The following is a case update written by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.), analyzing a recent decision of interest:
The Fifth Circuit Court of Appeals took the unusual route of ruling that a bankruptcy court’s factual findings were clearly erroneous when it reversed the finding that, when renewing a business loan guaranteed by the debtor, a creditor did not reasonably rely on the debtor’s false financial statement, the reversal resulting in the debt being nondischargeable under 11 U.S.C. Section 523(a)(2)(B). The Circuit Court’s reversal was founded on its perception that the reasonable reliance requirement of the statute is intended to target creditors acting in bad faith to prevent debtors from discharging debts. Veritex Community Bank v Osborne, 2020 WL 1140845 (5th Cir. 3/10/20).
To view the opinion, click here.
In 2012, Dr. John Osborne, a cardiologist, formed State of the Heart PLLC (SOTHC) and soon thereafter requested a $500,000 loan from Veritex Community Bank, a regional bank in Texas. Prior to that business loan, Osborne and Veritex had no prior relationship. Veritex required Osborne to personally guarantee the loan and, in doing so, Osborne provided to the bank a personal financial statement as of August 2012. This financial statement showed Osborne’s net worth to be almost $1.5 million. Veritex approved the loan. As part of the lending process, Osborne was required to notify the bank of any material unfavorable change in his financial condition.
Two days before the Veritex loan closed, SOTHC entered into a $1 million lease for a CT scanner with PMC, also guaranteed by Osborne. Although Osborne had advised the bank that SOTHC would be leasing the scanner, he did not tell the bank he would personally guarantee the lease, nor did he update his financial statement. SOTHC defaulted on the PMC lease a year later; Osborne promptly entered into a settlement agreement, which was quickly breached. As a result of that breach, judgment was entered against Osborne for more than $2 million in October 2013. Osborne did not advise Veritex of the lease, the breach, nor the judgment against him. When he applied for a renewal of the SOTHC loan in the same time frame, he provided the bank a one-page Excel spreadsheet listing his assets and liabilities and again showing a net worth of about $1.5 million with no reference to the PMC liability. Veritex renewed the loan in March 2014 after reviewing the financial condition of the corporation and Osborne. One month later, SOTHC filed a chapter 11 case, followed by a chapter 7 filing for Osborne.
Veritex, which learned of the PMC judgment, filed an adversary for its loan to be found nondischargeable under Bankruptcy Code § 523(a)(2)(B), which prevents a debtor from discharging a debt obtained through a materially false written statement of his financial condition. After reviewing the evidence, the bankruptcy court found the financial statement submitted for the renewal was materially false and submitted with the intent to deceive, but that Veritex had not reasonably relied on it. As a result, it entered judgment for Osborne. The district court affirmed, finding the bankruptcy court’s account of the evidence plausible. Veritex appealed to the Circuit. The Circuit Court reversed and entered judgment of nondischargeability in favor of Veritex.
In determining whether a creditor’s reliance on a false financial statement was reasonable, the Fifth Circuit had established a totality of the circumstances test, under which the court could consider whether there had been previous business dealings with the debtor to give rise to a relationship of trust, whether there were any red flags that would alert a prudent lender that something was amiss, and whether “even minimal investigation would have revealed the inaccuracy of the debtor’s representations.” Coston v Bank of Malvern (In re Coston), 991 F. 2d 257 (5th Cir. 1993) (en banc). Acknowledging this test, the Fifth Circuit looked at what other circuits had ruled on the reasonableness issue and found they had emphasized that the creditor’s burden “should not be an onerous one.” The court also reviewed the legislative history behind the reasonable reliance requirement, noting that Congress intended the requirement to target creditors acting in bad faith to prevent debtors from discharging debts. The relevant House report had looked at a frequent practice of consumer lenders to require such statement on a form with insufficient space to list liabilities and otherwise to manipulate the application process to make a misstatement the rule, not the exception.
Against this backdrop, the Circuit Court reviewed the evidence the bankruptcy court relied upon to find no reasonable reliance and found it could not support a determination that the creditor was acting in bad faith and that it had, in effect, made the creditor’s burden onerous. It concluded that the three factors cited by the bankruptcy court as demonstrating the reliance was not reasonable were insufficient to make this finding. It observed that although the initial loan was the first between the parties, by the time of renewal a year later, trust had developed in the relationship; it was not uncommon for the financial statement to be on other than the bank’s form; and there was evidence that the bank regularly relied on unsigned financial statements. There were no ignored red flags and nothing indicated the lender had somehow set up the debtor to make a misrepresentation. As such, no material evidence showed that Veritex’s reliance was not reasonable.
In the ten years I sat on the 9th Circuit BAP, we reversed only once based on a clearly erroneous factual finding. When an appellant pins its hopes for victory on this standard of review, the appeal is usually doomed for failure. But here the Fifth Circuit’s clearly erroneous reversal was more like a de novo clarification of the legal standard, emphasizing that the legislative purpose behind the slightly heightened measure of reliance (case law has determined that “reasonable” is a higher bar than “justifiable”) was not intended to inhibit the ability of a good faith lender to prove nondischargeable fraud. Absent a red flag on the face of the materially false statement, just about any level of consideration of the document in the loan approval process will be sufficient to show reasonable reliance.
Circuit court decisions such as this one – note that the Fifth Circuit said its sister circuits had also made clear the burden was not intended to be onerous – should encourage a jilted creditor faced with a materially false financial statement to pursue nondischargeability, especially where a business debt is involved.
These materials were authored by the Hon. Meredith Jury (United States Bankruptcy Judge, C.D. Cal., Ret.), a member of the ad hoc group, with editorial contributions by Monique Jewett-Brewster, an attorney with Hopkins & Carley, ALC, a member of the ad hoc group and 2018-19 Chair of the CLA Business Law Section. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.