‘Bankruptcy Planning,’ Alone, Doesn’t Equal Fraudulent Intent to Evade Creditors – IL ND

A Northern District of Illinois bankruptcy judge recently rejected a creditor’s attempt to nix a debtor’s discharge for fraud.  The creditor alleged the debtor tried to escape his creditors by shedding assets before his bankruptcy filing and by not disclosing estate assets in his papers.  Finding for the debtor after a bench trial, the Court in Monty Titling Trust I v. Granrath, 15 AP 00826 illustrates the heavy burden a creditor must meet to successfully challenge a debtor’s discharge based on fraud.

The Court specifically examines the contours of the fraudulent conduct exception to discharge under Code Section 727(a)(2) and Code Section 727(a)(4)’s discharge exception for false statements under oath.

Vehicle Trade-In and Lease

The court found that the debtor’s conduct in trading in his old vehicle and leasing two new ones in his wife’s name in the weeks leading up to the bankruptcy filing was permissible bankruptcy planning (and not fraud).  Since bankruptcy aims to provide a fresh start to a debtor, a challenge to a discharge is construed strictly against the creditor opposing the discharge.  Under the Code, a court should grant a debtor’s discharge unless the debtor “with intent to hinder, delay or defraud a creditor” transfers, hides or destroys estate property.

Under the Code, a court should grant a debtor’s discharge unless the debtor “with intent to hinder, delay or defraud a creditor” transfers, hides or destroys property of the debtor within one year of its bankruptcy filing. 11 U.S.C. s. 727(a)(2)(A).  Another basis for the court to deny a discharge is Code Section 727(a)(4) which prevents a discharge where a debtor knowingly and fraudulently makes a false oath or account.

To defeat a discharge under Code Section 727(a)(2), a creditor must show (1) debtor transferred property belonging to the estate, (2) within one year of the filing of the petition, and (3) did so with the intent to hinder, delay or defraud a creditor of the estate.  A debtor’s intent is a question of fact and when deciding if a debtor had the requisite intent to defraud a creditor, the court should consider the debtor’s whole pattern of conduct.

To win on a discharge denial under Code Section 727(a)(4)’s false statement rule, the creditor must show (1) the debtor made a false statement under oath, (2) that debtor knew the statement was false, (3) the statement was made with fraudulent intent, and (4) the statement materially related to the bankruptcy case.

Rejecting the creditor’s arguments, the Court found that the debtor and his wife testified in a forthright manner and were credible witnesses.  The court also credited the debtor’s contributing his 401(k) funds in efforts to save his business as further evidence of his good faith conduct.  Looking to Seventh Circuit precedent for support, the Court found that “bankruptcy planning does not alone” satisfy Section 727’s requirement of intent.  As a result, the creditor failed to meet its burden of showing fraudulent conduct by a preponderance of the evidence.

Opening Bank Account Pre-Petition

The Court also rejected the creditor’s assertion that the debtor engaged in fraudulent conduct by opening a bank account in his wife’s name and then transferring his paychecks to that account in violation of a state court citation to discover assets.  

The court noted that the total amount of the challenged transfers was less than $2,000 (since the most that can be attached is 15% gross wages under Illinois’ wage deduction statute) and the debtor’s scheduled assets exceeded $4 million.  Such a disparity between the amount transferred and the estate assets coupled with the debtor’s plausible explanation for why he opened a new bank account in his wife’s name led the Court to find there was no fraudulent intent.

Lastly, the court found that the debtor’s omission of the bank account from his bankruptcy schedules didn’t rise to the level of fraudulent intent.  Where a debtor fails to include a possible asset (here, a bank account) in his bankruptcy papers, the creditor must show the debtor acted with specific intent to harm the bankruptcy estate.  Here, the debtor testified that his purpose in opening the bank account was at the suggestion of his bankruptcy lawyer and not done to thwart creditors.  The court found these bankruptcy planning efforts did not equal fraud.

Afterwords:

1/ Bankruptcy planning does not equate to fraudulent intent to avoid creditors.

2/ Where the amount of debtor’s challenged transfers is dwarfed by scheduled assets and liabilities, the Court is more likely to find that a debtor did not have a devious intent in pre-bankruptcy efforts to insulate debtor assets.

