Opinion
Case No. 99-74118, Adversary Nos. 00-7101, 00-7055, 00-7103.
May 17, 2001
OPINION
These three adversaries were consolidated for trial. Van Diest Supply Co. and United Suppliers, Inc. seek to except their debts from discharge pursuant to 11 U.S.C. § 523(a)(2)(B). Roger Stone, Trustee of the bankruptcy estate of Hennings Feed Crop Care, Inc., seeks to except his debt from discharge pursuant to 11 U.S.C. § 523(a)(4). All three creditors object to the Defendants' discharge pursuant to 11 U.S.C. § 727(a)(5) for failure to explain the loss of corporate assets. In addition, the Trustee objects to the Defendants' discharge under 11 U.S.C. § 727(a)(2) and (3), alleging that the Defendants concealed income of the corporation in the form of grower rebate checks and that they took loans from the corporation within one year of the bankruptcy.
The Defendants, Larry and Marisa Hennings, are husband and wife. They formerly operated Hennings Feed and Crop Care, Inc. Mr. Hennings purchased the business in 1980. He incorporated it in 1982. Mr. Hennings was the sole shareholder of the corporation and served as its president. Mrs. Hennings served as the secretary/treasurer and as a director. There were no other officers or directors of the corporation. The Defendants received a total salary of $50,000 per year.
The corporation supplied and distributed agricultural products out of a facility in Shelbyville, Illinois. Prior to 1996, the corporation's business was primarily retail sales to farmers. In 1996, the corporation increased its sales of chemical products to brokers. Sales to brokers made up over 60% of the corporation's gross sales. The sales to brokers were at a price 30% below the corporation's cost. The sales to the brokers were booked as sales for a profit of 102% of cost. The difference between what the brokers actually paid and the reported sales price was reported as chemical company receivables.
The Defendants were unable to offer a convincing explanation of how they expected to make money by selling so much product at a loss. Mr. Hennings testified that he planned to make up the difference through rebates from manufacturers and distributors. In addition, he testified that free product was another form of rebate. However, Mr. Hennings' numbers were fuzzy, and the numbers never quite added up. According to the Trustee, a certified public accountant, the rebates averaged 15% to 18%. In a best case scenario, the corporation lost over 10% on each sale, and this calculation did not even include overhead.
The corporation's August, 1998, financial statement showed total corporate assets of $16.6 million. These total current assets were made up of trade accounts receivable ($7.3 million), chemical receivables ($7 million), and inventory ($2.2 million). This financial statement overstated inventory by approximately $1.8 million, overstated chemical company rebates in the full amount of $7 million, and substantially overstated trade receivables.
The August, 1999, corporate financial statement showed a decline in total current assets from the previous year in the amount of $15 million. The basis for this financial statement and the loss of these assets was a physical inventory which showed inventory on hand of only $350,000. In addition, the corporate accountants and corporate fiscal officer suggested that the chemical company receivables be totally written off, and that trade receivables be substantially written off as uncollectible.
Between October 1, 1998, and August 18, 1999, the Defendants made capital contributions to the corporation and took out officer loans. A review of the corporation's records indicates that the loan balance which the Defendants owed the company on the company books increased by an amount in excess of $180,000 during this period. The Defendants argued that they paid debts of the corporation or advanced money to the corporation during this period in an amount in excess of whatever monies would have flowed to them as officer loans, but their evidence did not support this argument. In particular, the Court notes that some of the canceled checks relied upon by the Defendants were clearly for personal expenses of the Defendants, e.g. the Defendants' personal credit card bills and a veterinarian bill for their son's horse. The Court further notes that the Defendants' testimony was vague when confronted with the question of what any particular check was for. In contrast to the unspecific testimony of the Defendants, the Trustee relied on the figures prepared by the accounting firm of Mose, Lively, Yockey Ford, which worked for the Defendants individually and the corporation during this period. The Court finds the officer loan information prepared by Mose, Lively, Yockey Ford and testified to by the Trustee to be more credible and persuasive on the issue of the transactions between the Defendants and the corporation. This evidence showed an excess of $180,000 in officer loans over capital contributions.
The Defendants set up several "dummy" accounts for the purpose of receiving rebate checks which they were not entitled to. Two of the accounts were in the names of their eight and 10 year-old sons. The Defendants did not adequately disclose this conduct in a timely fashion. In fact, there was no disclosure until the Trustee investigated the matter and found evidence of the scheme.
On August 18, 1999, the Defendants instituted proceedings to place the corporation in a Chapter 11 bankruptcy. Shortly thereafter, the Defendants were removed as debtors-in-possession and Mr. Stone was appointed the Chapter 11 Trustee.
