Reasonable Reliance and Dischargeability

A common exception to the discharge of a debt is that the debtor obtained credit by use of a false financial statement.[1] The Fifth Circuit recently examined this exception and provided important insight into what it means for a creditor to reasonably rely on a debtor’s statement as required by § 523(a)(2)(B).

In Veritex Community Bank v. Osborne,[2] the Fifth Circuit evaluated whether a debtor who provided a materially false financial statement should be discharged of the debt that resulted from a loan that was granted largely because of misrepresentations made by the debtor within the written statement. Section 523(a)(2)(B) provides that an individual debtor is not discharged from any debt:

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by —

(B) use of a statement in writing —

(i) that is materially false;

(ii) respecting the debtor’s or an insider’s financial condition;

(iii) on which the creditor to whom the debtor is liable for such money, property, services or credit reasonably relied; and

(iv) that the debtor caused to be made or published with intent to deceive.

This article explores the interpretation of § 523(a)(2)(B)(iii) and the burden it places on creditors to exercise “reasonable reliance” in order to successfully except discharge of debt under this provision.

The Osborne case involved a cardiologist who had personally guaranteed a loan made to his struggling business. The bank sought to disallow discharge of the debtor’s obligation because there was a material change in his financial position, including a judgment that was entered against him for over $2 million that the debtor purposefully failed to include in his written financial statements provided to the bank.[3] The bankruptcy court found that the statement provided by the debtor to the bank in support of his application for a loan extension was in fact false and put forward with the intent to deceive the bank and to induce it into agreeing to an extension of his loan. But the court found that the bank did not reasonably rely on the written statement, and therefore proceeded to discharge the debtor from the obligation. The district court affirmed the bankruptcy court’s decision. The Fifth Circuit reversed, holding that the bank had acted reasonably under the “totality of circumstances” test from Coston v. Bank of Malvern.[4]

A look at the legislative history reveals that the “reasonable reliance” standard in § 523(a)(2)(B)(iii) is meant to protect debtors from bad-faith creditors who may seek to shield their claim from discharge by purposefully relying on material misrepresentations made by debtors pre-petition.[5] Although there is some degree of due diligence required by lenders, this standard is not meant to be an unreasonably high or burdensome standard.[6] When determining whether a creditor has acted reasonably in a particular situation, courts should consider all the facts on a case-by-case basis. Coston states that a bankruptcy court “may consider, among other things: whether there had been previous business dealings with the debtor that gave rise to a relationship of trust; whether there are any ‘red flags’ that would have alerted an ordinarily prudent lender to the possibility that the representations relied upon were not accurate; and whether even minimal investigation would have revealed the inaccuracy of the debtor’s representations.”[7]

The Osborne court applied the Coston factors and found that the bank had acted reasonably and conducted the amount of due diligence required to except discharge of the debtor under § 523(a)(2)(B). The court found that the bank had no reason not to trust the debtor, since he was a well-respected doctor within the community who had been forthcoming about the financial struggles of his business.[8] It was further determined by the court that the debtor’s submission of financial statements on his own form (rather than the bank’s standard form), the lack of the debtor’s signature on the financial statement, and the failure of the debtor to list a personal guaranty related to the primary corporate borrower’s loan as a contingent liability (when the loan and guaranty were both in favor of the same lender and the lender was therefore aware of the guaranty) were not sufficient “red flags” such that the lender should have been on notice that the debtor was making material representations about his financial position.[9]

Additionally, the fact that the lender had knowledge that the corporate borrower was losing money or had changed to cash-basis reporting in the loan-extension application were also uncompelling “flags” to the court, since the bank was relying not on the financial health of the guarantor’s business, but on the underlying financial health of the personal guarantor when it decided to approve the loan extension.[10] Finally, because the bank required updated financial statements from the borrower and guarantor, ran an updated credit check on the guarantor (which did not reveal the large judgment against him), and considered the application for a loan extension for months before reaching a decision, the court found that the bank had conducted the “minimal investigation” necessary to uphold its burden.[11]

Unlike the situation in Osborne, there are plenty of cases where courts have found that creditors had not reasonably relied upon material false financial statements by borrowers. Additional factors courts have considered when determining a creditor’s reasonable reliance include: “(1) the creditor’s standard practices in evaluating credit-worthiness (absent other factors, there is reasonable reliance where the creditor follows its normal business practices); (2) the standards or customs of the creditor’s industry in evaluating credit-worthiness (what is considered a commercially reasonable investigation of the information supplied by debtor); and (3) the surrounding circumstances existing at the time of the debtor’s application for credit.”[12] In In re Cascio, the bankruptcy court found that a bank’s failure to “undertake even a minimal investigation to satisfy its own policy to ensure secondary sources of repayment when evaluating a loan applicant’s credit-worthiness” did not meet the reasonableness standard.[13] The court in Cascio further found that the bank’s failure to minimally investigate the true nature and value of an asset listed on a borrower’s financial statement as a note receivable worth $480,000 was not a reasonable level of inquiry to justify an exception to discharge.[14]

The Osborne case is a good reminder that lenders and other creditors should not rely solely on the face of written financial statements provided by potential borrowers when deciding whether to extend credit, funds, services or property to struggling businesses or individuals. Although the Bankruptcy Code “limits the opportunity for a completely unencumbered new beginning to the ‘honest but unfortunate debtor,’”[15] there is still an obligation imposed on creditors to investigate the accuracy of information provided to them on financial statements and to be on the look-out for fraudulent representations made by potential borrowers. Failure to exercise due diligence in this regard could limit a creditor’s ability to obtain an exception to discharge under § 523(a)(2)(B).