Michael E. Romero, United States Bankruptcy Judge.
There is a well-established adage that if something sounds too good to be true, it probably is. This case presents a situation where certain investors did not heed that adage to their detriment.
The Court has jurisdiction over this matter under 28 U.S.C. §§ 1334(a) and (b) and 157(a) and (b). This is a core proceeding under 28 U.S.C. § 157(b)(2)(I) as it concerns a determination as to the dischargeability of a particular debt.
Debtor/Defendant Chisan Chong ("Chong") filed his voluntary Chapter 7 petition on June 28, 2013. The Complaint filed by DRCK, LLC, William McCarthy and Rosemary McCarthy (the "Plaintiffs") asserts Chong's debt to the Plaintiffs is nondischargeable pursuant to 11 U.S.C. §§ 523(a)(2)(A), (a)(2)(B), (a)(4), and (a)(6).
As background, the Plaintiffs learned of Direction Labs, Inc. ("DLI") in mid-2011, when Mr. McCarthy's former employee, Steven Linnenkamp ("Linnenkamp"), contacted him about an investment opportunity in a software development company which was being formed. That company was DLI.
Chong and Linnenkamp, together with Greg Prewett and Matt Rutledge, formed DLI allegedly to use and develop software in which Chong had obtained an interest while working in South Korea. According
On September 28, 2011, Mr. and Mrs. McCarthy purchased 50,000 shares of DLI through a Stock Purchase Agreement ("SPA"), for $500,000.
The parties agree the $500,000 investment was for DLI corporate purposes only.
In January 2012, the McCarthys were approached about loaning or investing additional money. Although Chong told Linnenkamp he preferred a DLI loan or additional investment, the McCarthys preferred a trading account. The McCarthys and their accountant, Ms. Mira Fine, met with Chong, Prewett, and Rutledge in DLI's office. The McCarthys and their accountant heard presentations by Chong explaining how the trading software and trading process worked, using an overview document called a "pitch book" and income projections.
Chong represented the requested funds were not an investment in DLI, but a trading account to be conducted through a "frontend" brokerage firm, which in turn used another firm's trading platform, with the account managed by Chong personally
On March 5, 2012, the McCarthy's entered into an Investment Agreement with DLI, and provided a cashier's check to DLI in the amount of $300,000 for the purpose of establishing the trading account.
Eventually, Mr. McCarthy began asking to see the daily trades through the promised web site. At Chong's instruction, Rutledge created a Veruus web site. Also at Chong's instruction, Linnenkamp entered fake data into the website to show foreign currency trades.
Mr. McCarthy then raised his concern that the "trades" on the web site did not show a "trajectory" meeting the expected returns.
On June 8, 2012, Linnenkamp and Chong met with Mr. McCarthy and admitted to him both the original $500,000 and the $300,000 were gone, and informed him the $300,000 had been used for DLI expenses, not trading. Despite Chong's assurances he would repay the Plaintiffs, DLI shut down soon thereafter and the Plaintiffs never received any repayment.
As a preliminary matter, the Court notes it has had the opportunity to evaluate the testimony of the witnesses, and in particular that of William McCarthy, Steven Linnenkamp, and Chong. The Court finds the testimony of Mr. McCarthy to be credible. Moreover, the Court finds the testimony of Linnenkamp, while reflecting Linnenkamp's own misdeeds, was also credible. By contrast, Chong's testimony was evasive and often unresponsive to questions, and generally lacked credibility on substantive issues.
Section 523(a)(2)(A) states in relevant part:
A claimant may sustain a claim under § 523(a)(2)(A) by proving false pretenses, false representation or actual fraud, and these three independent causes of action require proof of different elements.
While the elements for each theory under § 523(a)(2)(A) differ, the common thread is a debtor's intent to defraud a creditor.
To sustain a claim of false representation, the Plaintiffs must prove the following elements: 1) Chong made a false representation or material omission; 2) Chong made the representation or omission with the intent to deceive the Plaintiffs; 3) the Plaintiffs relied on the representation or omission; 4) the Plaintiffs' reliance was justifiable; and 5) Chong's representation or omission caused the Plaintiffs to sustain damages.
Although Chong stressed the "Use of Proceeds" was not an "official" part of the SPA, the evidence nonetheless shows Chong represented the Use of Proceeds document reflected the proposed use of the Plaintiffs' initial $500,000. In fact, DLI's bank records reflect some of the money paid DLI expenses.
What Chong omitted to disclose was his intent to transfer the majority of the $500,000 to his personal checking account and then to the account of another company he controlled, for the purpose of trading in the foreign currency exchange market on his own behalf. Rather, during his conversations with the McCarthys, Chong represented their $500,000 would be used to fund development and improvement of trading software. He never told them he would take the money and use it in admittedly risky investments.
Further, Chong continually represented, through the initial $500,000 transaction, the $300,000 transaction, and the $48,000 loan, that DLI had many imminent deals coming to fruition, as well as many interested investors. The Court finds Chong's testimony about such deals to be lacking in credibility. At best, his representations to the McCarthys constituted mere puffery or exaggeration to create a false picture of DLI's potential value. At worst, Chong's representations about other deals were outright lies told to motivate the Plaintiffs to invest additional cash or to buy time after the Plaintiffs learned of his deception.
