Purchase and Sale of Assets

Nondischargeability and the Law of Assignments

By Myron A. Bloom

A soon-to-be debtor incurs debt using a false financial statement upon which a creditor reasonably relies. This conduct on the part of the debtor would generally result in the debt being declared non-dischargeable in a subsequently filed bankruptcy case. Before the debtor files for bankruptcy, however, the creditor assigns the debt to a third person. Does the pre-petition assignment of the claim transform the debt from a nondischarge into a dischargeable one? That was the question recently put to the Bankruptcy Appellate Panel of the 9th U.S. Circuit Court of Appeals.

In New Falls Corporation v. Boyajian (In re Boyajian), two sisters, executives of Blue Diamond Straw & Toothpick Company, personally guaranteed a 1999 lease entered into by Blue Diamond. In connection with providing those guarantees, each sister gave the lessor, Epic Funding Corporation, a personal financial statement that showed significant personal wealth. Less than one year later, Blue Diamond began to delay paying on its lease obligations ("cash flow problems" is how Blue Diamond put it).

In relatively rapid succession, Epic sold its interest in the Blue Diamond lease to Cupertino National Bank; Blue Diamond totally defaulted in its payment obligations under the lease; and the sisters defaulted on their guarantees. Cupertino, as successor to the Epic's rights, started suit against Blue Diamond and the sisters and obtained a judgment of almost $200,000 against all three. Cupertino then assigned all of its rights under the judgment to Stornawaye Capital, and Stornawaye began execution proceedings against the sisters by conducting depositions in aid of execution. It did not continue with execution, though; instead, Stornawaye assigned its rights under the judgment to New Falls.

A month after this final assignment, the sisters filed Chapter 7 bankruptcy cases. In both cases, New Falls filed nondischargeability complaints under Section 523(a)(2)(B) of the Bankruptcy Code, alleging that the sisters gave false financial statements to Epic in connection with the issuance of the guarantees. It then filed motions for summary judgment, arguing that as a matter of law, if the debts were to be found non-dischargeable as to Epic (the original creditor), then the debts must be held non-dischargeable as to Epic's various assignees. The sisters filed cross-motions, arguing that unless the creditor holding a claim at the time of the filing of the bankruptcy case could make out a non-dischargeability case as to it, the debt must be held dischargeable as a matter of law.

The bankruptcy court concluded that because New Falls, the assignee, had not itself relied upon the sisters' financial statements, New Falls could not prevail on a cause of action for nondischargeability under Section 523(a)(2)(B). It thus granted the sisters' cross-motions for summary judgment and entered judgments in their favor. New Falls appealed to the Bankruptcy Appellate Panel.

Section 523(a)(2)(B) provides that on request of a creditor, a debt will be declared non-dischargeable to the extent obtained by a written financial statement that is materially false; in respect of the debtor's financial condition; one on which the creditor to whom the debtor is liable reasonably relies; and one which the debtor made (or caused to be made) with intent to deceive.

All parties agreed that of these four elements, three (the first, second and fourth noted above) make sense only in the context of the entity originally extending credit. The question, therefore, is whether the third element above applies only to the original creditor, or to any creditor holding the debt. In other words, does the "reasonable reliance" element of Section 523 (a)(2)(B) have to be "re-evaluated" each time the debt is assigned.

The sisters argued that the phrase "creditor to whom the debtor is liable" can only mean that a re-evaluation must occur as to each creditor that holds the debt. This interpretation, they stated, is buttressed by the fact that the section refers to a "creditor," defined under Section 101(10) of the Bankruptcy Code as one that has a claim that arose at the time of or prior to the filing of the case, and not "the original creditor" or "the initial creditor," or some similar phrase. Applying this plain meaning, New Falls, the creditor at the time of the filing of the case, did not rely on the sisters' financial statements at the time of extension of credit; only Epic did.

The panel rejected this argument. It first stated that it is inconsistent with the general provision of Section 523 (a)(2) that a debt is excepted from discharge "to the extent obtained by . . . " the circumstances set forth in Section 523(a)(2)(B). The section, stated the panel, implies a unity of time. The panel also noted that Congress, when it intended to exclude debts owed to assignees, knew how to do so, referring specifically to section 523(a)(5)(A).

(Note: The provisions of BAPCPA include changes to Section 523(a)(5)(A), which the author believes does not affect the panel's reasoning, and was apparently done to eliminate a "loophole" under pre-BAPCPA legislation. See Brown and Ahern, 2005 Bankruptcy Reform Legislation with Analysis at 63 (2005).)

The second argument advanced by the sisters was that exceptions to dischargeability are to be narrowly construed in favor of debtors, and that the inclusion of the "reasonable" reliance standard in Section 523(a)(2)(B) suggests a "moderation" that should be applied to debts of this kind. The panel rejected this argument as well. The need for reasonable reliance, stated the panel, and as explained by other courts, was directed at curtailing abuses of lenders, primarily consumer lenders, who often requested some financial data as they completed applications for borrowers, and then "relied" on those skeletal applications in submitting that such debts should be held non-dischargeable in a subsequent bankruptcy case.

More fundamentally, stated the panel, the sisters' position did not take into account the legal implications of an assignment. Citing to hornbook law, the panel stated that an assignee steps into the shoes of the assignor; the assignee takes the rights of (and is subject to the defenses raised by) the assignor. The rights acquired by the assignee, as a general matter, are "all" rights. Citing to other cases, the panel stated that it was "not sensible" to argue that the Bankruptcy Code or rules somehow restrict an assignee's rights to assert all of the rights of the original creditor. As it was unquestioned that New Falls here had assigned to it all of Epic's rights, it should be clear that as a matter of basic assignment law, New Falls succeeded to all of Epic's right to object to dischargeability.

The sisters claimed that they gave statements five years before New Falls acquired the judgments, and it would not be reasonable to assume statements, whether true or false when given, would be true five years later. This position, stated the panel, created a red herring - it is the fraud at the time the statements are made that gives rise to non-dischargeability. The language of the statute, after all, speaks to the obtaining of credit based on fraud. This clearly indicates that future events are not at issue; rather, the issue is whether fraud existed at the time of the extension of credit.

Finally, the panel considered the policy implications of a contrary holding. It noted that a contrary holding would end up condoning a lie, if a debtor were to be fortunate enough to have his or her creditor assign the debt. This would in certain circumstances avoid the consequences of dishonesty by debtors, predicated on the chance sale of a claim. In the absence of Congressional intent to create such a policy, the panel noted, it would not do so here.

Accordingly, the panel reversed the bankruptcy court decision and remanded for trial.

It would seem that the real issue in cases of this type is who deserves the benefit of the windfall? The creditor, whose claim was likely purchased without any thought given to the circumstances surrounding the issuance of the credit? Or the debtor, whose lie occurred before the creditor showed up on the scene? The panel here came down on the side of the creditor. The question, it is submitted, would appear to be much closer than the panel made it.

This article is reprinted with the permission from the May 11, 2007 issue of The Legal Intelligencer.  Copyright 2007 ALM Properties, Inc.  Further duplication without permission is prohibited.  All rights reserved.