Dale L. Somers, United States Bankruptcy Judge.
The Complaint in this adversary proceeding was filed by Bank of Commerce & Trust Company, Wellington, Kansas (Bank), to except from discharge under 11 U.S.C. §§ 523(a)(2) and (a)(6) its claim against Debtors Jonathan I. Schupbach and Amy M. Schupbach (collectively Debtors) and for a determination of the amount excepted from discharge. The Court has jurisdiction.
Bank alleges that Debtors should not be discharged from damages caused by conversion. The conversion claim arises from six prepetition loans made by Bank to Debtors and their company, Schupbach Investments. Each of these loans was made for the purchase or refinance of an individual residential property.
Beginning in 2001, Debtors engaged in the business of buying, owning, and selling homes in low income areas of Wichita, Kansas. Initially the business was conducted
Schupbach Investments generally purchased distressed homes for less than fair market value, and then either rented or sold the properties. The purchase and renovation costs were financed through various lending institutions, including Bank. Bank started making loans to Schupbach Investments in 2004, when Clint Lawrence, currently a vice president of Bank and through whom the Schupbachs had obtained business loans while he was employed by another financial institution, solicited the Schupbachs' business. Although there is disagreement as to the exact number of loans,
Schupbach Investments filed for relief under Chapter 11 of the Bankruptcy Code on May 16, 2011. Jonathan and Amy Schupbach filed for relief on July 16, 2011, under Chapter 13, but the case was later converted to Chapter 11. Schupbach Investments' schedule A listed 165 parcels of real property, 39 of which were mortgaged to Bank. Bank filed a proof of claim for $748,748.72 against the Schupbachs.
The six loans which are the basis for the conversion claim were made over a two-and-half-year period and involve single residential properties requiring improvements before being rented. The dates and the amounts of the loans, and the addresses and the purchase prices of the Wichita properties mortgaged to secure the loans are: September 18, 2007 loan for $41,600, secured by 2611 E. 13th Street,
Each of the six loans was originated in accord with the customary procedures used by Bank and Schupbach Investments when Schupbach Investments desired financing to be secured by a home needing renovation. Jonathan Schupbach would contact Clint Lawrence. If Bank was interested in making the loan, Clint Lawrence would contact the appraiser whom he used for Wichita properties and who valued approximately 10 homes per year for loans to Schupbach Investments, resulting in the appraiser's being very familiar with Jonathan Schupbach and his business. Bank would instruct the appraiser to value the subject property as if the needed renovations and repairs had been completed. Then Jonathan Schupbach would show the property to the appraiser and inform him that he intended to make the "usual" renovations, meaning such things as roof repair, painting, new siding, new HVAC, and floor covering. Jonathan Schupbach did not provide the appraiser with a list of anticipated improvements for each property, but the appraisal report for each property included a list prepared by the appraiser of anticipated repairs. For example, the appraisal for the East 13th Street property states, "Owner is totally redoing the home inside and out. New electrical, new plumbing, new bath fixtures, dry wall, insulation, new porch, paint and siding. Storage shed,"
Bank would then loan Schupbach Investments an amount equal to 70% to 80% of the appraised value of the selected property for various terms, some for twenty years and some for one year. Each loan was evidenced by a promissory note executed by Debtors personally and on behalf of Schupbach Investments.
The loan proceeds were used for the general business expenses of Schupbach Investments. Some of the withdrawals from the account were for Debtors' personal expenses, such as home mortgage payments and utility costs. But Debtors, who worked full time for Schupbach Investments, were not paid salaries and regarded use of company funds for their personal expenses as their compensation. Salaries paid Debtors would have been regarded as business expenses; payment of personal expenses in lieu of salaries should also be so regarded. Further, examination of the bank statements shows that there were sufficient deposits from sources other than Bank's loans to cover the personal expenses. The Court therefore rejects Bank's position that the proceeds were used in part for purposes other than the business of Schupbach Investments.
Amy Schupbach, who maintained the financial records, could not identify any specific expenditures for improvements to the six mortgaged properties, but she did testify that some of the ongoing expenses, such as for contractors whom Schupbach hired to repair and maintain the company's properties, could have spent time on some of the six homes. Jonathan Schupbach testified that although he disagreed with some of the specific renovations listed on the appraisal reports, he intended to renovate the properties mortgaged to secure the six loans. As a business practice, Schupbach Investments made repairs on an as-needed basis. Easy turnaround homes were repaired first, and repair of those needing significant work was deferred. In 2010, Jonathan Schupbach estimated that there were 18 homes in line for repairs, and that although he intended to repair the six homes financed by Bank, all the company's resources were being devoted to other properties. As to the six homes, the electrical service at 2611 E. 13th Street was improved, the 1524 N. Lorraine property was cleaned out and secured, and broken windows were repaired at 434 S. Illinois and 1504 N. Erie.
