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Justifiable or Reasonable Reliance Under Section 523 of the Bankruptcy Code

Justifiable or Reasonable Reliance Under Section 523 of the Bankruptcy Code

Exception to Discharge Section 523 of the Bankruptcy Code

Reasonable Reliance Section 523 Bankruptcy

Sometimes a debtor is less than honest, that’s when you bring an adversary action in bankruptcy

Was your reliance justifiable  or reasonable when lending money to a dishonest debtor that. later ends up in bankruptcy. Collateral Base Attorney Tom Howard recently helped our client win a $1.8 million dollar verdict in a bankruptcy case out of the Central District of Illinois. The case, liura v. Brady (In re Brady), concerned several novel issues of law, including the standard for “justifiable” or “reasonable” reliance under §523(a)(2) of the Bankruptcy Code.

Exceptions to Bankruptcy Discharge under Section 523 –

Bankruptcy discharge is the value most debtors that petition for relief under the Bankruptcy Code are after.  The discharge of their debts can wipe away thousands or millions of dollars of debt holding down a debtor in order to give him or her a fresh start.  But not all debtors are honest but unlucky – some are lying about their debts, which is why you can file an action to except certain debts, usually obtained fraudulently, from discharge. Section § 523(a)(2) of the Code is the authority for such adversary proceedings, which provides, in relevant part:

  • (a) A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt—
  • (2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by—
  • (A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s or an insider’s financial condition;
  • (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, services, or credit reasonably relied; and
  • (iv) that the debtor caused to be made or published with intent to deceive[.]
  • 11 U.S.C. § 523(a)(2)(A), (B).

Pliura v. Brady – Justifiable or Reasonable Reliance under Section 523

The case concerns the Chapter 7 Bankruptcy of Bob Brady (Debtor), a prominent home builder in Central Illinois. After earning his MBA and spending several years in banking, Bob Brady joined Brady Homes, the family business. Brady Homes has built over 1,500 homes in the Bloomington/Normal area, and has also built and managed apartments and condominiums. The Debtor also participated in several other real estate businesses, including Pinehurst Development (Pinehurst) and Brew of Illinois, LLC (Brew). In other words, the Debtor was a very experienced and sophisticated real estate professional, and knew all about holding and transferring title of property.

As our Central Illinois readers might know, the Debtor is the brother of State Senator Bill Brady. At the time of the loan, Senator Brady was running for Governor of Illinois as the Republican Party nominee (he went on to narrowly lose the race to incumbent Governor Pat Quinn). Bob Brady needed the loan to pay subcontractors, who were threatening to file liens and go public with the Bradys’ ongoing financial woes. Naturally, this would have been embarrassing for Senator Brady’s campaign.

In 2010, Dr. Thomas Pliura (a lawyer and a physician) and his wife loaned Brady and his brother $1,000,000 at an interest rate of 6%. The note was accompanied by a Security Agreement, giving the Creditors security in several properties own by Brady and identifying each property, including the address and tax identification number. The Security Agreement stated that the Bradys were the “sole, legal and equitable owners” of the properties. In the interest of Brady’s political ambitions, Dr. Pliura agreed not to record a mortgage against the properties which secured the $1,000,000 Note. He simply relied on the promises and written representations of the Brady Brothers, whom he had known for twenty years.

In fact, all of the properties were owned by Pinehurst and Brew, not by Brady and his brother. Additionally, all of the properties were encumbered by mortgages to Busey Bank. The properties had actually been cross-collateralized to other loans, and the Bradys were underwater on their various loans by approximately $3 million dollars.

The Bradys made one payment to Dr. Pliura- a check that bounced. They never tendered any additional payments. Dr. Pliura retained an attorney to look into collecting on the Note, and discovered that the Properties were not owned by Brady, and were further encumbered to Busey Bank. Soon, Brady filed for bankruptcy, and Dr. Pliura filed his lawsuit.