 

‘Integration’ Versus ‘Non-Reliance’ Clause: A ‘Distinction Without a Difference?’ (Hardly)

Two staples of sophisticated commercial contracts are integration (aka “merger” or “entire agreement”) clauses and non-reliance (aka “no-reliance” or “anti-reliance”) clauses. While sometimes used interchangeably in casual conversation, and while having some functional similarities, there are important differences between the two clauses.

An integration clause prevents parties from asserting or challenging a contract based on statements or agreements reached during the negotiation stage that were never reduced to writing.

A typical integration clause reads:

This Agreement , encompasses the entire agreement of the parties, and supersedes all previous understandings and agreements between the parties, whether oral or written. The parties hereby acknowledge and represent that they have not relied on any representation, assertion, guarantee, or other assurance, except those set out in this Agreement, made by or on behalf of any other party prior to the execution of this Agreement. 

Integration clauses protect against attempts to alter a contract based on oral statements or earlier drafts that supposedly change the final contract product’s substance.  In litigation, integration/merger clauses streamline issues for trial and avoid distracting courts with arguments over ancillary verbal statements or earlier contract drafts.here integration clauses predominate in contract disputes,

Where integration clauses predominate in contract disputes, non-reliance clauses typically govern in the tort setting.  In fact, an important distinction between integration and non-reliance clauses lies in the fact that an integration clause does not bar a fraud (a quintessential tort) claim when the alleged fraud is based on statements not contained in the contract (i.e,. extra-contractual statements). *1, 2

A typical non-reliance clause reads:

Seller shall not be deemed to make to Buyer any representation or warranty other than as expressly made in this agreement and Seller makes no representation or warranty to Buyer with respect to any projections, estimates or budgets delivered to or made available to Buyer or its counsel, accountants or advisors of future revenues, expenses or expenditures or future financial results of operations of Seller.  The parties to the contract warrant they are not relying on any oral or written representations not specifically incorporated into the contract.”  

No-reliance language precludes a party from claiming he/she was duped into signing a contract by another party’s fraudulent misrepresentation.  Unlike an integration clause, a non-reliance clause can defeat a fraud claim since “reliance” is one of the elements a fraud plaintiff must show: that he relied on a defendant’s misstatement to the plaintiff’s detriment.  To allege fraud after you sign a non-reliance clause is a contradiction in terms.

Afterwords:

Lawyers and non-lawyers alike should be leery of integration clauses and non-reliance clauses in commercial contracts.  The former prevents a party from relying on agreements reached during negotiations that aren’t reduced to writing while the latter (non-reliance clauses) will defeat one side’s effort to assert fraud against the other.

An integration clause will not, however, prevent a plaintiff from suing for fraud.  If a plaintiff can prove he was fraudulently induced into signing a contract, an integration clause will not automatically defeat such a claim.

Sources:

  1. Vigortone Ag Prods. v. AG Prods, 316 F.3d 641 (7th Cir. 2002).
  2. W.W. Vincent & Co. v. First Colony Life Ins. Co., 351 Ill.App.3d 752 (1st Dist. 2004)

 

Retailers’ Sales Forecasts Not Factual Enough to Buttress Fraud In Inducement Claim (IL ND)

The Northern District of Illinois provides a useful synopsis of Federal court summary judgment standards and the scope of some Illinois business torts in a dispute over a canceled advertising contract to sell hand tools.

The plaintiff in Loggerhead Tools, LLC v. Sears Holding Corp., 2016 WL 5111573 (N.D.Ill. 2016) sued Sears when it canceled an agreement to promote the plaintiff’s Bionic Wrench product and instead bought from plaintiff’s competitor.   The plaintiff claimed that after Sears terminated their contract, it was too late for the plaintiff to supply product to competing retailers.  Plaintiff filed a flurry of fraud claims alleging the department store giant made inflated sales forecasts and failed to disclose it was working with  plaintiff’s competitor.  Sears successfully moved for summary judgment on the plaintiff’s claims.