Bank contends that the loan proceeds of each of the six loans were to be used exclusively for the renovation of the home securing each note. Clint Lawrence referred to the loans as "construction loans" and testified that if the entire proceeds were not used for the intended purpose, they were to be returned. Clint Lawrence testified that he and Jonathan Schupbach discussed structuring loans to be secured by single residences to require the submission of receipts for work performed, but rejected this method as impractical because Schupbach Investments' business model made it nearly impossible to document expenditures on individual properties. Bank made approximately 20 loans secured by individual residences requiring renovations in accord with the procedures discussed herein; of these, it appears that all were paid or refinanced, except for the six which are the subject of this litigation.
The amount of each loan was determined by the appraised value; the cost of anticipated repairs was not estimated, and the amount loaned was not related to the cost of the upgrades. The appraisal reports are the only documents in the loan files listing intended improvements.
The only provisions in the loan documents signed by Debtors or provided to them before closing that relate to the use of the loan proceeds are "purpose of loan" sections of the notes. Those provisions read as follows: "Refinance and Improve Business Investment";
In middle or late 2009, Clint Lawrence spoke with Jonathan Schupbach on the phone about the 13th Street property because it was in an area where the City of Wichita was buying properties for road improvements. He learned for the first time that the property had not been repaired, except for electrical work, even though the loan had been made in 2007. Clint Lawrence testified he assumed that Schupbach Investments had the loan proceeds, except those used to buy supplies for the intended renovations of the 13th Street property, in its bank account.
Even though Bank had notice in 2009 that the improvements to the 13th Street property listed in the 2007 appraisal had not been made, Bank continued to make
Neither of Debtors understood the purpose of the loans as stated in the notes to mean that the proceeds were to be held apart from the company's other assets and devoted solely to renovations of the mortgaged homes. Jonathan Schupbach testified that he believed the funds were provided for use in the operations of Schupbach Investments and that he was to do what he saw fit to run the business. Although he intended to eventually make the repairs on the financed homes, he did not understand the proceeds to be earmarked for this purpose and did not discuss the use of the loan proceeds with Clint Lawrence until October 12, 2010, when bankruptcy was imminent. Amy Schupbach testified she understood that the purpose of the loans was to fund Schupbach Investments' business, which was the purchase, improvement, rental, and sale of distressed real estate in low income areas of Wichita, and that the loans provided funds for the company to continue in business. She executed the loan documents at her home when they were presented to her by Jonathan Schupbach. Clint Lawrence could not recall having met with Amy Schupbach regarding the six loans. There was no evidence that she ever met with the appraiser.
Bank's dischargeability complaint is premised upon the Schupbachs' alleged conversion of the loan proceeds because they were not used for the intended purpose of renovating the six properties. For each of the six properties, damages were calculated by subtracting the purchase price and estimated closing costs of $1,000 from the loan proceeds. The total damages claimed are $172,000.
There are two preliminary matters which need to be addressed. First, Bank contends that Debtors' Answer to the Complaint binds them to Bank's view as to the purpose of the six loans. For each of the loans, the Complaint alleges that the loan was made, that the purpose of the loan was to make the renovations listed in the appraisal report for the property, and that based upon the representations and personal guarantees of the Schupbachs, Bank made a loan to Schupbach Investments "to renovate, modify and improve the property" securing the note.
Although the Court has difficulty understanding why Debtors admitted the factual allegations of the Complaint and the allegation that they "knew ... the proceeds... were required to be used on the homes that Schupbach Investments had purchased," it declines to find that the Answer limits the Court's ability to consider Debtors' understanding of the purposes of the loans. The purposes of the loans alleged in the Complaint are more general than Bank's position at trial, during which it essentially contended that the loans' purposes required that the proceeds be earmarked for renovation. This shift of position is similar to the subtle difference in the understandings of Bank and Debtors as to the loans' purposes, as reflected in the testimony and exhibits discussed below. Justice would not be served by foreclosing Debtors' ability to contest Bank's understanding of the purposes of the loans and the allowed use of the proceeds. The duty of the Court is to resolve the controversy between the parties, not to parse the meaning of admissions in the Answer.
Second, as stated above, the claim alleged in Count I of the Complaint for denial of the discharge of a debt for false pretenses, false representations, and actual fraud under § 523(a)(2), was dismissed as untimely. The evidence in this case is such that the most natural way to view a possible denial of discharge is from the perspective of fraud, but this temptation must avoided. The only claim before the Court is for denial of discharge of Bank's claim of damages from a willful and malicious injury to Bank's property based upon alleged conversion.
Subsection 523(a)(6), the basis for Bank's remaining dischargeability claim, provides as follows:
The Supreme Court has held that this subsection encompasses "only acts done with the actual intent to cause injury."
A debt for an injury caused by conversion may be nondischargeable under § 523(a)(6), if it is willful and malicious.
Conversion is defined as "the unauthorized assumption or exercise of the right of ownership over goods or personal chattels belonging to another to the exclusion of the other's rights."
In this case, Bank claims a debt for injury from conversion, but the Court finds that Debtors did not convert Bank's property. The pretrial order states, "Plaintiff contends that defendants willfully and maliciously injured the plaintiff by intentionally placing at risk, using, misappropriating and/or converting plaintiff's collateral for their benefit resulting in damage to the plaintiff."