Another blatant misrepresentation, of course, is Chong's assertion the second transaction, for $300,000, would be used to set up a trading account for the foreign currency exchange market, with the Plaintiffs to have full access to their funds and access to online information about the trading account's performance. In reality, Chong used the $300,000 for corporate expenses, including his own six-figure salary, and instructed Rutledge and Linnenkamp to create a false web site for Veruus and to input false data for trades. He admitted
This evidence definitively demonstrates Chong engaged in a continuous pattern of misrepresentation, omission and dissimulation for purposes of § 523(a)(2)(A).
"Intent to deceive under [§ 523(a)(2)(A)] may be inferred from the totality of the circumstances, and includes reckless disregard of the truth. Moreover, the scienter requirement may be established by material omissions."
McCarthy testified he and Mrs. McCarthy relied on Chong's statements as to the use of the money when they decided to invest in DLI. The Court believes such reliance was genuine. The question then becomes whether their reliance was justifiable.
It is important to note under § 523(a)(2)(A), the standard "is not `reasonableness' in the sense of whether an objectively reasonable person would have relied upon the debtor's false representations. Rather, the correct inquiry is whether the actual creditor's reliance was `justifiable' from a subjective standpoint."
The evidence in this case shows Chong made effective presentations regarding the efficacy of the DLI software, demonstrating persuasive knowledge of both the software's functioning and the foreign currency exchange market. Although the Plaintiffs' accountant believed the investment of the $300,000 to be very risky, she acknowledged Chong was able to answer the "hard questions." Further, while the McCarthys also recognized the foreign currency exchange market was risky, Chong's representations about the results already achieved with the software, and presentation about what could be achieved
While it is possible the Plaintiffs could have consulted additional professionals or done further research, that is not the legal standard. The standard is whether people with the McCarthys' mind set and experience were justified in relying on Chong, and the Court finds this standard was satisfied.
The issue of damages will be addressed more specifically below. Pursuant to § 523(a)(2)(A), however, the Plaintiff have established damages in the form of misused funds that were not repaid. Based on the above findings the Court concludes the Plaintiffs have established the requisite elements of false misrepresentations for debt arising from the initial $500,000 investment, the $300,000 trading account investment, and the $48,000 loan to "keep things going" until the purportedly imminent, but actually nonexistent, deals came through.
The United States Bankruptcy Court for the District of New Mexico has recently described false pretenses:
For example, false pretenses may be shown when a debtor's statements and conduct conceal the debtor's true intent.
Here, as described above, Chong's statements about what he would do with the $500,000 investment and the $300,000 trading account funds concealed his true plans for the money. He led the McCarthys to believe the market's interest in the software was much more than it really was, and flat out lied about setting up a trading account. All the time, he was failing to disclose his intent to use the money however he saw fit, setting up
As noted by the Bankruptcy Appellate Panel for the Tenth Circuit, "[a]ctual fraud occurs when a debtor intentionally engages in a scheme to deprive or cheat another of property or a legal right."
In order for their debt to be nondischargeable under § 523(a)(2)(B), the Plaintiffs must show the debt was obtained by the use of a statement in writing: 1) that was materially false; 2) respecting Chong's or an insider's financial condition; 3) on which the Plaintiffs reasonably relied; and 4) that Chong caused to be made or published with intent to deceive.
The Plaintiffs argue the SPA and Use of Proceeds documents, employing a greatly inflated valuation of DLI at $10 million, constitute false financial statements for purposes of § 523(a)(2)(B). In addition, they assert the financial projections and documents, including the "pitch book"
With respect to the Plaintiffs' initial $500,000 investment, the Court cannot find those funds were obtained by the use of the SPA or associated documents, because the evidence indicates the Plaintiffs had already made the decision to invest based on Chong's fraudulent representations, false pretenses, and actual fraud. Rather, to the extent they contained materially false information, the SPA and associated documents memorialized Chong's false representations made in the past which induced the Plaintiffs to invest.
In addition, the $48,000 loan was made based on oral representations given at Chong's direction. That amount, therefore, does not fall within the scope of this subsection.
With respect to the $300,000 investment for the trading account, however,
Pursuant to § 523(a)(4), "(a) A discharge under section 727 ... of this title does not discharge an individual debtor from any debt ... (4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny."
The Court finds the evidence does not support a finding of fiduciary duty existing for either the initial $500,000 transaction nor the $300,000 trading account transaction. The $500,000 investment is a commercial transaction, and the documentation contains no indication of an express trust. In addition, the SPA specifically provides DLI is not an investment company within the meaning of the Investment Company Act of 1940; accordingly, a statutory trust does not exist. For the same reasons, the evidence does not support a finding of fiduciary duty with respect to the $48,000 loan to meet payroll.
With respect to the $300,000 transaction, the Court notes the Colorado Supreme Court has declined to adopt a per se definition of securities brokers as fiduciaries.
