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Bankruptcy: The Fraud Exception

fraud

Bankruptcy: The Fraud Exception

burkeWhile the general rule is that a person who files for bankruptcy is relieved from all debts incurred by that person before the filing of the bankruptcy, as with all general rules, there are exceptions, and one of those exceptions has been the subject of some debate in recent years.  Specifically, the Bankruptcy Code does not allow a person to discharge a debt to the extent that debt was obtained by fraud.  Exactly how that provision of the Bankruptcy Code was to be enforced has been the subject of some disagreement, but the Supreme Court has now offered its opinion pursuant to a case arising out of Texas.

In Husky International Electronics, Inc. v. Ritz, the United States Supreme Court has found that the term “actual fraud” found in §523(a)(2)(A) of the Bankruptcy Code encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without making a false representation.

In Husky, a company controlled by Ritz incurred unsecured debt to Husky.  Rather than paying the debt, Ritz caused the assets of the debtor entity to be transferred to other entities owned and controlled by Ritz.  Husky then filed a lawsuit against Ritz seeking to hold him personally responsible for the company’s debt citing a Texas statute which made shareholders liable for their “actual fraud”.[1]  In response, Ritz filed for Chapter 7 bankruptcy relief.

Husky contended that Ritz could not discharge his obligations to Husky in bankruptcy because the inter-company transfer scheme constituted “actual fraud” pursuant to 11 U.S.C. §523(a)(2)(A).  That section reads as follows:

A discharge under [Chapter 7, 11, 12, or 13] of this title does not discharge an individual debtor from any debt . . . for money, property, services or an extension, renewal, or refinancing of credit to the extent obtained by . . . false pretenses, a false representation or actual fraud.

The Bankruptcy Court and the 5th Circuit Court of Appeals found the debt to be dischargeable.  The 5th Circuit held, specifically, that a necessary element of “actual fraud” is a misrepresentation from the debtor to the creditor, such as when a person applying for credit adds an extra zero to her income or falsifies her employment history.

The Supreme Court disagreed.  It reasoned that actual fraud has two parts: “actual” and “fraud”.  The word “actual” simply means any fraud that “involves moral turpitude or intentional wrong”.  The word “fraud” generally connotes deception or trickery and is difficult to define more precisely.  The Court, however, found that “from the beginning of English bankruptcy practice, courts and legislatures have used the term ‘fraud’ to describe a debtor’s transfer of assets that, like Ritz’s scheme, impairs a creditor’s ability to collect the debt”.

The Husky decision provides a powerful new tool for creditors – – provided that they can establish, under the relevant state law, a cause of action against corporate insiders.  All creditors and debtors should be mindful of this new opinion.

 

[1] Indiana does not have this statute.  Personal liability would have to be found on a piercing theory or aiding and abetting liability.

 

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When March Madness Goes to the “Courts”

basketball

When March Madness Goes to the “Courts”

hagenow2On February 7, 2015, an ugly fight broke out between two Indiana high school basketball teams.  As a result of the fight, the officials ended the game and the schools suspended the students who were involved the following Monday.  The Indiana State High School Athletic Association (“IHSAA”), of which both schools are members, then issued additional penalties, including suspending both schools from participating in the state tournament and cancelling each school’s remaining regular season games.

Both schools and the individual players on those teams filed a lawsuit seeking an injunction against the IHSAA hoping to be able to participate in the state tournament.  The trial court granted that injunction, and both teams were allowed to participate in the tournament, with one of those teams actually reaching the state championship game.

Despite the fact that season has long been over, the IHSAA appealed the trial court decision, and the Indiana Court of Appeals recently ruled in favor of the IHSAA and found that the trial court should not have issued the injunction that it did.

So why keep fighting?  The IHSAA likely wanted to get a judicial ruling that the IHSAA had the authority to issue rulings similar to what it did in this instance, because the longstanding rule in Indiana is that courts will exercise very limited interference with the rules and internal affairs of voluntary membership associations such as the IHSAA.

