TERRY L. MYERS, Chief Judge.
Plaintiff Darrell Adams ("Adams"), brought this adversary proceeding in his capacity as Trustee of the Carmella Adams Trust, seeking to deny the discharge of debtor Lawrence Darwin McKay ("Debtor") under § 727(a)(3).
Debtor is a self-employed business man. According to Debtor's testimony, beginning in 1978, he owned multiple, successful sod farm businesses, including Turf Company, Turf Corporation, and Turf Company LLC.
In 2004, Debtor's son, Brian McKay ("Brian"), was completing his master's degree in business administration and wanted to start his own business. Brian met a Granite Transformations franchisee who was very successful, and eventually decided he wanted to open a Granite Transformations franchise.
When Debtor received a large inheritance, Brian approached him about investing that money as start-up capital so Brian could purchase a Granite Transformations franchise. Debtor agreed, and the two formed Nevada Granite Industries Inc. ("NGI") in January 2005. See Ex. 100 (NGI Articles of Incorporation, filed with the Nevada Secretary of State on January 20, 2005). Debtor received 75,250 shares of NGI stock for his initial investment;
Testimony from both Debtor and Brian revealed that, while NGI was primarily Brian's business, Debtor had some involvement in it. He spent a significant amount of time in Reno during the winter of 2005, during a quiet time for his turf businesses, providing help and advice while Brian was setting up the business. Debtor testified that after that winter he had little time to participate in the operations of NGI, but he attended meetings of the board of directors and of the shareholders, usually when he had to be in Nevada on trips related to his turf business. He casually reviewed NGI's financial records and continued to provide advice to Brian. But Debtor was not involved in NGI's day-to-day operations, nor did he have any book-keeping responsibilities for the business.
Debtor also provided cash infusions needed to keep the business running. See Ex. 114 (NGI's Quickbooks account ledger for "28002 Long Term Darwin McKay"). Brian testified that, after the initial start-up capital, the remaining transfers of funds from Debtor to NGI were loans. Debtor's exhibits included promissory notes for all transactions after July 14, 2006. Ex. 206. No promissory notes were produced for transfers prior to that time, although several were listed on the Quickbooks ledger.
By 2006, Brian had determined that NGI needed a significant cash infusion. He had a friend list an investment opportunity with NGI on the region's real estate multiple listing service, and was eventually approached by Adams.
Adams ultimately paid $356,250.00 for 53,570 previously unissued shares of NGI stock, a number equal to the number of shares owned by Brian. Ex. 115 (Stock Purchase Agreement). Adams paid $181,250.00 of that amount before executing the Stock Purchase Agreement: $100,000.00 on May 22, 2006, $56,250.00 on July 12, 2006, and $25,000.00 on July 27, 2007. Adams paid the remaining $175,000.00 when the Stock Purchase Agreement was executed.
The parties disagree about what Brian, and possibly Debtor, told Adams prior to his investment in the business.
On May 31, 2006, shortly after Adams made the initial payment to NGI, NGI transferred $37,750.00 to Debtor, despite
Adams also questioned Debtor about six other transactions listed on the Quickbooks record as occurring on May 31, 2006. Each of those items was a transfer for $20,000.00; three were from Debtor to NGI, while three were from NGI to Debtor. The Quickbooks memo entry for two of the entries said "Reclassify fund ..." before being truncated, and the memo entry for another said "Correction to je ..." before being truncated. Brian testified he could not explain why those entries were made, but he believed they were corrective entries given the memo entries and the fact they were in apparently offsetting amounts.
The parties agree Debtor failed to produce a 2009 tax schedule K-1 establishing Debtor's shareholder income from NGI, although Debtor did produce K-1 schedules for the years 2005 through 2008. In 2008, Debtor paid his own accountant to file taxes for NGI because the corporation did not have the funds to do so. Debtor testified he did not provide the 2009 schedule K-1 because "there were no funds" to file them. Brian further explained that NGI did not have the money to pay an accountant to do its corporate taxes for 2009, and Brian personally could not afford to have it done either. Thus no corporate taxes returns were filed for 2009, and Debtor's schedule K-1 was not produced.
