Fraud Law Resources for Oregon and Washington
In re: Case No. 01-50091 William R. Justice, d.b.a W. R. Justice and Associates, and Patricia A. Justice, Debtors. Warren Christian, Plaintiff, v. William R. Justice, d.b.a. W. R. Justice and Associates, Defendant.
Adv. Pro. No. 01-02156, Chapter 7
UNITED STATES BANKRUPTCY COURT FOR THE SOUTHERN DISTRICT OF OHIO, EASTERN DIVISION
2002 Bankr. LEXIS 1540
December 23, 2002, Decided
December 26, 2002, Filed; December 27, 2002, Entered
DISPOSITION: Exception to discharge granted.
COUNSEL: For WARREN CHRISTIAN, Plaintiff: Richard
T Ricketts, Columbus, OH.
JUDGES: Charles M. Caldwell, United States Bankruptcy Judge.
OPINION BY: Charles M. Caldwell
OPINION: MEMORANDUM OPINION AND ORDER
The Defendant is an insurance agent. He started his career in 1964 as an underwriter for Buckeye Union Insurance. The Defendant obtained a license to sell securities while working at Prudential Insurance Company. The Defendant testified, however, that the license was not used. After leaving Prudential, the Defendant was an insurance agent with Farmers Insurance Group, and worked as a district manager until 1979, when he formed his own insurance agency, William R. Justice & Associates (“Justice & Associates”). It is authorized to sell annuities, and automobile, home, life, business, and health insurance. The Defendant also provided living trusts through an association with a Mr. Clyde Morgan (“Mr. Morgan”).
The 68-year-old Plaintiff worked as a truck driver for approximately 40 years. He and the Defendant are related by marriage. The two first met at a family gathering around 1984, and would periodically discuss insurance and investments. Also, the Plaintiff purchased an automotive insurance policy from the Defendant. The Plaintiff told the Defendant that he would be interested in higher-yield investments. The Plaintiff had approximately $ 50,000.00 in his savings account for retirement, and he had never invested in stocks or bonds.
In 1994, Mr. Morgan introduced the Defendant to an investment opportunity with Freeman Industries, Inc. (“Freeman Industries”), a Nevada corporation. It involved a promissory note with a high rate of return. Subsequently, the Defendant told the Plaintiff that he would attend a meeting in California at the office of Freeman & Associates, Inc. (“Freeman & Associates”), and upon his return, he would provide more information. In California, the Defendant was given a brochure that described the background of both Freeman & Associates, a California corporation, and Mr. James G. Freeman (“Mr. Freeman”), its founder. The brochure indicated that Freeman & Associates had a client base of about 92,000, with approximately $ 1.2 billion in tax sheltered annuities. Also Mr. Freeman was described as having worked in the insurance industry since 1958, with an emphasis in the tax sheltered annuity market. During the meeting, the Defendant was trained to explain the Freeman Industries notes and calculate the interest.
According to the Defendant, during the California meeting, he repeatedly inquired whether the notes were securities. Representatives of Freeman & Associates assured him that they were not. In addition, the Defendant was provided with documentation from an unidentified publication. The documentation detailed that the notes should be sold only to “accredited” investors. It also detailed that the notes should not be available for sale to the public, purchased for resale, and that any subsequent sale should be in an exempt transaction. The Defendant testified that he thought the term “accredited” investor referred to mental capability to read and comprehend the note. The Defendant also interpreted the documentation to require that the funds invested were of a “clean origin.” The Defendant testified, however, that he made no effort to independently ascertain a definition for the term “accredited” investor. In addition to being provided with the brochure and documentation, the Defendant was informed by Mr. Morgan that the California Department of Insurance had no complaints against Mr. Freeman in approximately 40 years.
During his long insurance career, the Defendant never sold a product similar to the Freeman Industries notes. The Defendant, however, never contacted the Ohio Division of Securities, the Securities and Exchange Commission, a securities broker, any financial rating service, or the underwriters for his insurance company, to inquire whether the notes were securities. There is no indication that the Defendant ever contacted his professional liability insurer to determine whether the sale of the notes was covered. The record does not indicate that the Defendant reviewed any financial statements or other financial records of Freeman Industries.
