As I regularly review court cases to keep up on the law, I often run into ones that provide a good way to help my readers understand some important aspect of bankruptcy. Today's blog post does this through a recent decision by the federal Ninth Circuit Court of Appeals, whose jurisdiction covers California and other western states. In Deitz v. Ford the court looked at whether Shawn Deitz, a building contractor, could discharge—legally write off—his obligation to Wayne and Patricia Ford, his customers, in Deitz' Chapter 7 case in spite of the Fords' allegations that he defrauded them. The court decided that under the facts of the case Deitz' actions were indeed fraudulent and so he could not discharge what he owed to the Fords for a home-building project that sour.
WHAT ACTIONS ARE CONSIDERED FRAUD SO THAT THEY RISK NOT BEING DISCHARGED IN BANKRUPTCY?
From the start be aware of this reality: any creditor can potentially challenge a debtor's attempt to discharge a debt on the basis of fraud, but the legal standards for doing so are quite high and so such challenges are very seldom raised. A huge majority of bankruptcy cases do not have any such discharge challenges.
The Deitz case showcases the elements that a creditor would have to prove to convince a bankruptcy court that a debt was based on fraud. The Fords argued that their claim for damages against Deitz regarding his attempt to build them a house should not be discharged in bankruptcy because of Deitz' fraud. The Fords alleged that:
Deitz knowingly made intentional material misrepresentations to them with the intent to deceive the Fords, upon which they justifiably relied in retaining Deitz, and that the Fords suffered damages as a result of Deitz' fraud.
Note that just about every word in that sentence had to be proved by the Fords in order to prevail. If any element is not established by a creditor, its debt is discharged. The court in this case quoted an earlier Ninth Circuit Court of Appeals decision stating: "The creditor bears the burden of proof to establish all . . . of these elements by a preponderance of the evidence."
WHAT KIND OF 'MATERIAL MISREPRESENTATIONS" DOES IT TAKE TO BE FRAUDULENT?
In this case the main misrepresentation Deitz made was that he was a licensed contractor, when he wasn't during the relevant period of time. "That a contractor was properly licensed was important to the Fords because it was a condition for their receipt of funds" from the Veterans Administration, which was providing most of the financing for the project. When the parties signed the contract for constructing the house Deitz did not have a valid license, it had been suspended a number of times, and was revoked during the construction. Deitz did not deny these facts about his license.
The Fords testified that although they were aware that Deitz had had some problems with his contractor's license, "based on their statements to them, the Fords believed that Deitz had resolved any problems with his contractors license before they entered into the building contract with them."
Interestingly, there was also evidence Deitz had made similar misrepresentations about his license to other customers. The bankruptcy court, and the court of appeals, accepted this as evidence of Deitz' misrepresentations, because under federal rules "[e]vidence of the habit of a person, or of a routine or practice, is relevant to prove that the conduct of a person on a particular occasion was in conformity with their habit or routine practice." So evidence of the fact that the contractor had misrepresented his license status to others was enough to constitute a "material misrepresentation" for purposes of establishing his fraud as to the Fords.
HOW DOES A CREDITOR SHOW A DEBTOR'S "INTENT TO DECEIVE"?
Indeed that is the element that this case hinged on. That's the only element that Deitz presented arguments about on appeal. He argued that "he never intended to defraud or willfully injure the Fords."
After hearing testimony from 5 people—the Fords, Deitz, an investigator and a subcontractor—and reviewing over 500 pages of documentary evidence—the bankruptcy court found that Deitz' "misrepresentations were intentional and designed specifically to deceive and induce [the Fords] for the sole purpose of being retained to build [the Fords'] home and profit thereby."
The court of appeals ruled that "because the bankruptcy court's factual findings were based in part on its assessment of the credibility of witnesses, those findings are entitled to deference from [the appeals court]." And because an appeals court can overturn a trial court (the bankruptcy court here) as to findings of fact only when it finds "clear error," the court of appeals decided that "Deitz' misrepresentations to the Fords were made with the requisite intent to deceive them."
DOES FRAUDULENT BEHAVIOR EXPOSE A PERSON TO CRIMINAL CHARGES AS WELL?
The kinds of behavior required to have a debt be considered not dischargeable can sometimes result in criminal charges. That happened here. The local District Attorney in Fresno County filed a criminal complaint against Deitz in the midst of his Chapter 7 case. He was charged with grand theft in connection with his building contracts with the Fords and three other customers, and was also charged with contracting without a license. After a jury trial, Deitz was found not guilty on the theft charges but guilty of the license violation, a misdemeanor.
Notice that Deitz was determined by a jury to be not guilty of theft, while the bankruptcy court, and then the court of appeals (plus in between a lower appeals court—the Bankruptcy Appellate Panel) determined, without a jury, that he defrauded the Fords and thus could not discharge the huge amount of money he owed them. The reason for the difference in result is a difference in the elements to be proved in the criminal vs. bankruptcy courts, and, probably more importantly, the higher standard of proof in criminal court—"beyond a reasonable doubt" instead of "by a preponderance of the evidence."
To be clear: if challenges to discharge for fraud and related behavior are uncommon, criminal charges for behavior by debtors against their creditors are even more rare. It usually takes something like embezzlement from an employer, a major business fraud, or a pattern of harming a number of people as in the Deitz case for it to rise to the attention of a district attorney.
WHAT OTHER KIND OF DEBTOR BEHAVIOR CAN RESULT IN A DEBT NOT BEING DISCHARGED IN BANKRUPTCY?
There are two other main kinds of potentially problematic behavior:
- Fraud in a fiduciary capacity
- Willful and malicious injury
Both these came into play in the Deitz case, although they were not the main focus.
The allegations about fiduciary capacity were that "through fraud, trick and device, with a preconceived design and intent, Deitz misappropriated monies from the Fords." The allegations about injury were that "Deitz' actions were willful, malicious, and the proximate cause of the Fords' financial damages."
The bankruptcy court found that Deitz took the Fords' money intended for building the house and used it for other purposes, resulting in embezzlement. The court also found that Deitz' deceitful misrepresentations resulted in him getting "substantial funds from the Fords," causing foreseeable willful and malicious financial injuries.
The court of appeals determined that the bankruptcy court's determinations would stand because Deitz failed to dispute them on appeal, or at least failed to do so "specifically and distinctly," and he thereby waived his challenge to them.
DOES THE BANKRUPTCY COURT HAVE POWER TO DECIDE WHETHER A DISPUTED CLAIM LIKE THIS CAN BE DISCHARGED, AND TO DETERMINE THE AMOUNT A DEBTOR OWES?
That was actually the initial big issue on appeal here, so this question is not at all out of line. Although it's clear that Congress has the power to legislate about bankruptcy under the U.S. Constitution, for decades there have been big debates about how much power bankruptcy judges can have under the Constitution. The situation was complicated a few years ago by an opinion of the U.S Supreme Court that somewhat restricted the power of bankruptcy judges.
Deitz attempted to use that Supreme Court opinion to challenge the power of the bankruptcy judge in his case to determine that his debt to the Fords was not dischargeable, and to fix the amount he owed them, exactly $386,092.76.
Simply put, the court of appeals determined that, yes indeed, the bankruptcy court has those powers. The Supreme Court opinion did not apply to non-dischargeability issues, which are firmly within the jurisdiction of the bankruptcy courts.