Wednesday, February 11, 2009

Accountant's Mistake on Financial Statement Leads to Non-Dischargeable Debt

A recent opinion from the Fifth Circuit demonstrates that non-dischargeable claims for false financial statements can extend beyond the traditional lender-borrower relationship and that a third party's error can create liability when it is knowingly adopted by the debtor. Matter of Morrison, No. 07-51118 (5th Cir. 1/16/09).

David Morrison was president of Morrison Excavation. Like many construction contractors, the firm was short of cash and looking for new work. On February 6, 2002, the company's CPA informed David that the company's financial condition was dire. To make things worse, on February 15, the company's bookkeeper found an accounting error which inflated the company's accounts receivable by $857,000. When the inflated receivables were removed, the company was insolvent. The previous day, the company had submitted a bid for a subcontract with Western Builders. After reviewing the company's work at several job sites and performing a credit check, Western requested a financial statement. On February 22, David faxed the financial statement containing the inflated receiveables to Western. On March 6, Morrison Excavation entered into a subcontract with Western and started taking draws on March 28. During that time, the company used the draws from Western to pay off lienholders who they said had previously been paid. David also gave himself a raise and paid off a personal home equity loan from company funds. By mid-August, Morrison Excavation abandoned the job. Western hired another contractor to finish the job at and additional cost of over half a million dollars. David Morrison filed chapter 7 on March 13, 2004.

Western filed a non-dischargeability action against David based upon submitting a false financial statement. At trial, two company employees testified that David was informed about the error in the financial statement somewhere around February 15, which was prior to the time that he provided the statement to Western. The bankruptcy court found that the subcontract created a debt which could be nondischargeable under Sec. 523(a)(2)(B) because Morrison could be held liable for the misrepresentation which benefited Morrison Excavation. The bankruptcy court also entered a money judgment against David in the amount of $549,773.63. On appeal, the Fifth Circuit affirmed, finding that the Bankruptcy Court had the jurisdiction to enter a money judgment in a dischargeability action (agreeing with five other circuits) and affirming the Bankruptcy Court's conclusions on liability and non-dischargeability.

While the result in this case is not particularly remarkable, it demonstrates how personal liability for a non-dischargeable debt can arise in a business setting.

1. While false financial statement cases often arise from a loan application, the Morrison case shows that they can arise in any context. What is interesting about this case is the fact that Western Builders did a substantial amount of due diligence before entering into the contract with Morrison Excavation. It observed job sites, ran a credit check and requested a financial statement. Although reliance was not discussed in the Fifth Circuit opinion, it seems clear that Western was trying to protect itself from doing business with a financially shaky subcontractor who would not be able to complete the job.

2. It did not matter that the financial statement was for Morrison Excavation or that David Morrison was not the person responsible for preparing the financial statement. When David Morrison faxed the financial statement to Western for the purpose of being awarded the subcontract and after being informed that it erroneously showed a positive net worth instead of a negative one, he fell within the statutory language of receiving money or property based upon "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 . . . reasonably relied; and

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

The financial statement was materially false because it showed the company as solvent rather than insolvent. It depicted the financial condition of an insider. The creditor reasonably relied on the statement as shown by the fact that it conducted several types of due diligence before entering into the contract. Finally, the debtor's intent to deceive was shown by the fact that he had been told that the statement was inaccurate but faxed it anyway.

3. It was not necessary to pierce the corporate veil to impose liability on the corporate officer. Under Texas tort law, an individual may be held liable for "fraudulent or tortious acts commited while in the service of his corporation."

4. The creditor was allowed to obtain both a judgment of non-dischargeability and a money judgment in the same proceeding. This allowed the creditor to obtain all of the necessary relief in one action.

3 comments:

Michael Miller said...

Interesting case, Steve.

While it is very clear that 523(a)(2) is not limited to loans, I'm still not clear about this case. It appears from your summary that the debt was for the contract damages (the cost of completion), not the draws (which are usually obtained only by properly completed work). It's possible that all draws were for properly completed work (thus, no debt for that money), yet the uncompleted part might cost more to complete than Morrison had agreed to be paid for that part. If so, the debt is only for the benefit of the bargain. I don't see 523(a)(2) covering mere "benefit of the bargain" contract damages. Suppose, after being awarded the contract but before beginning any work (or getting any draws), Morrison Excavation told Western it would not perform, so Western hired another company at a higher price, leaving a "benefit of the bargain" debt for the difference. Morrison Excavation (and Morrison) would have obtained no money, property, services or credit. Why would 523(a)(2) apply to that debt? Did the court discuss this?

Also, do you know of any case law holding that an LLC is a "corporation" under the Code? The Code specifically says that a limited partnership is not a "corporation," so a limited partnership is not an affiliate of its general partner (but could be an insider anyway). The definition of "corporation" does not seem to include an LLC. The definition of "insider" does not mention LLCs per se. I've been wondering about this for a while, and this case made me remember, and wonder what result if the company were an LLC.

Michael Miller

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Houston Bankruptcy Attorney Alex Wathen said...

The really interesting issue is how this bears on the right to a jury trial in certain core proceedings such as fraudulent transfers. Does this also apply to non-dischargeability? Certainly if the non-core issue of liability is litigated then there is a right to a jury trial in many cases. Increasingly good bankruptcy attorneys will have to raise this issue and possibly also whether there is a right to an Article III tribunal in a core bankruptcy matter.