Relying solely on the information provided to him by Mr. Morgan and Freeman & Associates, the Defendant once again contacted the Plaintiff. He promoted the note using the Freeman & Associates brochure, blank copies of the note, and the lender's agreement. The Defendant was aware he was selling a note offered by Freeman Industries, not Freeman & Associates, but he was unaware that Freeman Industries was a Nevada corporation, not a California corporation. The Defendant testified that it was his belief he did not need a license to sell the notes because they were not securities. He also believed that Mr. Freeman and all of his entities were responsible for payment on the notes.
According to the Plaintiff, the Defendant told him that Freeman Industries had a “triple-A” rating, that the notes were a safe investment, and that his money could be retrieved at any time. The Defendant admits all these representations were made, except the reference to a triple-A rating. When promoting the notes, the Defendant also informed the Plaintiff that they were not securities, that his own mother was going to invest, and that all of the companies owned by Mr. Freeman were obligated to repay the Plaintiff. It was later revealed that the Defendant’s mother did not purchase the notes. According to the Defendant, soon after he explained the notes to the Plaintiff, he was called by someone at Freeman Industries who indicated the minimum qualifying investment was raised from $ 10,000.00 to $ 20,000.00. The Plaintiff testified that he was aware he was purchasing a note, but did not know that it was a security. Also, the Plaintiff did not know that the Defendant at that time was not licensed to sell securities.
On or about October 26, 1994, the Plaintiff gave the Defendant a check for $ 50,000.00, payable to Freeman Industries. The Plaintiff testified that he did not have a chance to personally review the note or have it examined by an attorney, banker, or accountant. According to the Plaintiff, once he gave the check to the Defendant, he was presented with a “receipt-type” form, rather than a note. It was the Plaintiff’s understanding that the Defendant would forward the check to Freeman Industries, and it would send the note. Contrary to the Plaintiff’s version of the events, the Defendant testified that he typed the information in the note, and took the note to the meeting with the Plaintiff. The Defendant reviewed the note with the Plaintiff, and then the Plaintiff signed the note.
In any event, after receiving the check from the Plaintiff, the Defendant forwarded it directly to Freeman Industries. On or about October 26, 1994, James G. Freeman signed the note as president of Freeman Industries. Under the note, the Plaintiff was to receive a return of 12 percent for the first nine months, and then 20 percent for the balance of the term. The Defendant was to receive a commission of 1.25 percent per month for up to nine months. Six months later, however, the Plaintiff received an April 17, 1995, letter from the Federal Bureau of Investigation (“FBI”). The letter informed him of an active investigation of Freeman & Associates and related companies, for possible misrepresentation of the nature of their investments.
The Plaintiff immediately contacted the Defendant, the FBI and Freeman Industries. The Defendant assured the Plaintiff that he would look into the matter and get back in contact with him, but the Defendant failed to do so, immediately. The Plaintiff again contacted the Defendant, who informed him that he was unable to obtain any information. At that time the Defendant’s wife typed a letter for the Plaintiff to Freeman Industries requesting that his account be closed. In the letter a refund was also requested. The Defendant testified that he placed several unsuccessful phone calls to Mr. Freeman. After forwarding the letter to Freeman Industries, the Defendant was finally able to talk with one of its representatives, Carl Overset, to inquire into the refund of the Plaintiff's money. The money, however, was never returned.
On or about September 19, 1995, and approximately a year after purchasing the note, the Plaintiff received a letter from Freeman Industries. He was informed that no interest could be paid because its activities had been suspended by the United States government, and the funds had been frozen. On or about April 25, 1996, the Plaintiff received correspondence from the FBI informing him that all of the defendants in the criminal case, United States v. James G. Freeman, et al., pleaded guilty and were to be sentenced. Mr. Morgan’s plea included one count mail fraud and one count money laundering. Mr. Freeman's plea included two counts wire fraud and two counts money laundering. Freeman Industries was liquidated, and the Plaintiff received the sum of $ 29,648.79. The Plaintiff obtained a Court of Common Pleas judgment against the Defendant in the amount of $ 20,351.21 based upon the violation of the Ohio law governing the sale of unregistered securities. The Court of Common Pleas also ruled that the Defendant's professional liability policy did not cover the sale of the notes.