As has been discussed extensively through this blog in other contexts, Indiana courts are very reluctant to interfere with contractual relationships, particularly between sophisticated parties.  This same principle of non-interference is also used by the courts with respect to the rules and bylaws of associations of which the members are voluntarily associated.  In the recent decision, the Indiana Court of Appeals noted:

In Indiana, courts exercise limited interference with the rules and internal affairs of voluntary members of associations:

 

A voluntary association may, without direction or interference by the courts, for its government, adopt a constitution, bylaws, rules and regulations which will control as to all questions of discipline, or internal policy and management, and its right to interpret and administer the same is as sacred as the right to make them. . . .

 

The rules of voluntary associations are viewed as a contract between the association and its members and among the members themselves.  Absent fraud, illegality, or abuse of civil or property rights having their origin elsewhere, Indiana courts do not interfere with the internal affairs of a voluntary association, nor second guess an association’s interpretation or application of its rules.

The Court of Appeals also noted that a court is not to substitute its own judgment for that of an association such as the IHSAA.  In fact, all that needs to be shown by such an association is that there is enough evidence to form a basis which would lead a reasonable and honest person to the same conclusion.  It does not even need to reach the level of “preponderance” (more than 50%), which is the standard in civil law.

This is the same sort of review that Indiana courts apply to other contracts: so long as the contract does not call for a party to do something illegal, a court will enforce the parties’ agreement and will not substitute its own judgment for that of the parties.

The Court of Appeals ultimately ruled that the sanctions imposed did not violate IHSAA rules, and nothing in those IHSAA rules requires the IHSAA to impose consistent punishment for similar violations.

For those of us who are sports fans, we have heard about various challenges to associations’ abilities to impose penalties against its members and the players.  Examples of this include the NCAA and the NFL.  Before commenting on whether or not a particular decision is just or appropriate, just keep in mind that, at least in Indiana, those associations have significant discretion in what penalties they can impose, and if the particular members do not like allowing the association or its commissioner to have that sort of power, then the rules of the association (the contract) need to be changed by the members of the association.

As is true with most reported decisions, there likely are a number of facts and circumstances that were not included in the actual court opinion, and therefore the author is making no commentary about whether or not an appropriate decision was reached here.  However, simply keep in mind for both your personal and business matters, that when you voluntarily join an organization, you will be subject to that organization’s rules, and so long as those rules are not illegal or otherwise abuse your civil or property rights, Indiana courts are likely to enforce those rules strictly as written.

With that being said, good luck with your brackets.  Let March Madness begin.

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Tax Deeds 1, Adverse Possession 0

adverse possession

Tax Deeds 1, Adverse Possession 0

bullington

A recent Indiana Supreme Court decision decided the relative rights of a tax deed purchaser versus a party with an adverse possession claim against real estate.  The result: tax deeds defeat adverse possession claims.

In Bonnell v. Cotner et al, a 35 foot wide strip of land was sold at tax sales in 1993 and 2011.  The Pulaski County Board of Commissioners purchased the parcel at the second tax sale, then sold the property to Bonnell.  Bonnell believed that the 35 foot wide strip of land ran along adjacent farmland to the east of an old fence.  However, a survey revealed that the strip of land was actually on the west side of the fence.  The property owners to the west of the strip of land, including Cotner, believed that their properties extended east to the fence line and had treated the 35 foot strip of land as their own property since the 1960s.

Under Indiana common law, the doctrine of adverse possession permits a party to take title to a property that the party has treated as its own despite not having held legal title to the property.  In order to take title, the party must demonstrate that (i) it has had control of the property, (i) it has had an intent to own the property, (iii) others had notice of the intent to take ownership of the property, and (iv) the possession has been for a sufficient duration of time.  In Bonnell, it was undisputed that all of these common law requirements were satisfied.  In addition to the common law requirements, Indiana Code § 32-21-7-1 also requires that the adverse possessor must have paid property taxes on the disputed parcel, or at least have had a good faith belief that he paid such taxes.  Here, Cotner had been paying taxes on a barn partially constructed on the parcel since 1968, which the Court found to be sufficient to demonstrate a good faith belief that he was paying all taxes assessed against such parcel.  Therefore, Cotner met all the requirements under Indiana law necessary to take title to the disputed parcel through the doctrine of adverse possession.