Summary Judgment Guideposts

Summary judgment is appropriate where the movant shows there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.  Courts deciding summary judgment must view the facts in the light most favorable to the nonmoving party only if there is a “genuine” dispute as to those facts.  A genuine fact dispute exists where a reasonable jury could return a verdict for the nonmoving party. 

The summary judgment movant has the initial burden of establishing an absence of a genuine fact dispute.  Once the movant meets this burden, it then shifts to the nonmovant/respondent who must point to specific evidence in the record that shows there is a genuine issue for trial.  But only “material” factual disputes will prevent summary judgment.  A fact is material where it is important and could potentially affect the outcome of a case.

The summary judgment movant has the initial burden of establishing an absence of a genuine fact dispute.  Once the movant meets this burden, it then shifts to the nonmovant/respondent who must point to specific evidence in the record that shows there is a genuine issue for trial.  But only “material” factual disputes will prevent summary judgment.  A fact is material where it is important and could potentially affect the outcome of a case.

The summary judgment movant has the initial burden of establishing an absence of a genuine fact dispute.  Once the movant meets this burden, it then shifts to the nonmovant/respondent who must point to specific evidence in the record that shows there is a genuine issue for trial.  But only “material” factual disputes will prevent summary judgment.  A fact is material where it is important and could potentially affect the outcome of a case.

The summary judgment movant has the initial burden of establishing an absence of a genuine fact dispute.  Once the movant meets this burden, it then shifts to the nonmovant/respondent who must point to specific evidence in the record that shows there is a genuine issue for trial.  But only “material” factual disputes will prevent summary judgment.  A fact is material where it is so important that it could alter the case’s outcome.

Fraud Analysis:

The crux of Plaintiff’s fraud suit was that Sears strung Plaintiff along by creating the false impression that Sears would market Plaintiff’s products.  Plaintiff alleged that Sears concealed its master plan to work with Plaintiff’s competitor and only feigned interest in Plaintiff until Sears struck a deal with a competing vendor.

An Illinois fraud plaintiff must show:  (1) defendant made a false statement of material fact, (2) defendant knew the statement was false, (3) the defendant intended the statement to induce the plaintiff to act, (4) the plaintiff justifiably relied on the statement’s truth, and (5) plaintiff suffered damages as a result of relying on the statement.

A bare broken promise doesn’t equal fraud.  An exception to this “promissory fraud” rule is where the defendant’s actions are part of a “scheme to defraud:” that is, the defendant’s actions are part of a pattern of deception.  The scheme exception also applies where the plaintiff can show the defendant did not intend to fulfill his promise at the time it was made (not in hindsight).

In determining whether a plaintiff’s reliance on a defendant’s misstatement is reasonable, the court looks at all facts that the plaintiff had actual knowledge of as well as facts the plaintiff may have learned through ordinary prudence.

Here, Sears’ sales forecasts were forward-looking, “promissory” statements of hoped-for sales results.  Sears’ profuse contractual disclaimers that sales forecasts were just “estimates” to be used “for planning purposes” only and “not commitments” prevented the Plaintiff from establishing reasonable reliance on the projections.

The court also rejected the plaintiff’s fraudulent concealment claim.  To prevail on a fraud claim premised on concealment of material facts, the plaintiff must show that the defendant had a duty to disclose the material fact.  Such a duty will arise where the parties have a special or fiduciary relationship that gives rise to a duty to speak.  

Parties to a contract are generally not fiduciaries.  Relevant factors to determine whether a fiduciary relationship exists include (1) degree of kinship of the parties, and (2) disparity in age, health, mental condition, education and business experience between the parties.

Here, there was no disparity between the parties.  They were both sophisticated businesses who operated at arms’ length from one another.

Afterwords: This case provides a good distillation of summary judgment rules, promissory fraud and the scheme to defraud exception to promissory fraud not being actionable.  It echoes how difficult it is for a plaintiff to plead and prove fraud – especially in the business-to-business setting where there is equal bargaining power between litigants.

This case provides a good distillation of summary judgment rules, promissory fraud and the scheme to defraud exception to the promissory fraud rule.  The case further illustrates the difficulty of proving fraud – especially in the business-to-business setting where there is equal bargaining power between the parties.