On January 4, 2001, the Defendant and his wife filed a joint petition for relief under chapter 13 of the Code. On March 7, 2001, the Defendant's chapter 13 case was converted to chapter 7. The Plaintiff commenced this adversary proceeding against the Defendant on June 19, 2001. The Plaintiff alleges that the debt should be excepted from the discharge under sections 523(a)(2)(A), (a)(4), and (a)(6) of the Code.
To establish that a debt is nondischargeable under section 523, creditors must prove their case by a preponderance of the evidence. Grogan v. Garner, 498 U.S. 279, 291, 112 L. Ed. 2d 755, 111 S. Ct. 654 (1991).
Regarding the false pretenses and false representation provision of the Code (section 523(a)(2)(A)) it must be shown that:
(1) the debtor obtained money through a material misrepresentation that, at the time, the debtor knew was false or made with gross recklessness as to its truth;
(2) the debtor intended to deceive the creditor;
(3) the creditor justifiably relied on the false representation; and
(4) its reliance was the proximate cause of the loss.
In re Rembert, 141 F.3d 277, 280-281 (6th Cir. 1998), cert. denied 525 U.S. 978, 142 L. Ed. 2d 357, 119 S. Ct. 438 (1998). The sale of unregistered securities by an unlicensed dealer, which may amount to statutory fraud, is not alone sufficient to block a discharge. In re Alvarez, 13 B.R. 571, 574 (Bankr. S.D. Fla. 1981); In re Steed, 157 B.R. 355, 358 (Bankr. N.D. Oh. 1993). Dealers, however, are obligated to conduct thorough due diligence.
False pretenses have been defined as conduct intended to give a false impression that serves as an implied misrepresentation. In re Hoover, 232 B.R. 695, 700 (Bankr. S.D. Oh. 1999). Because debtors are unlikely to admit they intended to deceive, intent may be inferred from their actions at the time of and subsequent to the loss. The role of the Court is to, ". . . consider whether the circumstances, as viewed in the aggregate, present a picture of deceptive conduct by the debtor which indicates an intent to deceive the creditor." In re Patrick, 265 B.R. 913, 916-917 (Bankr. N.D. Oh. 2001); In re Monfort, 276 B.R. 793, 796 (Bankr. N.D. Oh. 2001); In re Hoover, 232 B.R. at 700. Also, intent to deceive may be inferred where the false impressions or representations are made with a reckless disregard for their accuracy. In re Woolley, 145 B.R. 830, 835-836 (Bankr. E.D. Va. 1991); In re Booth, 174 B.R. 619, 624 (Bankr. N.D. Ala. 1994). The creditor must show "justifiable reliance" on the representations. To establish proximate cause, it must be demonstrated that the conduct was a substantial factor in the loss, or the loss may be reasonably expected to follow. In re Hoover, 232 B.R. at 700.
Under section 523(a)(4) of the Code (fiduciary fraud, embezzlement, or larceny), the creditor must show: (1) the establishment of an express trust regarding the funds; (2) that the debtor acted in a fiduciary capacity; and (3) the debt is based upon the debtor's fraud or defalcation while acting as a fiduciary. In re Pomainville, 254 B.R. 699, 702 (Bankr. S.D. Oh. 2000). The express trust must pertain to particular property, and is created by a manifestation of intent to confer equitable duties to act for the benefit of others. In re Pomainville at 702-704. The embezzlement and larceny portions of section 523(a)(4) do not require the showing of a fiduciary relationship; however, it must be demonstrated that the funds were taken for an unintended purpose, and the circumstances indicate fraud. In re Pomainville, at 704-706.
