Shaw Steel, Inc v. Morris, Hewlett E.

In the

United States Court of Appeals

For the Seventh Circuit

No. 99-3800

In re:

Hewlett E. Morris, Jr.,

a/k/a H. Edward Morris,

Debtor-Appellee.

Appeal of: Shaw Steel, Inc.

Appeal from the United States District Court

for the Northern District of Illinois, Eastern Division.

No. 99 C 2327--Elaine Bucklo, Judge.

Argued May 31, 2000--Decided August 11, 2000

Before Flaum, Chief Judge, and Bauer and

Harlington Wood, Jr., Circuit Judges.

Flaum, Chief Judge. Plaintiff Shaw Steel, Inc.

appeals the district court’s decision affirming

a bankruptcy court’s determination that defendant

Hewlett E. Morris, Jr.’s (a/k/a H. Edward Morris)

debt to Shaw Steel was not exempt from discharge

under 11 U.S.C. sec. 523(a)(2)(B) of the United

States Bankruptcy Code. For the reasons stated

herein, we affirm the decision of the district

court.

I. Background

In 1993, Shaw Steel filed suit in the United

States District Court for the Northern District

of Ohio against O.L. Anderson Co. and defendant

Morris, the Chairman of the Board and Chief

Executive Officer of O.L. Anderson. In its

complaint, Shaw Steel alleged that O.L. Anderson

owed it money for materials that Shaw Steel had

previously shipped to O.L. Anderson. Shaw Steel

also alleged that Morris, in his capacity as a

corporate officer for the company, had

fraudulently induced Shaw Steel to extend credit

to O.L. Anderson for the purchase of those

materials.

On September 1, 1993, the United States

District Court for the Northern District of Ohio

entered judgment in favor of Shaw Steel and

against O.L. Anderson in the amount of

$215,836.69 plus 10% interest on that amount from

November 17, 1992. At the time this judgment was

entered, Shaw Steel’s complaint against Morris

was dismissed without prejudice. Subsequent to

the entry of judgment in favor of Shaw Steel, and

prior to the satisfaction of O.L. Anderson’s

judgment debt to Shaw Steel, O.L. Anderson was

dissolved without any money being paid to Shaw

Steel.

When O.L. Anderson was dissolved prior to the

payment of its judgment debt to Shaw Steel, Shaw

Steel again filed suit against Morris in the

United States District Court for the Northern

District of Ohio alleging the same fraud that was

the subject of its first complaint. On July 26,

1994, Shaw Steel signed a stipulated entry

dismissing its case against Morris with prejudice

and, on August 22, 1994, Shaw Steel and Morris

executed a "Settlement Agreement and Mutual

General Release" ("Settlement Agreement" or

"Agreement"). This Agreement provided for the

payment of $35,000 by Morris to Shaw Steel, and

it contained a variety of representations as to

Morris’s financial condition./1 The Agreement

also incorporated an Affidavit of Financial

Condition previously given by Morris to MNC

Financial Group, a major lender to O.L. Anderson.

As part of the Settlement Agreement, Morris

consented to Shaw Steel’s investigation of the

representations he made in that Agreement.

Under the terms of the Settlement Agreement,

Shaw Steel had the right to challenge the

statements made by Morris in the Settlement

Agreement as to his financial condition by

commencing an arbitration proceeding. If Shaw

Steel decided to commence such a proceeding, the

sole issue to be arbitrated was the material

accuracy of Morris’s representations. The

Settlement Agreement also provided that if the

arbitration terminated in Shaw Steel’s favor, a

previously-agreed consent judgment in the amount

of $215,000 could be filed in the United States

District Court for the Northern District of Ohio.

On July 13, 1995, Shaw Steel commenced

arbitration proceedings pursuant to the

Settlement Agreement after an investigation led

it to believe that Morris’s statements as to his

financial condition were false. Morris then filed

suit in Michigan state court seeking to enjoin

Shaw Steel from proceeding with the arbitration.