Section 523: Two Ways to Recover

Normally in bankruptcy, a debtor’s outstanding debts are discharged, and creditors have their rights to collect curtailed or outright eliminated. Under Section 523 of the Bankruptcy Code, there are a few ways to prevent this, or have a debt declared “non-dischargeable.” Section 523(a)(2) again provides:

(a) A discharge under section 727, 1141, 1192, 1228(a), 1228(b), or

1328(b) of this title does not discharge an individual debtor from any

debt—

. . .

(2) for money, property, services, or an extension, renewal, or

refinancing of credit, to the extent obtained by—

(A) false pretenses, a false representation, or actual fraud,

other than a statement respecting the debtor’s or an insider’s

financial condition;

(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, services, or credit reasonably

relied; and

(iv) that the debtor caused to be made or published with

intent to deceive[.]

  • Under 523(a)(2)(A), the Pliuras had to show “(1) the Debtor made a false representation or omission; (2) the Debtor knew the misrepresentation was false or made the representation with reckless disregard for the truth; (3) the Debtor made the misrepresentation with intent to deceive; and (4) they justifiably relied on the misrepresentation in making the loan.”
  • In contrast, under 523(a)(2)(B) the Pliuras were required to prove that the Debtor submitted to them, as part of their loan transaction, a written statement “(1) that was materially false; (2) that included information respecting the Debtor’s financial condition; (3) that they reasonably relied on in extending the loan; and (4) that the Debtor made or published with intent to deceive.”

The two sections have previously been held to be mutually exclusive. Under the recent Supreme Court case of Lamar, Archer & Cofrin, LLP v. Appling, the reasonable reliance bankruptcyCourt found that “a statement about a single asset” could be a “statement respecting a debtor’s financial condition.” That is, if the Bradys made a statement about a single one of their assets, the Pliuras would be in Section 523(a)(2)(B) and the “reasonable reliance” standard. The Court briefly addressed this issue, and found that Brady had made written representations about his financial condition, so the Pliuras would have to recover under 523(a)(2)(B).

Was There Reasonable Reliance?

There was no real dispute that Brady knowingly made materially false statements about his ownership of the Properties, and that the money was, in fact, owed to the Pliuras. There was a mountain of evidence that Brady knowingly and intentionally deceived Pliura to induce him to make the loan. But the bigger question was: did Dr. Pliura reasonably rely on Brady’s representations?

The Court began its analysis by noting that usually, reasonable reliance is determined based on the lender’s lending standards. However, “[h]ere, of course, the Pliuras are not traditional lenders and have no standard practices or any relation to the lending industry; it would be unfair and inappropriate to evaluate their reliance as though they were commercial bankers.” As the court further explained, while “reasonable reliance does not generally require creditors to conduct an investigation prior to entering into agreements with prospective debtors[.]” In re Morris, 223 F.3d 548, 554 (7th Cir. 2000). But, at the same time, creditors cannot ignore “obvious red flags.” Harris N.A. v. Gunsteen (In re Gunsteen), 487 B.R. 887, 902 (Bankr. N.D. Ill. 2013).

The Court looked at the various statements made by parties to the Note. However, at the end of the day, it was not just that the parties has discussed ownership of the properties, but that “Dr. Pliura put the information they were relying on in writing, and the Debtor signed that writing.” It was unrebutted that Brady read the representations in the Note at closing, and did not raise any objections at the time. The court also relied on Dr. Pliura’s personal relationship with the Bradys in assessing his reliance. “He knew that William Brady was a state senator and a candidate for governor and, apparently, he held Sen. Brady in high regard. He knew the Bradys as successful businessmen in the community, and, despite also knowing of their current financial distress and urgent need to borrow money, he had no reason to think that any of the Bradys, including the Debtor, would look him in the eye and lie.”

This case provides significant guidance for creditors who are proceeding under 523(a)(2)(B). Even sophisticated individuals can be misled and lied to by people they know and trust. This case clarifies that for debtors who are betrayed by people close to them, the law is still on their side.

The full opinion of the Court is available here.

David Silvers

David Silvers

Regulatory Lawyer

Whether this is your first land use issue or most recent, our office has helped people and businesses alike.