In order to block the discharge of a debt under section 523(a)(6) of the Code (willful and malicious injury), it must be proved that the creditor's loss was caused by the willful and malicious conduct of the debtor. Injuries that are recklessly or negligently inflicted are not sufficient. It must be shown that there was an intent to cause harm, or that there was a substantial certainty that harm would occur. Kawaauhau v. Geiger, 523 U.S. 57, 61-64, 140 L. Ed. 2d 90, 118 S. Ct. 974 (1998); In re Markowitz, 190 F.3d 455, 463-466 (6th Cir. 1999); In re Bullock-Williams, 220 B.R. 345, 347 (6th Cir. BAP 1998); In re Devore, 282 B.R. 643, 645-646 (Bankr. S.D. Oh. 2002).
The Court has concluded that sections 523(a)(4) and (6) are not applicable to the facts in this case. Regarding section 523(a)(4), an express trust pertaining to the funds is required. In re Pomainville, 254 B.R. at 702. The Defendant as a salesman/broker merely received the funds, and immediately forwarded them to Freeman Industries. This act alone, is insufficient to establish a trust relationship. The concept of embezzlement is not relevant because the funds were properly transmitted to Freeman Industries. There is no larceny since the funds were given to the Defendant. In considering section 523(a)(6), the United States Supreme Court has made it clear that willful and malicious conduct must be shown. Kawaauhau v. Geiger, 523 U.S. at 61-64. There is no such evidence in this case.
On the other hand, the Court must conclude from the evidence that section 523(a)(2)(A) is applicable, and that the Plaintiff has sustained the burden by a preponderance of the evidence. There is no indication that the Defendant was an active participant in the fraudulent activities of Mr. Freeman and his associates. That fraud, however, is not the relevant set of circumstances in this dischargeability proceeding. Instead, the actions of the Defendant to induce the Plaintiff to invest is what matters. It must also be understood that the transaction was more than fraudulent. It was also highly risky, given the Plaintiff's proximity to retirement, modest income level, and the fact that he was investing his life savings in one product.
In reviewing the evidence, the Court finds the Plaintiff's testimony credible that he was misled in two critical respects. First, the Defendant through his family connections and past insurance sale transaction with the Plaintiff, gave the false impression that he had the legal authority to sell the investment product. The Plaintiff was given no reason to believe that he was being sold an illegal, unregistered security, and that the Defendant was not licensed at the time to sell securities. Given the significant disparity in education and sophistication between the Plaintiff and the Defendant, this false impression was the inducement to the Plaintiff to hand over a $ 50,000.00 check. That check represented his life savings and primary means of retirement. In addition to this false impression, the Court finds the Plaintiff's testimony credible that he was told that the investment was safe and that he could get his money back at any time. In fact, the Plaintiff was told that it was so safe that the Defendant was going to have his mother invest. This representation unfortunately turned out to be as false as the others.
The Defendant is a veteran of the insurance industry with almost forty years of experience. At an early point in his career he even held a securities license. With this background, he goes to the California headquarters of Freeman and Associates, and he is given a brochure of this company but receives an education on an investment product offered by a Nevada corporation, Freeman Industries. He asks whether the investment is a security, and he is given material from an unidentified publication that details that it is exempt from registration, but yet should be sold only to “accredited” investors.
According to his testimony, the Defendant concludes from
all of this information that Mr. Freeman and all of his entities are bound by
the obligation, and that the transaction was exempt from registration as long as
the Plaintiff could comprehend the terms of the note, and the funds invested
were legally obtained. These inexplicable conclusions were reached solely on the
material and representations he received from Messrs. Morgan and Freeman. They,
of course, stood to gain by promoting the sale of this product. This most
important fact should have been understood by the Defendant.
