the judgment.
In the course of negotiations with the lender over several months, the couple never disclosed the judgment. Having first granted interim extensions of maturity, the lender granted a one-year extension of the loan several months after the original maturity date.
About six weeks after the lender extended maturity of the loan, the corporation filed a chapter 11 petition, and the couple filed a chapter 7 petition.
The Doctor Wins in Bankruptcy Court
The lender filed a nondischargeability complaint against the doctor under Section 523(a)(2)(B). The lender alleged that it had “reasonably relied” on a “materially false” written statement regarding the doctor’s “financial condition.”
The bankruptcy court decided that the doctor did not intend to deceive the lender in connection with the original loan by failing to disclose his guarantee of the lease.
With regard to the loan renewal, the bankruptcy court concluded that the financial statement was false and intended to deceive. The bankruptcy court ruled that the wife, who presented the statement to the lender, was acting as the doctor’s agent. Nonetheless, the judge found that the lender’s reliance was not reasonable.
The bankruptcy court therefore ruled that the doctor was entitled to discharge the debt. Believing that the bankruptcy court’s conclusions from the evidence were plausible, the district court affirmed.
The Circuit Reverses on the Facts
In his 18-page opinion for the Fifth Circuit on March 10, Circuit Judge W. Eugene Davis said that an appellate court will not set aside a trial court’s findings of fact absent a definite and firm conviction that a mistake has been made. He then turned to the standard for “reasonable reliance.”
Judge Davis said that Congress engrafted a “reasonable reliance” requirement onto Section 523(a)(2)(B) to forestall “abuse” by lenders who importune borrowers to verify false financial information and thus ensure that the debt will be nondischargeable. The Fifth Circuit, he said, has “not exhaustively explored the facts that might give rise to a finding of reasonable reliance.”
Following “our sister circuits,” Judge Davis said “that the reasonable reliance requirement is a low hurdle for creditors to satisfy. The requirement is primarily meant to target bad-faith creditors who ignore red flags with the knowledge that they can later avoid the debtor’s discharge under § 523(a)(2)(B).”
Judge Davis applied the standards separately to the original loan and the extension.
The Initial Loan
When initially submitted, the first financial statement was accurate. It became inaccurate when the debtors did not update the statement to disclose their guarantees of the lease.
Judge Davis concluded that the bankruptcy court “did not clearly err” in finding that the doctor acted “without dishonest intent.” In other words, the couple’s actions in relation to the initial loan did not make the debt nondischargeable.
The loan renewal was a different matter.
The Loan Extension
The financial statement in connection with the loan renewal did not list the guarantees for either the loan or the lease. Concluding that the omissions were not red flags, Judge Davis said that the lender “had no reason to believe the [couple] would have other contingent liabilities.” He concluded that the omission of the guarantees did not make the lender’s reliance unreasonable.
The doctor argued there were other “red flags” making reliance on the financial statement unreasonable. Judge Davis took a different approach. He said the “red flags . . . spoke to the soundness of [the lender’s] decision to extend the loan to [the corporation] rather than dishonesty by [the debtor].”
Judge Davis elaborated: “The fact that [the corporation’s] financial statements showed [the doctor’s] practice was in financial trouble would not have alerted [the lender] to the possibility that [the doctor] was lying on his personal financial statement. If anything, it showed that [the doctor] was upfront about any financial struggles [his company] was facing.”
Setting aside the trial court’s finding on reliance, Judge Davis concluded that the “bankruptcy court erred in focusing on the soundness of the loan to [the corporation] rather than the truthfulness of [the doctor’s] representations.” The “alleged red flags,” he said, “were not significant enough to alert [the lender] to [the doctor’s] dishonesty.”
Observation: The opinion could be cited for the proposition that “kicking the can down the road” in itself does not waive a claim for nondischargeability.
Imputation of Fraud
Recall that the doctor’s wife had presented the new and faulty financial statement to the lender in connection with negotiations for the loan extension. The doctor argued that his wife’s misrepresentation should not be attributed to him.
Judge Davis noted that the Fifth Circuit imputes the fraud of one partner to an agent or to another partner in a Section 523(a)(2)(A) litigation for a false representation that is not about the debtor’s financial condition. The appeals court, he said, had not ruled on the same issue under Section 523(a)(2)(B), dealing with false written statements about financial condition.
With little ado, he held “that a fraudulent statement by a debtor’s partner or agent may be imputed to the debtor under § 523(a)(2)(B).”
Citing caselaw, Judge Davis said that the wife qualified as the doctor’s agent in submitting the false financial statement alongside the loan extension. He therefore directed the bankruptcy court to enter judgment declaring that the debt was not discharged.
Holding that “the reasonable reliance requirement is a low hurdle for creditors to satisfy,” the Fifth Circuit decided that the bankruptcy court’s findings of fact were clearly erroneous, and directed entry of judgment declaring that a debt was not discharged under Section 523(a)(2)(B) for issuing a fraudulent written statement about the debtor’s financial condition.
In addition, the opinion provides a safe harbor for a lender who extends the maturity of an existing sour loan when the debtor’s financial condition is deteriorating. In other words, extending maturity of a loan to a debtor known to be failing will not in itself result in discharging the debt if the debtor has issued a false financial statement in connection with negotiations to renew the loan.
The Doctor-Debtor
The debtor was a cardiologist. Along with his wife, they personally guaranteed a $500,000 loan to finance his corporate medical practice. The loan application required the doctor to notify the lender of any change in financial condition.
Two days before the loan closed, the corporation leased $1 million of medical equipment. The doctor and his wife personally guaranteed the lease. They did not notify the lender on the $500,000 loan that they had incurred the additional contingent lease liability.
A year later, the corporation defaulted on the lease. The state court entered judgment against the couple for more than $2.1 million. The couple did not inform the lender about the judgment.