Business Law

In re Winick (Bankr. S.D. Cal.) – The Court gave effect to a release of the equipment lessor, in the face of the lessee’s claims of fraudulent inducement.

The following is a case update written by Dean T. Kirby, Jr., a member of the ad hoc group of the California Lawyers Association’s (CLA) Business Law Section, analyzing a recent decision of interest:

SUMMARY

In re Winick, 2019 WL 4918085 (S.D. Cal. October 3, 2019) involved a workout agreement entered into after a default under a UCC Article 2A finance lease. The Court gave effect to a release of the equipment lessor, in the face of the lessee’s claims of fraudulent inducement.

Facts:  Plaintiff Joseph Lee was one of the founders of Simply Smokin’ Records, Inc., a corporation formed for the purpose of operating a jazz club. In April, 2003 Simply Smokin’ entered into an equipment lease with Creative Capital Leasing Group. The Lease provided that it “qualifies as a Statutory Finance Lease as defined by the California Commercial Code.” Article 2A of the Uniform Commercial Code facilitates financing of equipment acquisitions by third party lessors who are, in practical effect, secured lenders.

Defendant David Winick negotiated and executed the Lease on behalf of Creative Capital. Mr. Lee and his wife guaranteed the obligations of Simply Smokin’ under the Lease. Lee alleged that at the inception of the Lease he was induced to sign the guarantee by Winick’s representations that the Lease could be “refinanced” if Simply Smokin’ “repaid whatever amount Creative Capital had advanced . . . and there would be no prepayment penalty.”

Creative Capital advanced $393,271 to Simply Smokin’. In October, 2003, about six months after the inception of the Lease, Simply Smokin’ obtained a bank loan for the purpose of refinancing the Lease. Winick then told Lee that the payoff amount was more than $1,000,000. Counsel for Creative Capital followed up with a demand for $1,020,070.37, which included “the balance of payments due on the lease.”

Following this exchange, the parties (including Lee as a guarantor) entered into a Third Addendum to the Lease, which recited that Simply Smokin’ was in default. The Third Addendum restructured the rent schedule and stated that if the payments were made “neither Lessee nor Guarantors are in default . . . [and] Lessor agrees to withhold any action to accelerate payments under the Lease.”

The Third Addendum included a general release of Winick, including a release of unknown claims, waiving the limitation on such releases contained in California Civil Code section 1542.

The opinion mentions that in 2006 Lee sued in Superior Court “to reform the financing documents to conform those documents to a loan.” Lee was given permission to add Winick personally as a defendant, including a claim for fraud, and Lee obtained a default judgment against Winick. No other details are provided.

In May, 2018, Winick filed a chapter 7 bankruptcy petition. Lee filed a complaint seeking a determination that Winick’s debt to him was non-dischargeable, because it was obtained by “false pretenses, a false representation, or actual fraud . . .” within the meaning of 11 U.S.C. §523(a)(2)(A). The Bankruptcy Court granted Winick’s motion to dismiss for failure to state a claim under Federal Rule of Civil Procedure 12(b)(6). Lee appealed to the United States District Court for the Southern District of California, which affirmed.

Reasoning:  In affirming the dismissal, the District Court rejected two arguments made by Lee. First, Lee contended that the release contained in the Third Addendum was not effective because it was procured by fraud in the inducement. Lee cited California Civil Code section 1668, which provides that “contracts which have for their object, directly or indirectly, to exempt anyone from responsibility for his own fraud . . . are against the policy of the law.” The Court cited SI 59 LLC v. Variel Warner Ventures, LLC, 29 Cal.App.5th 146, 148, 239 Cal.Rptr.3d 788 (2018) which held that “section 1668 negates a contractual clause exempting a party from responsibility for fraud or a statutory violation only when all or some of the elements of the tort are concurrent or future events at the time the contract is signed.” In applying this rule, the Court considered the Third Addendum separately from the Lease that it amended. While Lee alleged that he was fraudulently induced to sign the Lease to begin with, the conflicting claims about the amount necessary to pay off the Lease had been made, and were known to Lee, before the Third Addendum was signed. The Court reasoned that while the law may regard the Lease and the Addendum as a single contract “[t]he rule does not govern fraud, which treats subsequent agreements separately.”

The Court gave short shrift to Lee’s second argument, that Winick was not entitled to enforce the release because he (Creative Capital) breached the Third Addendum. The opinion briefly discusses authority to the effect that “[a] breach does not terminate a contract as a matter of course but is ground for termination at the option of the injured party” Whitney Inv. Co. v. Westview Dev. Co., 273 Cal.App. 2d 594, 602, 78 Cal. Rptr. 302, 308 (1969). But the Court did not attempt to explain the significance of that rule in this case, perhaps because the Court ruled that it was clear on the face of the pleadings that it was Lee, not Winick, who breached the Third Addendum.

Author’s Comment:  Workout and forbearance agreements often include clauses under which the borrower or tenant releases the lender or landlord, including a release of unknown claims. In the Winick case, the facts constituting the alleged fraud were out in the open when the release was signed. In other cases, elements of concealment and continuing reliance may exist at the time that the release is made, and damages may not have begun to accrue.

The above-quoted California Civil Code section 1668 could be literally applied to deny effectiveness to a release contained in any settlement between a plaintiff and a defendant who committed fraud. The Court in SI 59, supra., observed that “[w]hether section 1668 might apply to past torts is a slippery question.” 29 Cal.App.5th at 152. Use of recitals in a workout agreement, to make clear that the alleged tort being released has already taken place, and that damages have already resulted, would be obviously problematic.

If Lee’s Complaint had plausibly alleged that Creative Capital did breach the Third Addendum, then it would have been necessary to delve more deeply into the legal consequences of that breach as to the release. Lee apparently did not allege that he had rescinded the Third Addendum and the opinion does not explore what would have been necessary to rescind.

The Court did not discuss whether Winick’s position, that it was necessary to pay all future rent for the remainder of the seven year term in order to “pay off” the Lease, was correct. UCC Article 2A includes provisions limiting damages for the breach of finance leases, more so in cases in which the leased goods are tendered back to the lessor. See, UCC section 2A-528, California Commercial Code section 10528.

This case comes in the wake of the California Supreme Court’s controversial decision in Riverisland Cold Storage, Inc. v. Fresno-Madera Prod. Credit Assn., 55 Cal. 4th 1169, 291 P.3d 316 (2013) which held that the parol evidence rule does not bar evidence of fraudulent promises at variance with terms of an integrated written contract. This means that Winick could be sued for representing to Lee, before he signed the Lease, that the Lease did not mean what it presumably said.

Finally, Creative Capital Leasing Group, LLC was itself a debtor in the Southern District of California, in a bankruptcy case that was pending for a bit less than ten years after it was converted to chapter 7 in 2008. A review of the 1277 docket entries in Bankruptcy Case No. 07-04977 will confirm that when Creative Capital sought bankruptcy protection its legal affairs were, to put it mildly, not in order. .

These materials were written by members of the California Lawyers Association Business Law Section for the Commercial Finance Newsletter, published weekly on Westlaw. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them.  This material may not be further distributed without the consent of Thomson Reuters.

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