Fourth, upon receipt of the letter, the Plaintiff testified he immediately contacted the Defendant, the FBI, and Freeman Industries. The Defendant assured him that he would look into the matter and contact him again, but he failed to call back immediately. The Plaintiff had to call the Defendant again. It was only at this point that the Defendant directed his wife to type a letter for the Plaintiff to have the funds returned. The fact that the product was sold to the Plaintiff, who is related by marriage, and also to a handful of other acquaintances of the Defendant, including clergy, should have elicited a more enthusiastic effort. Fifth, sometime after the Plaintiff and the Defendant discussed the investment, the Defendant testified that the enrollment requirements were increased so that his mother could no longer invest, contrary to his representation to the Plaintiff. There is no corroboration of this change. Also, there is no indication that this information was ever passed on to the Plaintiff in time to reconsider his investment.
In reviewing the justifiable reliance and proximate causation requirements of section 523(a)(2)(A), the Court has considered that the Plaintiff, as a 68-year-old retired truck driver, had never before purchased any investments. The Plaintiff and the Defendant were related by marriage, met at family gatherings, and had one prior insurance sale transaction. The Court finds that the Plaintiff was not given an opportunity to have the instrument examined by an attorney prior to handing the $ 50,000.00 check to the Defendant. Given all of these facts, the Court has determined that the countervailing consideration of a high rate of return, and the red flags it should raise, is not sufficient to conclude that the Plaintiff's reliance was not justifiable. Finally, regarding proximate cause, while the criminal actions of Mr. Freeman and his associates certainly contributed to the loss, the funds would have never been received but for the involvement of the Defendant. He marketed Mr. Freeman's fraudulent product, and he forwarded the Plaintiff's life savings. The Court finds that the false impressions and representations of the Defendant were the proximate cause of the Plaintiff's loss.
For these reasons, the Court concludes that the obligation
is nondischargeable, pursuant to section 523(a)(2)(A) of the Code.
 These sections provide:
(a) A discharge under section 727 . . . 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; . . .
(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny; . . .
(6) for willful and malicious injury by the debtor to another entity or to the property of another entity;. . .
 As noted by one court:
Before selling the notes, the broker must review available investment ratings from qualified financial rating services. The broker must request and review with a critical eye audited financial statements . . . as well as other literature . . . discussing . . . sales history and the background of key employees. A broker cannot rely on slick, marketing brochures or insurance coverage, refrain from asking hard questions about the legitimacy of the product, and then assure a proper investigation was completed. In re World Vision Entertainment, Inc., 275 B.R. 641, 645 (Bankr. M.D. Fla. 2002). (emphasis supplied).
 Under section 523(a)(2)(A), the standard is "justifiable reliance" as opposed to "reasonable reliance" under section 523(a)(2)(B) (False Financial Statements). One commentator has defined the distinction as follows:
“Justifiable reliance can be found in the gray area that exists between actual and reasonable reliance. This standard of reliance requires more than mere actual reliance, but does not require the type of investigation required by reasonable reliance. . . . (It) is a more subjective standard . . . that takes into account the interactions between and experiences of the two parties involved. This standard . . . is a "fact-sensitive standard" that depends on "the circumstances of the particular case, rather than of the application of a community standard of conduct to all cases.”
Jeffrey R. Priebe, "Field v. Mans and In re Keim: Excepting Debts From Bankruptcy Discharge and The Difference Between "Experienced Horsemen" and "Reasonable Men," 54 Ark. L. Rev. 99, 109-110 (2001). (emphasis supplied) (citations omitted).
 Without endorsing their applicability, the Court has found the following definitions of the term "accredited" investor:
(15)(ii) any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies as an accredited investor under rules and regulations which the Commission shall prescribe.15 U.S.C.A. § 77b(a)(15)(ii). (emphasis supplied).
(a) . . . "Accredited investor" shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of securities to that person:
(5) Any natural person whose individual net worth, or joint net worth with that person's spouse . . . exceeds $ 1,000,000;
(6) Any natural person who had an individual income in excess of $ 200,000 in each of the two most recent years or joint income . . . in excess of $ 300,000 . . . and has a reasonable expectation of reaching the same income level in the current year;
17 C.F.R. § 230.501(a)(5) and (6). (emphasis supplied).