Nevertheless, this did not end the analysis given that the parcel was transferred by tax deed before Cotner had legally established ownership of the parcel through adverse possession by filing a quiet title action.  Under Indiana Code 6-1.1-25-4(f) and 6-1.1-25-4.6(g), a tax deed “vests in the grantee an estate in fee simple absolute, free and clear of all liens and encumbrances created or suffered before or after the tax sale.”  Accordingly, the Pulaski County Board of Commissioners obtained “fee simple absolute” in the parcel, free and clear of any and all encumbrances, including Cotner’s adverse possession claims to the parcel.

Furthermore, the trial court’s attempt to craft an equitable remedy by granting Cotner an easement to access his barn on the disputed parcel was also impermissible given that the property was transferred by tax deed.  Under Indiana Code § 6-1.1-25-4(g), a tax deed transfers a property free of any easement that is not shown by public record.  Because the Cotner’s use of the disputed parcel was not pursuant to a recorded easement, the tax deed transferred the property free from any easement rights held by Cotner, and it was an error for the trial court to grant an easement in favor of Cotner.

While this decision is an important development in Indiana real estate law, it also contains a very practical lesson for all litigants.  Bonnell offered to sell the disputed parcel to Cotner for $890.  Cotner refused that offer and instead chose to litigate.  The expense of that litigation for each party, including appeals to the Indiana Court of Appeals and the Indiana Supreme Court, significantly dwarfed the value of the property.  And after paying those litigation costs, Cotner does not own the parcel and has a barn encroaching onto Bonnell’s property without an access easement.  While it is always easy to second guess decisions in hindsight, there was virtually no possibility that even if Cotner was successful with his litigation, it would be resolved for less than the $890 asking price.  The impracticality of the litigation was noted by the Indiana Court of Appeals when it stated in its conclusory paragraph that “[a]fter more than three years of litigation and two vigorous appeals, Mr. Bonnell now owns a 35-foot-by-100-foot section of land in the Cotners’ backyard, predominately covered with a pole barn, which Bonnell values at approximately $890.”

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Say What You Mean; Mean What You Say

hagenow2When a person files bankruptcy, the law allows for certain “exemptions” so that the person can keep certain things that the legislature has determined are the bare necessities of life in order to make a fresh start.  Any property that is not “exempt”, and assuming it is of sufficient value, is to be gathered and then sold for the benefit of the creditors of the person filing bankruptcy.

Different States have different laws about what exemptions are allowed.  While there are many similarities, each State is allowed to make its own laws concerning what is exempt and what is not or it can utilize the exemptions created by Congress.  In Illinois, one of those things that a person is allowed to keep is a bible.  In a recent case, we were again reminded that courts, when faced with unambiguous language in a law (similar to what courts will do with a contract) will enforce the exact terms of the law and not attempt to infer any intent from those words or give those words any different meaning other than their plain and ordinary meaning.

In the recent case, the person who filed bankruptcy (“debtor”) had a bible.  But it was no ordinary bible.  It was a first edition Book of Mormon from 1830.  Everyone agreed that the bible was worth $10,000.  The bankruptcy trustee, and the bankruptcy court, said that the debtor should not be allowed to keep this very rare bible, but instead it should be sold for the benefit of her creditors.  It was also noted that she had several additional copies of the Book of Mormon in different forms.  The bankruptcy court ruled that allowing her to exempt (keep) this particular bible would violate the intent and purpose of the statute, which the bankruptcy court said was to protect a bible of “ordinary value” so as to not deprive a debtor of a worship aid.

The 7th Circuit Court of Appeals reversed the bankruptcy court, and ruled that when looking at a statute, the court first looks at the language itself.  It is only when the meaning of the statute is unclear from the language used that the court may look past that language and consider the purpose (intent) behind the law.  Because the statute does not say there is any limitation on the value of the bible that can be exempted, it is not the court’s role to read into the statute this additional element of a bible “of limited value”.