This state court action was removed to federal

district court and, after summary judgment was

granted to Shaw Steel, the arbitration continued.

On April 16, 1997, an arbitration panel ruled in

Shaw Steel’s favor, finding that there were

material inaccuracies in the representations made

by Morris in the Settlement Agreement. This

arbitration award was later confirmed by the

United States District Court for the Northern

District of Ohio and Shaw Steel’s consent

judgment against Morris was entered.

On December 23, 1997, Morris filed a voluntary

bankruptcy petition under Chapter 7 of the

Bankruptcy Code in the United States Bankruptcy

Court for the Northern District of Illinois.

Although Shaw Steel argued that the money owed to

it by Morris pursuant to the arbitration award

and consent judgment was not dischargeable in

bankruptcy under 11 U.S.C. sec. 523(a)(2)(B), the

bankruptcy court disagreed. The bankruptcy court

held that Morris’s debt to Shaw Steel was

dischargeable because Shaw Steel could not show

that its reliance on Morris’s representations was

reasonable. This determination was affirmed by

the district court, and Shaw Steel now appeals.

II. Analysis

"In the ordinary course of bankruptcy, the

debtor’s assets are applied to the payment of his

debts and, even though the assets will usually be

insufficient to pay those debts in full, he will

emerge from bankruptcy with the unpaid balance

discharged . . . ." McClellan v. Cantrell, 2000

WL 876933, at *1 (7th Cir. July 5, 2000). In this

case, however, Shaw Steel contends that Morris’s

debt is exempt from a general discharge under

Chapter 7. Specifically, Shaw Steel argues that

because Morris’s debt stems from his fraudulent

misrepresentations as to his financial condition,

that debt is excepted from discharge under 11

U.S.C. sec. 523(a)(2)(B). See, e.g., FDIC v.

Meyer (In re Meyer), 120 F.3d 66, 68 (7th Cir.

1997) (stating that "debts [that] can survive

[bankruptcy] whole despite a general discharge"

include "those that a debtor incurred with the

aid of fraud and deceit"). In considering the

bankruptcy court’s determination that Shaw Steel

did not reasonably rely on Morris’s statements

regarding his financial condition, we recognize

that "’exceptions to discharge are to be

constructed strictly against a creditor and

liberally in favor of the debtor.’" Goldberg

Securities, Inc. v. Scarlata (In re Scarlata),

979 F.2d 521, 524 (7th Cir. 1992) (quoting In re

Zarzynski, 771 F.2d 304, 306 (7th Cir. 1985)). We

review the bankruptcy court’s legal conclusions

de novo and its factual findings for clear error.

See In re A-1 Paving & Contracting, Inc., 116

F.3d 242, 243 (7th Cir. 1997).

The statutory provision at issue in this case,

section 523(a)(2)(B) of the Bankruptcy Code,

provides that:

A discharge . . . 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-

-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, services, or credit

reasonably relied; and (iv) that the debtor

caused to be made or published with intent to

deceive . . . .

11 U.S.C. sec. 523(a)(2)(B); see also In re

McFarland, 84 F.3d 943, 946 (7th Cir. 1996); In

re Sheridan, 57 F.3d 627, 633 (7th Cir. 1995)

("In order to prevail on a claim under 11 U.S.C.

sec. 523(a)(2)(B), a creditor must prove . . .

that a debtor made, with an intent to deceive, a

materially false written statement regarding his

financial condition and that the creditor relied

on that statement."). Under section 523(a)(2)(B),

Morris’s debt to Shaw Steel is presumed to be

dischargeable, see McFarland, 84 F.3d at 946,

unless Shaw Steel can demonstrate by a

preponderance of the evidence that the debt meets

the requirements of the statutory exception, see

Grogan v. Garner, 498 U.S. 279, 291 (1991); In re

Thirtyacre, 36 F.3d 697, 700 (7th Cir. 1994).