Thomas Howard was on the ball and got things done. Easy to work with, communicates very well, and I would recommend him anytime.
R. Martindale

LLC Operating Agreements

LLC Operating Agreements

What to Put Your Illinois Company's Operating Agreement An Operating Agreement is the contract of your Illinois company’s life – which it really does not have. However, your company is a legal fiction of a person that has a beginning, called articles of organization...

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Filing Financing Statements and Determining Priority

Filing Financing Statements and Determining Priority

Determining Priority

Determining Priority in Perfected Security Interests

Who’s on first? This question decides what creditor gets paid, and what becomes an unsecured creditor whose best option is to recover pennies on the dollar for the money loaned to a business that purportedly had collateral. Priority to collateral needs determination to see who can seize it in satisfaction of its indebtedness to the business. 

How and Where to File UCC Financing Statements

 

As a general rule, in all secured transactions involving a security agreement executed by the debtor, the debtor authorizes the secured party to file a financing statement describing the collateral. See 810 ILCS 5/9-509(a)(1).  A financing statement perfects the lien in the collateral securing the transaction, often a loan to a business.

The financing statement is filed with the Secretary of State’s office in which the collateral is located, or the lien arose because some collateral is mobile. In addition, Article 9 provides that a person holding an agricultural lien that arises by operation of law and requires no written agreement may file a financing statement without consent provided the financing statement covers “only collateral in which the person holds an agricultural lien.” 810 ILCS 5/9-509(a)(2).

UCC Financing Statement Filing

Problem Ag Loan

UCC Financing Statement Illinois Example

UCC Financing Statement Illinois

A UCC 1 in Illinois is common knowledge for commercial bankers and you can find a copy of the fillable PDF form LINKED HERE.

Description of Collateral for Perfection of UCC Lien

The financing statement does not need to include the legal description of leased real estate as a condition of perfection. Article 9 only requires this description only for “as-extracted collateral or timber to be cut.” 810 ILCS 5/9-502(b). “As-extracted collateral” means oil, gas, or other minerals that are subject to a security interest that is created by a debtor having an interest in the minerals before extraction and attaches to the minerals as extracted. 810 ILCS 5/9-102(a)(6). However, a legal description may be appropriate as an indication of “the collateral covered by the financing statement.” 810 ILCS 5/9-502(a)(3). One example is the landlord’s lien on crops growing on specific acreage. When the debtor is a tenant farmer that does not have a record interest in the real estate, counsel also must provide the name of the record owner. 810 ILCS 5/9-502(b)(4).

With a few exceptions, all financing statements are required to be filed in the office of the Secretary of State. 810 ILCS 5/9-501(a). The law governing perfection of priority of security interests is generally determined by the location of the debtor. 810 ILCS 5/9-301. For agricultural liens, the law governing priority is the local law of the jurisdiction where the farm products are located. 810 ILCS 5/9-302.

The debtor’s location depends on how the debtor is conducting the farm business. When a debtor is an individual, he or she is located at the individual’s principal residence. When the debtor is a non-registered organization, such as a general partnership, it is located at its place of business or its chief executive office if it has more than one place of business. 810 ILCS 5/9-307(b). However, when the debtor is an organization that is organized under state law, like a corporation or a limited liability company, it is located in the state where it is registered. 810 ILCS 5/9-307(e). The failure to file in the proper jurisdiction or to otherwise fail to satisfy the specific requirements for completing and filing the financing statement can be fatal. See, e.g., Duesterhaus Fertilizer, Inc. v. Capital Crossing Bank (In re Duesterhaus Fertilizer, Inc.), 347 B.R. 646 (Bankr. C.D.Ill. 2006).

Priorities: Which Agricultural Lien Wins?

In a conflict between security interests and agricultural liens in the same collateral, priority generally dates from the earlier of the time the filing covering the collateral is first made or the security interest or agricultural lien is first perfected. See 810 ILCS 5/9-322, 5/9-338.

