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Partnership That Never Existed Cannot Create Nondischargeable Debt

In Utnehmer v. Cruel (In re Utnehmer), 2013 Bankr. LEXIS 4482, NC-12-1362-PaDJu (9th Cir. BAP Oct. 10, 2013), the Bankruptcy Appellate Panel of the United States Court of Appeals for the Ninth Circuit ("BAP") ruled that Bankrupcty Code Section 523(a)(4) did not apply to render a debt nondischargeable in relation to a partnership that was never formed.  Specifically, an agreement to re characterize debt as profit-sharing equity was conditional upon events that did not occur.

William Utnehmer participated in a general partnership for real estate development.  In connection with the development of a luxury residence, Utnehmer provided the plaintiffs with a loan agreement, a promissory note and a private offering memorandum.  To summarize, the documents provided that the plaintiff would make a loan of $100,000 at 12% interest secured by a lien against the property.  Conditional upon the drafting and execution of a formal operating agreement, $50,000 of the loan would be re characterized as an equity contribution with a 10% annual preferred return and a 35% share of the profits, prorated based on the equity contribution.  The agreements were executed, and the loan was funded, but the operating agreement was never prepared.  The plaintiffs received interest payment in the three years that followed, but no principal.

After the plaintiffs retained counsel to enforce the obligation, Utnehmer and his spouse agreed to pay $50,000 in installments of $2,000 per month and that the remaining $50,000 would be recharacterized as equity upon the sale of the property and paid along with a 10% preferred return and their prorated share of 35% of the net proceeds.  Only $4,000 was paid, and when the property was sold for $3,725,000, Utnehmer apparently told the plaintiffs he could not pay them from the proceeds.  The plaintiffs brought and action, which resulted in a default judgment for $213,645.17.

Thereafter, Utnehmer and his spouse filed a chapter 7 bankruptcy case, and the plaintiffs brought an action to render the debt nondischargeable.  The complaint plead causes of action under Bankruptcy Code Sections 523(a)(2) (fraud) and 523(a)(6) (willful and malicious injury), which were unavailing, but prevailed under Section 523(a)(4), which was raised at trial and not challenged as untimely.

Bankruptcy Code Section 523(a)(4) provides that a debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny" is nondischargeable.  The phrase "while acting in a fiduciary capacity" has long been interpreted to require the existence of an express trust (arising by agreement) or technical trust (arising by statute or by law).  The Ninth Circuit previously applied a very low standard to "defalcation," holding that it includes any failure to account sufficiently, regardless of benign intent.  In re Lewis, 97 F.3d 1182, 1186-1187 (9th Cir. 1996).  To summarize, the claim that arises when a trustee takes property out of trust is not dischargeable in bankruptcy.

The bankruptcy court applied In re Lewis in finding that there was a defalcation.  However, there was a subsequent change in the law when the Supreme Court of the United States decided Bullock v. BankChampaign, N.A., 133 S.Ct. 1754 (2013), in which the Court rule that "defalcation" includes "a culpable state of mind requirement akin to that which accompanies application of the other terms in the same statutory phrase.  We describe that state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior."

The bankruptcy court also concluded that the debtor and the plaintiff were partners based upon the loan agreement's terms providing for a re characterization if debt as equity.  California law provides that that all partners hold partnership assets in trust.  Ragsdale v. Haller, 780 F.2d 794 (9th Cir. 1986).  

The BAP reviewed this determination de novo and found that the loan agreement was insufficient to establish a partnership as a matter of law.  Specifically, the text of the agreement plainly stated that the loan would be partially re characterized as equity only upon the execution it an operating agreement for a limited liability company to be formed in the future.  An agreement to be partners in the future or upon the fulfillment of a contingency does not establish a partnership until that time arrives.  Solomont v. Polk Dev. Co., 245 Cal.App.2d 488, 496 (1966).  The parties may have become partners of they actually shared profits or management, but they never did.  

Moreover, the court notes that there is no case applying the rule in Ragsdale to a limited liability company.  Likewise, California law provides that officers and directors of a corporation do not hold company assets in trust within the meaning if Bankruptcy Code Section 523(a)(4).  Cal-Micro, Inc. v. Cantrell, 329 F.3d 1119 (9th Cir. 2003).

Also seen on Legal By the Bay, the Bar Association of San Francisco's blog.