Lender Had Duty To Investigate Claim to Promissory Note

In a harsh decision for the lender, the U.S. Court of Appeals for the Tenth Circuit has determined that a debtor’s loan may be discharged in chapter 7 bankruptcy— despite the borrower’s admission that his personal financial statement contained materially false representations about his financial condition.

In First National Bank v. Cribbs (In re Cribbs), 2006 U.S. App. LEXIS 17090 (10th Cir. July 7, 2006), the Tenth Circuit determined that the lender should have undertaken at least a minimal investigation into the legitimacy of a promissory note the borrower claimed was owed to him. In fact, the note did not exist. The order and judgment by the Tenth Circuit was issued without oral argument as an unpublished opinion, which is not precedential. Therefore, the decision may reflect the thinking of the court, but does not legally bind future parties.

Promissory Note

In 2000, Cribbs sought a construction loan from First National Bank (“FNB”) to finance an assisted living center project in Oklahoma (the “Purcell Project”). He submitted a financing statement  that included among its list of assets a promissory note for $483,630, which Cribbs claimed one of his closely held businesses, Phoenix Health Services, Inc., owed to him on another assisted living center project in Mustang, Okla. (“Mustang Project”).

Cribbs also orally represented that he would contribute the proceeds from the Mustang Project, but omitted from his statement the fact that Phoenix owed his wife’s trust $600,000. A commercial bank officer at FNB reviewed the prospectus for the Purcell Project, inspected the Mustang Project, and contacted the bank handling the Mustang Project loan, which confirmed that the debtor’s company was current on its obligations.

However, FNB’s loan officer never asked to see the promissory note, nor attempted to take a security interest in or an assignment on the note. FNB funded the loan for nearly $3 million, for which Cribbs and certain co-investors each executed a personal guaranty. The bank also extended a second loan for more than $100,000 for fixtures and equipment that was secured by Cribbs’ personal guaranty.

Cribbs’ company defaulted on both loans, and Cribbs and the other investors refused to honor their guaranties. FNB obtained a judgment against Cribbs on both loans in Oklahoma state court. Cribbs then filed a petition for bankruptcy under chapter 7.

FNB initiated an adversary proceeding to have the debt excepted from discharge. The bankruptcy court held the debt was dischargeable because FNB failed to establish that it actually and reasonably relied on Cribbs’ financial statement, even though Cribbs had acted with intent to deceive. The Bankruptcy Appellate Panel for the Tenth Circuit affirmed and FNB appealed.

Tenth Circuit Review

On appeal, the Tenth Circuit first noted that the law provides for an exception from discharge for debts obtained by the use of a written statement:

(i) that is materially false;

(ii) that respects the debtor’s or an insider’s financial condition;

(iii) on which the creditor…reasonably relied; and

(iv) that is made with the intent to deceive.

“Cribbs concedes that his personal financial statements contained materially false representations about his financial condition,” the court noted. But the court concluded that FNB could not show that it had “reasonably relied” on the debtor’s representations concerning the promissory note.

The bankruptcy court found that FNB’s decision to make the loan was based primarily on the guaranties provided by the co-investors. Further, “[t]he [bankruptcy] court noted that, despite insisting that the decision to extend the loans was based on the Note, FNB never even asked to see the Note or to take an assignment on it,” the Tenth Circuit stated.

The bankruptcy court held that FNB did not “actually rely” on Cribbs’ financial statement. The support of the new guarantors resolved the bank’s concerns regarding the lack of adequate liquid capital, which was the reason the bank had denied the debtor’s first loan application.

In addition to disputing FNB’s claim that it relied on Cribbs’ claim to the promissory note, the Tenth Circuit examined whether reliance upon the note would have been “reasonable,” and concluded under the facts of the case that it would not.

“Relevant factors a court must consider include the creditor’s standard lending practices, the standard in the creditor’s industry, and the surrounding circumstances at the time the debtor applies for credit, including whether there are any ‘red flags’ in the application, whether there was an ongoing business relationship, and whether further investigation would have revealed inaccuracies in the debtor’s application,” the Tenth Circuit stated.

The court found that FNB’s lack of diligence as to the note rendered reliance on Cribbs’ financing statement unreasonable, the court concluded.

While the case is not precedential, it reinforces the relatively high standards that must be met when prosecuting a claim for nondischargeability of a debt for the debtor’s use of a falsified financial statement. Not only must fraud be demonstrated, but the creditor must be prepared to show that it reasonably relied on the financial statement as well.