A perfected security interest in growing crops has a priority over a conflicting interest of the owner or the mortgagee of the real property on which such crops are grown. 810 ILCS 5/9-334(i)(1)(A). The same priority applies between an assignee of a beneficial interest in an Illinois land trust and the holder of a perfected security interest in crops. See 810 ILCS 5/9-334(i)(1)(B). Lenders financing farm real estate that also want to maintain priority in crops must comply with Article 9 of the Uniform Commercial Code.

Problem Ag Loan

Thomas Howard

Thomas Howard

Real Estate Lawyer

Whether this is your first land use issue or most recent, our office has helped people and businesses alike.

Thomas Howard was on the ball and got things done. Easy to work with, communicates very well, and I would recommend him anytime.
R. Martindale

LLC Operating Agreements

LLC Operating Agreements

What to Put Your Illinois Company's Operating Agreement An Operating Agreement is the contract of your Illinois company’s life – which it really does not have. However, your company is a legal fiction of a person that has a beginning, called articles of organization...

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What is an Agricultural Lien under the UCC?

What is an Agricultural Lien under the UCC?

agricultural lien

What is a UCC Agricultural Lien

As we detailed in our introductory article on security interests, a security agreement gives a creditor some form of legal right over the property of a creditor. While this definition is fairly straightforward, there are all kinds of quirks which are unique to agricultural liens. Under the 2001 amendment of Article 9 of the Uniform Commercial Code (UCC), agricultural liens are a special kind of interest for lenders.

810 ILCS 5/9-102(a)(5) defines an “agricultural lien” to mean an interest, other than a security interest, in farm products:

  • (A) which secures payment or performance of an obligation for goods or services furnished in connection with a debtor’s farming operation;
  • (B) which is created by statute in favor of a person that in the ordinary course of its business furnished goods or services to a debtor in connection with a debtor’s farming operation; and
  • (C) whose effectiveness does not depend on the person’s possession of the personal property.

There are at least three types of statutory liens in Illinois that involve agriculture:

  1. agister’s lien;
  2. thresherman’s lien; and
  3. landlord’s crop lien.

Problem Ag Loan

What is an Agister’s Lien?

An “agister” cares for livestock. They have a special statutory lien set forth in §50 of the Innkeepers Lien Act, 770 ILCS 40/0.01, et seq.:

Agisters and persons keeping, yarding, feeding or pasturing domestic animals, shall have a lien upon the animals agistered, kept, yarded or fed, for the proper charges due for agisting, keeping, yarding or feeding thereof. 770 ILCS 40/50.

The agister’s lien is a possessory lien which extends animals in the care and possession of the farmer or rancher. Therefore, it does not fit the UCC definition of “agricultural lien,” and compliance with the filing requirements of Article 9 is not required.

What is a Thresherman’s Lien?

The next kind of lien, a a thresherman’s lien, is defined at §50a of the Innkeepers Lien Act:

Every person who, as owner or lessee of any threshing machine, clover huller, corn sheller or hay baler, threshes grain or seed, hulls clover, shells corn or presses hay or straw at the request of the owner, reputed owner, authorized agent of the owner or lawful possessor of such crops shall have a lien upon such crops, beginning at the date of the commencement of such threshing, hulling, shelling or baling, for the agreed contract price of the job, or, in the absence of a contract price, for the reasonable value of the services or labor furnished. Such lien shall run for a period of eight (8) months after the completion of such services or labor notwithstanding the fact that the possession of the crops has been surrendered to its owner or lawful possessor, provided that such lien shall not be valid and enforceable against a purchaser of said crops from the owner or lawful possessor thereof unless the lien holder shall, previous to or at the time of making final settlement for such crops by such purchaser, serve upon such purchaser a notice in writing of the existence of such lien. 770 ILCS 40/50a.

Unlike the agister’s lien, the thresherman’s lien continues after possession of the crops has been surrendered and therefore it fits the UCC definition of “agricultural lien.” Consequently, the rules for perfection, priority, and enforcement of this lien are provided by Article 9. Perfection is achieved by filing with the Secretary of State, and the priority rules of first to file apply. See 810 ILCS 5/9-310(a), 5/9-322.