The issue in dispute between Morris and Shaw

Steel centers on the reasonableness element of

section 523(a) (2)(B)’s reliance requirement. See

11 U.S.C. sec. 523(a)(2) (B)(iii); see also Field

v. Mans, 516 U.S. 59, 68 (1995) (stating that, in

contrast to the less-demanding justifiable

reliance standard applied in section 523(a)(2)(A)

cases, "[s]ection 523(a)(2)(B) expressly requires

. . . reasonable reliance . . ."). The district

court held that the bankruptcy court correctly

found that Morris’s debt to Shaw Steel did not

qualify for an exemption from discharge on the

ground that Shaw Steel did not reasonably rely on

the representations Morris made in the Settlement

Agreement as to his financial condition. In

reaching this conclusion, the district court

found it significant that Melvin Morris, Vice

President of Shaw Steel, testified that he had

"reservations" about Morris’s honesty and that he

did not know whether the statements made by

Morris in his affidavit were true or false. The

district court also noted that Howard Klein, Shaw

Steel’s investigator, stated that both Melvin

Morris and Harry Sulzer, the President of Shaw

Steel, did not believe the representations in

Morris’s affidavit. Moreover, as the district

court recognized, Morris’s past dealings with

Shaw Steel gave the company good reason to doubt

his veracity. According to the district court,

Shaw Steel could not have reasonably relied on

Morris’s affidavit absent prior investigation in

light of the legitimate doubts its officers

admitted having as to the representations made by

Morris in the Settlement Agreement.

Although Shaw Steel acknowledges its burden to

establish that it reasonably relied on Morris’s

statements, it contends that the bankruptcy court

applied too strict a standard of reasonableness.

In support of this argument, Shaw Steel cites

prior judicial interpretations of the

reasonableness standard, including a decision of

this Court in which we stated that

"reasonableness is circumstantial evidence of

actual reliance" and that a creditor should not

be denied protection against discharge unless the

"creditor’s claimed ’reliance’ on a ’financial

statement’ would be so unreasonable as not to be

actual reliance at all." Northern Trust Co. v.

Garman (In re Garman), 643 F.2d 1252, 1256 (7th

Cir. 1980)./2 Shaw Steel further notes that one

of our sister circuits, relying in part on our

decision in Garman, has stated that "[a] district

court reviewing a bankruptcy court’s

determination of reasonable reliance is not ’to

undertake a subjective evaluation and judgment of

a creditor’s lending policy and practices.’" Bank

One, Lexington, N.A. v. Woolum (In re Woolum),

979 F.2d 71, 76 (6th Cir. 1992) (quoting Garman,

643 F.3d at 1256). According to Shaw Steel, the

bankruptcy court erred in its reasonableness

determination because it failed to recognize that

"the reasonableness requirement of sec. 523(a)

(2)(B) ’cannot be said to be a rigorous

requirement, but rather is directed at creditors

acting in bad faith.’" Woolum, 979 F.2d at 76

(quoting Martin v. Bank of Germantown (In re

Martin), 761 F.2d 1163, 1166 (6th Cir. 1985)).

Although we agree with Shaw Steel’s analysis of

the relevant precedent and its assertion that

district courts are not to use the reasonable

reliance requirement of section 523(a)(2)(B) to

second-guess a creditor’s lending decisions, we

cannot conclude that the district court clearly

erred in finding that Shaw Steel did not

reasonably rely on Morris’s representations as to

his financial condition, see Fed.R.Bank.P. 8013

(mandating a clearly erroneous standard of review

for a bankruptcy judge’s findings of fact); In re

Bonnett, 895 F.2d 1155, 1157 (7th Cir. 1989)

("[A] bankruptcy court’s determination of

dischargeability is subject to a clearly

erroneous standard of review.") (citing Prairie

Prod. Credit Ass’n v. Suttles (In re Suttles),

819 F.2d 764, 765 (7th Cir. 1987)). "The

reasonableness of a creditor’s reliance should be

determined on a case by case basis," Bonnett, 895

F.2d at 1157 (citation omitted), and the

bankruptcy court should not be "overturned

’simply because [the appellate court] is

convinced it would have decided the case differently.’"