NGI continued to lose money, even after Adams' investment, and Debtor continued to loan funds to the company. Over the life of the business, Debtor's loans to NGI totaled $598,965.20. Ex. 114. By early 2009, Debtor informed Brian that he could no longer afford to put additional funds into NGI, and they decided to dissolve the corporation. Brian asked the franchisor to take over, and the franchisor finished the last few jobs and paid the employees their final paychecks.
After NGI dissolved, Adams filed a lawsuit against NGI and Debtor in the Second Judicial District Court of the State of Nevada. On February 8, 2012, the Court entered a $425,511.45 judgment against Debtor. Ex. 109 at 4-5.
Debtor filed a voluntary chapter 11 petition on April 19, 2012, Case No. 12-00902-TLM. Adams filed a $429,856.86 claim against Debtor based on the state court judgment. Ex. 109. The case was converted on Adams' motion on January 4, 2013. Adams filed this adversary proceeding on April 18, 2013.
Section 727(a) of the Bankruptcy Code requires the court grant the debtor a discharge unless, among other things,
§ 727(a)(3).
This discharge exception "should be strictly construed in order to serve the Bankruptcy Act's purpose of giving debtors a fresh start." Caneva v. Sun Communities Operating Ltd. P'ship (In re Caneva), 550 F.3d 755, 761 (9th Cir.2008) (quoting Industrie Aeronautiche v. Kasler (Matter of Kasler), 611 F.2d 308, 310 (9th Cir.1979)) (internal quotation marks omitted). "[A] total bar to discharge is an extreme penalty," Ditto v. McCurdy, 510 F.3d 1070, 1079 (9th Cir.2007) (quoting Rosen v. Bezner, 996 F.2d 1527, 1534 (3d Cir. 1993)) (internal quotation marks omitted) (alteration in original), and "reasons for denial of a discharge must be real and substantial rather than technical and conjectural," 6 Collier on Bankruptcy ¶ 727.01[4], 727-12 (16th ed., Alan N. Resnick and Henry J. Sommer, eds.).
To establish a prima facie case under § 727(a)(3), a creditor must show (1) that the debtor failed to maintain or preserve records, and (2) that the debtor's failure "makes it impossible to ascertain the debtor's financial condition and material business transactions." Caneva, 550 F.3d at 761 (quoting Lansdowne v. Cox (In re Cox) ("Cox II"), 41 F.3d 1294, 1296 (9th Cir.1994)) (internal quotation marks omitted). Then the burden of proof "shifts to the debtor to justify the inadequacy or nonexistence of the records." Id. (quoting Cox II, 41 F.3d at 1296) (internal quotation marks omitted).
The Ninth Circuit has explained that while the purpose of § 727(a)(3) "is to make discharge dependant on the debtor's true presentation of his financial affairs," Caneva, 550 F.3d at 761 (citing Cox II, 41 F.3d at 1296), it "does not require absolute completeness in making or keeping records," id. (quoting Rhoades v. Wikle, 453 F.2d 51, 53 (9th Cir.1971)) (internal quotation marks omitted). Instead, a debtor must provide sufficient written documentation to allow his creditors to reasonably "ascertain his present financial condition and to follow his business transactions for a reasonable period in the past." Id. (quoting Rhoades, 453 F.2d at 53) (internal quotation marks omitted).
A debtor must provide adequate records for the businesses he owns or controls. See Caneva, 550 F.3d at 762 ("Without the records ..., [a creditor] cannot determine what assets [the debtor's] business entities held or may still hold, what assets passed through them and where they might have gone, and what their present value is, if anything.... Thus we hold that when a debtor owns and controls numerous business entities and engages in substantial financial transactions, the complete absence of recorded information related to those entities and transactions establishes a prima facie violation.").