What is a Landlord’s Crop Lien?

Lastly, for a landlord’s crop lien in Illinois, §9-316 of the Code of Civil Procedure, 735 ILCS
5/1-101, et seq., provides in part:

Every landlord shall have a lien upon the crops grown or growing upon the demised premises for the rent thereof, whether the same is payable wholly or in part in money or specific articles of property or products of the premises, or labor, and also for the faithful performance of the terms of the lease. Such lien shall continue for the period of 6 months after the expiration of the term for which the premises are demised, and may be enforced by distraint as provided in Part 3 of Article IX of this Act.

A good faith purchaser shall, however, take such crops free of any landlord’s lien unless, within 6 months prior to the purchase, the landlord provides written notice of his lien to the purchaser by registered or certified mail. Such notice shall contain the names and addresses of the landlord and tenant, and clearly identify the leased property.

A landlord may require that, prior to his tenant’s selling any crops grown on the demised premises, the tenant disclose the name of the person to whom the tenant intends to sell those crops. Where such a requirement has been imposed, the tenant shall not sell the crops to any person other than a person who has been disclosed to the landlord as a potential buyer of the crops. 735 ILCS 5/9-316.

  • Historically, the landlord’s lien was beyond the scope of Article 9. The most common priority dispute was between a UCC lien creditor and a landlord claiming a crop lien. The landlord’s lien usually prevailed. See Dwyer v. Cooksville Grain Co., 117 Ill.App.3d 1001, 454 N.E.2d 357, 73 Ill.Dec. 497 (4th Dist. 1983); Farmers Grain & Supply Co. v. Skinner, 161 Ill.App.3d 201, 514 N.E.2d 216, 112 Ill.Dec. 750 (3d Dist. 1987).
  •  
  • However, with P.A. 91-893, the Illinois General Assembly amended the landlord’s crop lien statute to fit within the Article 9 definition of “agricultural liens.” Furthermore, by P.A. 92-819, in 2002 the legislature added the following provision to the statutory crop lien:

A lien arising under this Section shall have priority over any agricultural lien as defined in, and over any security interest arising under, provisions of Article 9 of the Uniform Commercial Code. 735 ILCS 5/9-316.

As a result of this law, the landlord’s statutory lien for rent against crops grown on leased land continues to be superior to any consensual lien that the tenant may give on the crops, even those created under Article 9. Schweickert v. Ag Services of America, Inc., 355 Ill.App.3d 439, 823 N.E.2d 213, 215, 291 Ill.Dec. 203 (3d Dist. 2005) (“The 2002 amendment restored the original language of the statute as it was before the 2001 amendment.”). Therefore, the statutory lien for landlords requires no financing statement to perfect the lien.

Limitations for Ag Liens Under Bankruptcy

While Illinois created protections for lienholders, those protections are a different story under bankruptcy. The landlord’s statutory lien for unpaid rent may be avoided under the Bankruptcy Code, 11 U.S.C. §101, et seq. 11 U.S.C. §§545(3), 545(4). See Marshall v. Aubuchon (In re Marshall), 239 B.R. 193 (Bankr. S.D.Ill. 1999); Pogge v. Powers (In re Smith), 302 B.R. 865 (Bankr. C.D.Ill. 2003). If a landlord wants to prevail over a trustee in bankruptcy on the crop lien, the landlord needs a consensual security interest and a properly filed UCC financing statement. If a landlord fails to perfect by filing a financing statement, the statutory crop lien once avoided will relegate the landlord to the status of an unsecured creditor.

Thomas Howard

Thomas Howard

Secured Transaction Attorney

Whether this is your first land use issue or most recent, our office has helped people and businesses alike.

Thomas Howard was on the ball and got things done. Easy to work with, communicates very well, and I would recommend him anytime.
R. Martindale

Need A Business Lawyer?

Call our law offices with your legal questions for help on:

  1. real estate contracts
  2. business contract disputes
  3. Shareholder litigation
  4. cannabis business
  5. fraud actions
  6. mechanic's liens

 

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