Id. (quoting Anderson v. City of Bessemer City,

470 U.S. 564, 573 (1985)). Rather, "’[w]here

there are two permissible views of the evidence,

the [bankruptcy court’s] choice between them

cannot be clearly erroneous.’" EEOC v. Sears,

Roebuck & Co., 839 F.3d 302, 309 (7th Cir. 1988)

(quoting Anderson, 470 U.S. at 575). "Under the

’abuse of discretion’ standard of review, the

relevant inquiry is . . . whether any reasonable

person could agree with the [bankruptcy] court."

Deitchman v. E.R. Squibb & Sons, Inc, 740 F.2d

556, 563 (7th Cir. 1984).

In this case, the bankruptcy court determined

that both the President and Vice-President of

Shaw Steel had serious doubts about the truth of

Morris’s statement of his financial condition, a

conclusion that was based largely on the

bankruptcy court’s observation of the witnesses

and their testimony. See Bonnett, 895 F.2d at

1157 (stating that appellate courts should give

particular deference to the bankruptcy court’s

evaluation of witness testimony). The bankruptcy

court further found that Shaw Steel’s concerns

about Morris’s veracity were justified by the

company’s past dealings with Morris. In spite of

its questions as to Morris’s truthfulness,

however, Shaw Steel entered into a Settlement

Agreement with Morris without engaging in any

attempt to ascertain Morris’s true financial

condition. While we understand that the concept

of reasonable reliance does not generally require

creditors to conduct an investigation prior to

entering into agreements with prospective

debtors, such a precaution could be the

ordinarily prudent choice in circumstances where

the creditor admits that it does not believe the

representations made by the prospective debtor.

See Coston v. Bank of Malvern (In re Coston), 991

F.2d 257, 261 (5th Cir. 1993) (stating that when

determining reasonable reliance, "[t]he

bankruptcy court may consider, among other

things: whether there had been previous business

dealings with the debtor that gave rise to a

relationship of trust; whether there were any

’red flags’ that would have alerted an ordinarily

prudent lender to the possibility that the

representations relied upon were not accurate;

and whether even minimal investigation would have

revealed the inaccuracy of the debtor’s

representations"). Under these circumstances, the

bankruptcy court’s determination was a

permissible one, and we cannot conclude that the

court clearly erred in finding Shaw Steel’s

reliance unreasonable.

III. Conclusion

Because we determine that the bankruptcy court

did not clearly err in finding that Shaw Steel’s

reliance on Morris’s representations was not

reasonable, we AFFIRM the decision of the district

court.

/1 Paragraph 4 of the Settlement Agreement stated

that:

The parties acknowledge that this Agreement has

been entered into, in part, based upon the

following representations, only:

a. Those contained in the Affidavit of Financial

Condition attached hereto and incorporated herein

as Exhibit B; and

b. That Defendant’s personal financial condition

has not materially changed since his execution of

the Affidavit of Financial Condition;

c. That to the best of Defendant’s knowledge,

there are no trust agreements in existence in

which Defendant, his wife, nor any member of his

immediate family has any present or future

interest; and

d. That Defendant has not been released of any

liability he has to MNC related to its loans to

O.L. Anderson Company, a Delaware corporation.

/2 Although Garman involves the interpretation of

section 17(a)(2), the predecessor statute to

section 523(a)(2)(B)(iii), that case’s

interpretation of reasonable reliance applies

with equal force to section 523(a)(2)(B)(iii)

because "Congress clearly indicated that section

523(a)(2)(B)(iii) is merely a codification of the

cases construing section 17(a)(2)." First Nat’l

Bank of Lansing v. Kreps (In re Kreps), 700 F.2d

372, 376 (7th Cir. 1983).