Here, Adams established a prima facie case. Debtor failed to provide certain
Debtor argues that even if the records he provided were inadequate, his failure to keep adequate records was justified by the circumstances surrounding his involvement with NGI.
According to the Ninth Circuit, "`[j]ustification for [a] bankrupt's failure to keep or preserve books or records will depend on ... whether others in like circumstances would ordinarily keep them.'" Cox II, 41 F.3d at 1299 (quoting Gross v. Russo (In re Russo), 3 B.R. 28, 34 (Bankr. E.D.N.Y.1980)) (second alteration and omission in the original). The Circuit recognized that reliance could factor into a debtor's justification, stating:
Cox v. Lansdowne ("Cox I"), 904 F.2d 1399, 1403 (9th Cir.1990).
The Circuit remanded the case, listing six factors the bankruptcy court was to consider, along with other relevant factors:
While the holding in Cox I specifically said reliance on a spouse should be considered when analyzing a debtor's justification, the Court's reasoning explicitly stated delegation of responsibilities could happen in any business relationship. Here, Debtor had a close familial relationship with Brian, and Debtor trusted Brian to run the business in which Debtor had invested a significant amount of money. Debtor also trusted Brian to keep or oversee the keeping of that business' books.
Debtor's reliance on Brian to maintain records for the business was reasonable. While Debtor operated turf farms and other businesses for more than thirty years, his role in NGI was supposed to be minimal. NGI was Brian's business. Brian did not have experience running a business, but had earned an MBA and had taken an accounting class and so appeared to have the requisite knowledge and skills to ensure adequate records were kept. And Debtor was managing his own turf businesses, leaving him little time to delve deeply into NGI's finances.
While Debtor had significantly more involvement in the subject business than did the debtor in Cox, the violations of § 727(a)(3) were less egregious. In his informal review of NGI's books as an officer and director of the corporation, Debtor was presented with evidence that Brian was actually keeping the books, and so his failure to note the lack of documentation on particular transfers was reasonable. While Debtor's past business experience allowed him to understand the books and provide advice on business operations, his experience and his role at NGI were not such that Debtor could be reasonably expected to notice what was not there, among all the records that were. The Court determines Debtor's failure to provide the documents underlying the $37,750.00 transfer from NGI to Debtor is justified on the whole of this record.
Adams' counsel did not mention Debtor's failure to provide a schedule K-1 in his closing arguments, and thus appeared to abandon that contention. To the extent Adams did not intend to abandon it, the Court determines the failure of Debtor to provide a schedule K-1 for 2009 was also justified under the particular circumstances of this case. NGI had run out of funds and could not afford to pay an accountant to compile the corporation's tax documents. Debtor and Brian had neither the requisite knowledge to file the taxes themselves, nor the money to pay a tax professional. Indeed, by that point, NGI's franchisor had stepped in to finish NGI's remaining jobs and pay NGI's employees. The Court does not condone NGI's failure to complete its taxes, nor does the Court condone Debtor's failure as an officer and director of NGI to ensure the corporation filed its taxes and the corporation's dissolution was properly handled and documented. But the Court recognizes that Debtor could not provide the K-1 when it did not exist.
Ultimately, Debtor was shown to have failed to keep or produce certain documents that would shed further light on his
Judgment will be entered for Debtor. A proposed form of judgment shall be submitted by his counsel.
Debtor also attempted to defend the adequacy of the records by pointing out that Brian had provided various records and reports to Adams for the duration of NGI's operations after Adams invested in NGI, and that Adams had received those records without complaint. Ultimately, Adams' failure to object to NGI's previously provided records is immaterial to this inquiry. The adequacy of the records provided in this bankruptcy must be determined by whether creditors can ascertain Debtor's financial condition from them, not by whether a creditor objected to the adequacy of those records in the past, when they were provided for other purposes.