One week prior to the corporation's bankruptcy filing, Mr. Hennings paid himself $20,000 from corporate assets for rent that he claimed was due. This transfer occurred after bankruptcy counsel had been retained.
The Defendants filed their petition pursuant to Chapter 7 of the Bankruptcy Code on December 16, 1999.
Van Diest was a major supplier of the corporation. Van Diest holds a judgment against the Defendants entered in the United States District Court for the Central District of Illinois on October 8, 1999, in the amount of $2,931,861.22. This judgment is based upon the personal guaranty by the Defendants of the debts to Van Diest of the corporation.
United Suppliers was also a major supplier of the corporation. United is a creditor of the corporation and a creditor of the Defendants pursuant to a personal guaranty of the corporation's debt to United. The total sum due and owing to United is $8,532,368.41.
The Trustee claims to be a creditor of the Defendants. The Trustee's claim is based upon the $180,000 owed to the corporation from the Defendants as officer loans, and $2,000,000 lost to the corporation by the Defendants' conduct of selling the corporation's inventory.
The Defendants attack the Trustee's standing to file an adversary complaint because he did not file a proof of claim in their bankruptcy case. The only requirement for standing to commence an adversary proceeding to except a debt from discharge or to object to a discharge is that the proceeding must be commenced by a creditor. In re Davis, 194 F.3d 570 (5th Cir. 1999). This is true even when a proof of claim has not been filed. In re Stone, 90 B.R. 71, 73 (Bankr.S.D.N.Y. 1998), aff'd, 94 B.R. 298 (S.D. N.Y. 1988), aff'd, 880 F.2d 1318 (2d Cir. 1989) (§ 523 proceeding); In re Hunn, 49 B.R. 430 (Bankr.M.D.Fla. 1985) (§ 727 proceeding). In this case, the Trustee is a creditor of the Defendants based upon his claims for officer loans and willful depletion of corporate assets. Therefore, he has standing to object to the Defendants' discharge and contest the dischargeability of debts to the corporation.
11 U.S.C. § 523(a)(2)(B) provides in relevant part:
(a) A discharge. . . does not discharge an individual debtor from any debt — . . . .
(2) for money, property, services or an extension, renewal, or refinancing of creditor, to the extent obtained by — . . . .
(B) 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 for such money, property or services, or credit reasonably relied; and
(iv) that the debtor caused to be made or published with intent to deceive(.)
Van Diest and United must prove each of these elements by a preponderance of the evidence in order to succeed under this section. In re Miller, 39 F.3d 301, 304 (11th Cir. 1994).
It is undisputed that there is a statement in writing respecting a corporation solely owned and controlled by the Defendants. It is also undisputed that the financial statement was materially false. The issues are whether the Defendants published the financial statement with intent to deceive, and whether Van Diest and United reasonably relied on it.
The Defendants point out that the financial statement was not signed by the Defendants. However, there is no requirement under § 523(a)(2)(B) that the debtor sign the financial statement. In re Howard, 73 B.R. 694 (Bankr.N.D.Ind. 1987). Nevertheless, the debtor must affirm the writing in some respect, as by using or adopting it. In re Eckert, 221 B.R. 40, 44 (Bankr.S.D.Fla. 1998). In this case, the Defendants "published" the financial statement by submitting it to Van Diest and United.
It is irrelevant that the goods obtained from Van Diest and United went to the corporation rather than the Defendants. It is well-settled that where an individual uses fraud to induce another to pay money to that individual's corporation, the individual has "obtained" such money within the meaning of § 523(a)(2)(B). Cutillo v. Hubner, 247 B.R. 766, 769 (S.D.Ind. 2000). Even though the Defendants may not have directly obtained the products from Van Diest and United as officers, directors, and shareholders of the corporation, they received the benefit of the products shipped to the corporation.
The Defendants argue that Van Diest and United could not have reasonably relied upon the false financial statement because the financial statement indicated on its face that it was unaudited. This argument is not persuasive. Brigadier Homes v. Hert, 81 B.R. 38, 640 (Bankr.N.D.Fla. 1987). Most financial statements are unaudited. The Defendants were experienced business people; they could be expected to know the importance of providing accurate financial information and the consequences of inaccurate information. The credit managers from both Van Diest and United testified that they reviewed the financial statement and relied upon it. They would not have extended credit to the corporation if they had known of the corporation's true financial condition.
The Defendants' main argument is that they did not know that the financial statement was false when it was delivered to the creditors because physical inventories were not taken and they believed that the chemical company receivables were in fact collectible. The sheer magnitude of the inaccuracies on the financial statement as well as the size of the unsecured debts make it difficult to believe that the Defendants did not know of the deception. The Court does not believe that a physical inventory is necessary to recognize the difference between a reported $2.2 million inventory and an actual $350,000 inventory; a cursory visual inspection would have indicated that the inventory was not at the level that the Defendants were reporting to Van Diest and United. Further, the Defendants were selling product to brokers for cash at 70% of cost, booking the sales for a profit of 102% of cost, and recording the difference as chemical company receivables. The Defendants had to know that these receivables were not collectible.
