Wednesday, October 15, 2008

9th Circuit BAP: Debt is Dischargeable Under § 523(a)(2)(A) Although Debtor's Knowing and Intentional Misrepresentation Was Reasonably Relied Upon

By Andrew Toth-Fejel, Bankruptcy Litigation Support for Attorneys,

Ghomeshi v. Sabban (In re Sabban)
BAP No. CC-07-1269-MoPaD
February 20, 2008

In this split 2-1 BAP opinion (with Judge Randy Dunn, in his BAP capacity, siding with but not writing the majority opinion), the Court affirmed the bankruptcy court in holding that a $123,000 debt was dischargeable under § 523(a)(2)(A) notwithstanding that the transaction involved a misrepresentation by the debtor, which debtor knew to be false, and upon which the creditor has reasonably relied. The BAP relied on a 1998 U.S. Supreme Court opinion interpreting § 523(a)(2), Cohen v. De La Cruz, 523 U.S. 213 (1998). The BAP held that because the debt was based on an underlying state court judgment which clearly awarded the damages to the creditor for violation of a specific statute, and that statutory violation did not arise out of debtor's fraud or misrepresentation, this debt was dischargeable.

The Facts, and The State Court Judgment
Debtor was an unlicensed contractor who contracted with creditor to remodel creditor's home. In a state court action the trial court found that debtor represented to creditor that he was licensed, when he "knew it to be a false representation," and creditor relied on that representation and was induced into entering into the remodeling contract by it. Creditor paid $123,000 to debtor, who in turn paid out more than that to subcontractors. The state court awarded judgment against debtor exclusively for his violation of two state statutes.

The first provided that a person induced to contract with a building contractor "in reliance on false or fraudulent representation or false statements knowingly made" can be awarded a $500 penalty plus attorney fees, plus "any damages sustained by him by reason of such statements or representations made by the contractor." The court awarded creditor this $500 penalty plus $71,000 in attorney fees, but expressly found that the $123,000 paid by the creditor were NOT damages "sustained by him by reason of such statements or representations."

The second statute which the debtor was found to have violated allows a person contracting with an unlicensed contractor "to recover all compensation paid" to the contractor. This disgorgement statute is not limited to damages based on fraud.

On cross motions for summary judgment, the bankruptcy court held that the $123,000 "disgorgement" award was dischargeable but the $500 penalty and $71,000 in attorney fees were not. The creditor appealed; the debtor did not cross appeal as to the penalty or attorney fees, indeed did not even file a responsive brief in creditor's appeal.

Section 523(a)(2)(A)
This subsection exempts from discharge debts "to the extent obtained, by ... false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's . . . financial condition." Under 9th Circuit precedent, the elements a creditor must show are the misrepresentation, debtor's knowledge of its falsity, debtor's intent to deceive, the creditor's justifiable reliance on the misrepresentation, and damage to the creditor "proximately caused" by his reliance on the misrepresentation.

The BAP's Analysis and Holding
The Court focused on the last of these elements, whether the $123,000 awarded by the state court were damages "proximately caused" by creditor's reliance on debtor's misrepresentation about being a licensed contractor; or in the language of the Supreme Court's opinion in Cohen v. De La Cruz, whether that award was money "obtained by" that misrepresentation. Applying a strict construction to exceptions to discharge, the BAP construed Cohen to state that damages "assessed on account of the fraud" are not dischargeable, but distinguished the case here in that the state court had specifically held that the $123,000 in damages were not based on debtor's misrepresentation about being licensed. Instead the judgment for the $123,000 was based on the disgorgement statute which "is neutral as to fraudulent intent and was enacted to deter unlicensed contractors from offering their services for pay."

Thus the BAP held:
Because the $123,000 disgorgement of compensation under [the state statute] did not arise or flow from Debtor’s fraudulent conduct, the bankruptcy court correctly held that section 523(a)(2)(A) did not apply to that debt.

The dissenting judge believed that the Supreme Court's holding in Cohen mandated that the $123,000 award was nondischargeable. It objected to the majority opinion's strict construction of the discharge exception, stating that instead the Court "should decline to employ a general rule of construction in favor of the specific interpretation given the same statute [§ 523(a)(2)(A)] at issue in this appeal by Cohen." "Cohen admonishes that all financial liability stemming from a fraudulent act, whether it be compensatory, punitive or statutory, is excepted from discharge." "Here, the facts show that but for the debtor’s fraud, Creditor would have never hired nor paid him. Plainly, the debtor’s responsibility to disgorge payments to Creditor is directly traceable to his deception." The dissent did not specifically discuss whether or not the two statutes that the state court judgment had been based on provided for damages arising from debtor's misrepresentation.

Bottom Line
A state court judgment award, to the extent it is based on a statute which provides the creditor compensation not arising from debtor’s fraudulent conduct, is dischargeable under section 523(a)(2)(A), even though debtor may otherwise have knowingly and intentionally engaged in a fraudulent misrepresentation reasonably relied upon by creditor.

by: Andrew Toth-Fejel
Bankruptcy Litigation Support for Attorneys

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