Therefore, even though this particular bible would have likely raised enough money to pay back approximately half of the debt that was discharged by the debtor, the 7th Circuit allowed the debtor to keep the very valuable bible rather than having it sold and the money distributed to her creditors.

The lesson in all of this, again, is something that has been discussed extensively throughout this blog, which is when the courts look at either a statute or a contract, the court will enforce the plain meaning of the words used either in that contract or in the statute.  It is only when contracts or statutes are ambiguous or unclear that the court is to look at what was the parties’ intent.  Therefore, while most people reading this blog will not likely be involved in drafting laws, they will be drafting or reading contracts, and this case serves as yet another reminder to use plain, ordinary language that truly states what the parties want from the particular agreement.  The cost of taking the time to draft contracts like that and spend a little more time doing so will save everyone to the contract a lot of time, expense, and heartache that comes from the litigation that would ensue over an uncertain agreement.

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Ag Lending: Could Selling Crops Be a Crime?

crops

Ag Lending: Could Selling Crops Be a Crime?

hagenow2In an agriculture heavy state such as Indiana, lenders necessarily will have a certain portion of its lending dedicated to agricultural and farming operations.   There are certain protections for lenders under both Indiana law and federal law, which, while easy to follow, may not often be employed by lenders.

The Uniform Commercial Code (“UCC”) was written to provide guidance concerning commercial transactions, and has been adopted in some fashion throughout the United States, including Indiana.  States are free, however, to adopt certain other provisions or deviations from the UCC.  As a general rule under the UCC, someone who buys a product in the “ordinary course” of the seller’s business buys that product free from any security interest or lien that a lender may have attached to that product.  This is true even if the lien is perfected and the buyer knows about the lien.

Historically, there was an exception to this rule for “farm products”, which includes crops.  Therefore, under the UCC, a wholesale buyer of a farmer’s crops bought those crops subject to any lender’s lien.

Congress, however, passed a federal law in 1985 to override this UCC exception, and stated that a buyer who in the ordinary course of business buys a farm product from a seller engaged in farming operations buys that farm product free of any lender’s lien.

As with every rule, there are exceptions, and this one is no different.  This same federal law provides that the buyer of farm products will take the farm products subject to the lender’s lien if the buyer has been provided specific written notice of that lien within one year before the sale.

So what happens in the situation where a farmer has borrowed money, pledged a security interest (granted a lien) in his crops, has provided a list of the people to whom he intends to sell those crops, but then, not wanting to repay the lender, sells those crops to a buyer not shown on the list?  Under the federal law, that farmer would be fined the greater of $5,000 or 15% of what the farmer received for those farm products.

In 2001, Indiana took this “written notice” concept from the federal law and incorporated a version of it into the Indiana UCC.  Under the Indiana law, a buyer in the ordinary course of business takes free of a lien granted by the seller, even if the lien is perfected and the buyer knows of its existence.  This applies to farm products as well unless the lender has followed the same notice provisions as are identified in the federal law.  If the lender does provide that notice, Indiana says that a farmer who then sells his crops to someone not on the list of buyers or fails to pay the proceeds of that sale to the lender within fifteen days of the sale, has actually committed a crime (Class C misdemeanor).  In addition, any purchaser who has received notice from the lender of the lender’s lien and fails to issue a jointly payable check (to include the lender) takes those farm products subject to the lien.

So what does this all mean for lenders making agricultural loans?  First, the security agreement should include language that requires the farmer/borrower to provide a list of all of the buyers to whom the farmer intends to sell in the next year.  The lender needs to update this list each year.  After receiving that list of potential buyers, the lender should notify those potential buyers of the lender’s security interest in any farm products delivered by the particular borrower.  By taking these two relatively simple steps, the lender can better protect its security interest, and also create additional remedies to be repaid its loan.

Image courtesy of Exsodus at FreeDigitalPhotos.net

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