Such a discussion might be pertinent if Chong had actually set up a trading account and managed the trades himself, as represented, yet done them improperly. However, the Court finds the entire representation of Chong trading the $300,000 on an account set up for the Plaintiffs was false. No account ever existed with respect to which Chong would have committed defalcation. Rather, he simply continued his fraudulent misuse of the Plaintiffs' funds and his fraudulent misrepresentation as to what was being done with the funds. Accordingly, a fiduciary relationship analysis is not relevant to these facts.
However, § 523(a)(4) does not require the existence of a fiduciary relationship in order to establish that a debt created by acts of embezzlement or larceny is nondischargeable in bankruptcy.
Accordingly, the difference between larceny and embezzlement "is that with embezzlement, the debtor initially acquires the property lawfully, whereas larceny requires that the funds originally come into the debtor's hands unlawfully."
Because the funds in this case were initially transferred from the Plaintiffs to Chong or his entities legally, larceny is not applicable. Regarding embezzlement, however, this Court previously adopted the prevailing five-part standard in this District, requiring evidence of the following: 1) entrustment (originally lawfully obtaining); 2) of the property; 3) of another; 4) misappropriating the property (using it for a purpose other than that for which it is entrusted); and 5) with fraudulent intent.
The evidence discussed above shows Chong and entities he controlled received the $500,000, $300,000, and $48,000 legally.
Section 523(a)(6) of the Bankruptcy Code provides "(a) A discharge under section 727 ... of this title does not discharge an individual debtor from any debt ... (6)
Willfulness "may be established by direct evidence of specific intent to harm a creditor or the creditor's property. Willful injury may also be established indirectly by evidence of both the debtor's knowledge of the creditor's ... rights and the debtor's knowledge that the conduct will cause particularized injury."
In this case, Chong and entities he controlled intentionally obtained the Plaintiffs' initial $500,000 investment, but did not use the majority of it for the represented purposes. Instead, Chong used the majority of the $500,000 to trade on the foreign currency exchange market on his own behalf. Thereafter, Chong intentionally obtained an additional $300,000 from the Plaintiffs to set up a trading account, but never did so. Instead, he caused the funds to be used to pay DLI expenses, and created a fake web site with fake data to prevent the Plaintiffs from discovering his scheme. Still later, he obtained $48,000 more from the Plaintiffs to meet payroll, after directing misrepresentations to be made to them about DLI's prospects.
This ongoing pattern of deceit demonstrates Chong intentionally and deliberately misled the Plaintiffs in the parties' transactions. It also shows Chong knew or should have known his acts and omissions would cause the very financial damage to the Plaintiffs which they indeed suffered. Accordingly, the Court finds, in addition to being nondischargeable under § 523(a)(2)(A) and § 523(a)(4), the Plaintiffs' debt is nondischargeable under § 523(a)(6).
The Plaintiffs provided a total of $848,000 in cash in exchange for Chong's promise to invest those funds in the foreign
In this case, however, the Plaintiffs have also shown entitlement to treble damages under the Colorado Civil Theft Statute.
The Court finds Plaintiffs have met their burden of proof by a preponderance of the evidence and are entitled to treble damages. Under COLO. REV. STAT. § 18-4-405:
Under Colorado law, "theft" is broadly defined as follows:
Further, COLO. REV. STAT. § 18-4-401 specifically sets forth the components of "theft" as follows:
In the instant matter, Chong knowingly used the Plaintiffs' funds for purposes other than their intended use. Further, he used the funds in such a manner as to deprive the Plaintiffs permanently of their use and benefit. Accordingly, the Court finds Plaintiffs have established a "theft" has occurred, and treble damages are proper under COLO. REV. STAT. § 18-4-405. Therefore, the $848,000 in actual damages will be trebled to $2,544,000.
There is no bankruptcy statute or rule specifically providing for attorney fees in the context of § 523(a)(2), (a)(4) and (a)(6), FED. R. BANKR. P. 7054(b) provides for an award of costs to the prevailing party.
As recently noted by Judge Elizabeth Brown of this Court:
The Court concludes the circumstances of this case warrant an award of pre-judgment interest at the Colorado statutory rate accruing from the date of the state court judgment, April 17, 2013. Therefore, pre-judgment interest shall be awarded at the rate of 8% per annum, compounded annually, pursuant to COLO. REV. STAT. § 5-12-102. In addition, the Court finds the Plaintiffs are entitled to post-judgment interest from the date of judgment until paid at the rate set forth in 28 U.S.C. § 1961.
Based on the findings and conclusions set forth above,
IT IS ORDERED Chong's debt to the Plaintiffs is nondischargeable pursuant to §§ 523(a)(2)(A), 523(a)(2)(B),
IT IS FURTHER ORDERED that within fourteen (14) days from the date of this Order, the Plaintiffs shall file a bill of costs pursuant to FED. R. CIV. P. 7054 containing their respective total expenses under 28 U.S.C. § 1920 incurred in connection with this adversary proceeding.