The Defendants were not credible witnesses. Mrs. Hennings' testimony was that she was either "not sure", "did not know", or "did not remember". Indeed, she could not even remember how much she was paid even though she wrote the checks, cashed the checks, and kept the books. She could not explain how the corporation could make a profit by selling products at a 30% discount. She blamed the corporation's financial problems on the woman Mr. Hennings placed in charge of the rebate program. Mr. Hennings was more forthcoming in his testimony, but his answers made little or no sense. Mr. Hennings still maintains that the corporation could make money by selling products at 30% below cost. Based on the totality of the circumstances, the Court finds that the Defendants had the requisite intent to deceive. Therefore, the debts to Van Diest and United are nondischargeable pursuant to 11 U.S.C. § 523 (a)(2)(B).
Section 523(a)(4) of the Bankruptcy Code excepts from discharge any debt "for fraud or defalcation while acting in a fiduciary capacity. . ." The Defendants were officers and directs of the corporation, and therefore were "fiduciaries of the corporation within the meaning of § 523(a)(4). In re Wang, 247 B.R. 211 (Bankr.E.D.Tex. 2000). They clearly enjoyed a position of ascendancy over the corporation. In re Rosenzweig, 237 B.R. 453 (Bankr.N.D.Ill. 1999).
As fiduciaries of the corporation, the Defendants owed a duty to the corporation to act in the best interest of the corporation. Nevertheless, the Defendants reduced the company assets by taking officer loans and making payments to themselves of over $180,000 during a time when the corporation obviously could not pay its other debts. Moreover, the Defendants willfully depleted company assets by selling millions of dollars of chemical products to brokers at amounts often exceeding 30% below the actual cost of the products. The Trustee estimated the losses to the corporation at a minimum of $2 million. These debts are excepted from discharge under § 523(a)(4).
Section 727(a)(5) of the Bankruptcy Code provides that "the court shall grant the debtor a discharge, unless. . . the debtor has failed to explain satisfactorily. . . any loss of assets or deficiency of assets to meet the debtor's liabilities. . ." There are two stages of proof with respect to § 727(a)(5). In re Bryson, 187 B.R. 939, 955 (Bankr.N.D.Ill. 1999). First, the party objecting to discharge has the burden of proving that the debtor at one time owned substantial and identifiable assets that are no longer available for his creditors. Id. Second, if the party objecting to the discharge meets its burden, then the debtor is obligated to provide a satisfactory explanation for the loss. Id. A debtor's explanation must consist of more than vague, indefinite, and uncorroborated reasons; a satisfactory explanation is one that convinces the bankruptcy court. In re Hasan, 245 B.R. 550 (Bankr. N.D. Ill. 2000). The inquiry under § 727(a)(5) is not limited to events or transactions which have occurred within a specific number of months or years before the bankruptcy filing. In re Buzzelli, 246 B.R. 75, 117 (Bankr.W.D.Pa. 2000).
The Defendants argue that there was no loss or deficiency of assets because they never had the assets to begin with. They suggest that the objecting creditors must prove that the assets stated in the August, 1998, financial statement actually existed. Because it is undisputed that those assets did not exist, or at least were overstated, they argue that the creditors have failed to meet their initial burden under § 727(a)(5).
The Defendants' argument misses the mark. The creditors did not have to prove that the assets existed in August, 1998, only that they existed at some point in time. It is clear from all the evidence that the corporation had millions of dollars of inventory coming into the business. There were also significant amounts of accounts receivables, rebates, and cash coming into the business. The critical question is what happened to all of these assets.
Mr. Hennings explained the loss of inventory as follows: There never was $2.2 million of inventory on the premises in August, 1998. Mr. Hennings did not say what the inventory level actually was at that time; the corporation did not perform physical inventories. The corporation's financial problems prevented it from getting credit after the fall of 1998. Therefore, the inventory on hand was sold, but not replenished. In addition, because of a delay in entry of broker sales in the computer system, large quantities of inventory that were drop-shipped directly to brokers were reported as inventory on the corporate financial statement even though they were never premises on the premises. As to the chemical company rebates and trade receivables, Mr. Hennings testified that they were written off at the suggestion of the corporation's accountant. Some of these rebates were subsequently collected by the Trustee.
Mr. Hennings' testimony provides an adequate explanation for some, but not all, of the losses suffered by the corporation. His explanation that the corporation did not have the inventory in August, 1998, does not account for what happened to all of the chemical products that were shipped to the company. His rationale for selling products at 30% or more below cost was unconvincing. There was no explanation of what happened to the $180,000 in officer loans that the Defendants took from the company in 1998 and 1999. The explanation for the dummy accounts used to collect rebates was not satisfactory. The Court is convinced that the tremendous losses suffered by the corporation in 1998 and 1999 were due to more than a more accounting legerdemain, and the Defendants have failed to adequately explain the losses.
The Trustee also seeks to deny the Defendants a discharge pursuant to 11 U.S.C. § 727(a)(2) and (3), which provides as follows:
(a) The court shall grant thee debtor a discharge, unless — . . . .
(2) the debtor, with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of property under this title, has transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed —
(A) property of the debtor, within one year before the date of the filing of the petition; or
(B) property of the estate, after the date of the filing of the petition;
(3) the debtor has concealed, destroyed, mutilated, falsified, or failed to keep or preserve any recorded information, including books, documents, records, and papers, from which the debtor's financial condition or business transactions might be ascertained, unless such act or failure to act was justified under all of the circumstances of the case(.)
The Trustee produced evidence that the Defendants took $180,000 in officer loans from the corporation within one year of the bankruptcy filing. The Defendants suggest that this is not a basis for a denial of discharge; they argue that it is at most a preference or fraudulent conveyance. The transfers did not constitute preference because they were not in payment of an antecedent debt. The $180,000 in dispute were payments in excess of any debts owed to the Defendants. Thus, the transfer of the $180,000 was a fraudulent conveyance. The Seventh Circuit has specifically held that a fraudulent transfer supports a denial of discharge under 11 U.S.C. § 727(a)(2)(A). Cohen v. Bucci, 905 F.2d 1111, 1113 (7th Cir. 1990).
As to 11 U.S.C. § 727(a)(3), the Trustee produced evidence that the Defendants concealed income or assets in the form of crop rebate checks which they mailed to themselves under fictitious names. The Defendants did not disclose this income until the Trustee's investigation turned up evidence of this scheme. The Defendants take the position that the grower rebates were never assets of the corporation, and the Defendants were never entitled to receive these assets. It is not for the Defendants to decide what is and is not relevant. The Bankruptcy Court requires full disclosure. The Defendants had control over these grower rebate checks through the dummy accounts. Therefore, they should have been disclosed. Concealment of this scheme is a basis for the denial of the Defendants' discharge under § 727(a)(3).
The Defendants argue that Mrs. Hennings was not aware of any alleged fraud. While it is certainly true that Mr. Hennings was the mastermind behind the fraudulent schemes, Mrs. Hennings' testimony that she was too busy raising her two children to be aware of what was going on in the corporation was not credible. Mrs. Hennings kept the books for the corporation; she knew exactly what was going on. For example, Mrs. Hennings testified that she did not understand anything about the fictitious rebate accounts maintained by the parties through post office boxes and false names. However, some of those checks were made payable to Mrs. Hennings and sent directly to her. In addition, Mrs. Hennings made all entries showing the deposits of these rebate checks in the parties' personal checking account. There was also evidence that Mrs. Hennings supplied financial information regarding the corporation to Dunn Bradstreet. Thus, while Mrs. Hennings' culpability may not rise to the level of her husband's in all instances, it does reach the level necessary to deny her a discharge or to except her debts from discharge.
For the foregoing reasons, the debts to Van Diest and United Suppliers are determined to be nondischargeable pursuant to 11 U.S.C. § 523 (a)(2)(B), the debts to the Trustee are nondischargeable pursuant to 11 U.S.C. § 523(a)(4), and the Defendants' discharge is denied pursuant to 11 U.S.C. § 727(a)(2), (3), and (5).
This Opinion is to serve as Findings of Fact and Conclusions of Law pursuant to Rule 7052 of the Federal Rules of Bankruptcy Procedure.
ORDER
For the reasons set forth in an Opinion entered this day,
IT IS THEREFORE ORDERED that the discharge of Larry and Marisa Hennings be and is hereby denied pursuant to 11 U.S.C. § 727(a)(2), (3), and (5).
IT IS FURTHER ORDERED that the debt of $2,931,861.22 owing to Van Diest Supply Company be and is hereby determined to be nondischargeable pursuant to 11 U.S.C. § 523(a)(2)(B).
IT IS FURTHER ORDERED that the debt of $8,532,928.16 owing to United Suppliers, Inc. be and is hereby determined to be nondischargeable pursuant to 11 U.S.C. § 523(a)(2)(B).
IT IS FURTHER ORDERED that the debt of $2,180,000 owing to Trustee Roger Stone be and is hereby determined to be nondischargeable pursuant to 11 U.S.C. § 523(a)(4).