The evidence is inadequate to establish injury from conversion of collateral. Bank's presentation of evidence and its damage calculations were based solely upon the theory that the property converted was the cash proceeds of the six loans. Yet, there is no evidence that Bank even attempted to retain a security interest in the cash proceeds. Rather, it is uncontroverted that the six properties were the sole collateral for Bank's loans. There is no evidence and no contention that Debtors exercised rights with respect to the mortgaged homes inconsistent with Bank's interest as mortgagee. Debtors did not convert Bank's collateral.
Debtors also did not convert the loan proceeds. As stated above, an essential element of conversion is an interference with the plaintiff's interest in the property allegedly converted. In this case, that element is lacking. The loan proceeds were distributed to Schupbach Investments by cashiers' checks. When delivered, they ceased to be Bank's property.
Bank seeks to overcome the foregoing deficiency in its conversion claim by asserting that a conversion occurred when the loan proceeds were used for purposes other than those for which they were loaned. The Court finds this conversion theory to be valid. In re Atkins
In this case, the Court finds the evidence regarding the limitations upon the use of the loan proceeds provided by Bank to Schupbach Investments is insufficient to support a claim of conversion. The notes state the purposes of the six loans as follows: "Refinance and Improve Business
The Court finds that the purposes stated in the notes are ambiguous, in that both Bank's and Debtors' readings are reasonable interpretations of the notes. Therefore, to ascertain if the use of the proceeds was limited to the repair of the specific properties which secured each note, the Court considers the other loan documents, the circumstances surrounding the making of the loans, and the actions of the parties after the loans were closed.
The notes are the only documents purporting to state the purposes of the loans, and they do not enumerate the anticipated repairs. The only documents in the loan files addressing the specific improvements for each property are the appraisal reports. But they were not signed by the borrower or Debtors, and there is no evidence that Debtors received copies before the execution of the notes. The appraisal reports are therefore excluded from consideration as a part of Schupbach Investments' agreements with Bank by the integration clauses contained in each of the notes. Further, the lists of repairs in the appraisal reports were drafted by the appraiser and not assented to by Jonathan Schupbach or Bank. Clint Lawrence instructed the appraiser to value the properties as if the repairs had been made; he did not consider the value of the properties without the repairs or the cost of the repairs, which was never estimated. Clint Lawrence did not discuss the repairs needed on each property with Jonathan Schupbach. The loan documents did not state a date by which repairs were to be completed or require evidence that repairs were made. There was no provision that precluded commingling the loan proceeds with other assets of Schupbach Investments and no requirement that Schupbach Investments return any funds not used for repairs.
Although Clint Lawrence testified that he regarded the loans as construction loans, his conduct does not support this interpretation of the transactions. He testified that he and Jonathan Schupbach discussed structuring loans to be secured by single residences to require the submission of receipts for work performed, but rejected this method as impractical because
Bank's evidence is insufficient for the Court to conclude that the use of the loan proceeds was restricted in such a way that Schupbach Investments' use of the proceeds for general business purposes constituted a conversion. The relationship between Bank and Debtors is that of creditor-debtor; Debtors have no liability for conversion.
Finally, even assuming that (1) the loan agreements required Schupbach Investments to use the loan proceeds exclusively for the improvement of the mortgaged properties, (2) such requirement was breached when the proceeds were used for general business purposes, and (3) Debtors are liable to Bank for conversion, Bank has not sustained its burden to prove that the alleged injury from conversion was willful and malicious, as required for the debt to be excepted from discharge under § 523(a)(6).
As stated by the Supreme Court, "[t]here is no doubt that an act of conversion, if willful and malicious, is an injury to property within the scope of this exception [the predecessor to § 523(a)(6) ].... But a willful and malicious injury does not follow as of course from every act of conversion, without reference to the circumstances. There may be a conversion which is innocent or technical, an unauthorized assumption of dominion without willfulness or malice."
As to the willful element, "nondischargeability takes a deliberate or intentional injury, not merely a deliberate or intentional act that leads to injury."
Bank's evidence is inadequate to prove a willful injury by either Jonathan or Amy Schupbach. There is no direct evidence of intent to injure. Rather, both Debtors credibly testified that they intended to repay the loans and believed they were using the loan proceeds in accord with the terms of the loan agreements. Likewise, there is no indirect evidence of willful injury. Assuming the loan proceeds were Bank property notwithstanding Bank's payment of the proceeds to Schupbach Investments, the evidence does not establish that Debtors had knowledge of Bank's interest. Further, Debtors had no knowledge that their conduct in using the loan proceeds for the general business operations of Schupbach Investments would cause injury to Bank's property.
In contrast to the definition of "willful," the definition of "malicious" for purposes of § 523(a)(6) has not been authoritatively declared by the Supreme Court. The Tenth Circuit has stated that "the term `malicious' requires proof `that the debtor either intend the resulting injury or intentionally take action that is substantially certain to cause the injury,'"
Assuming a conversion, Bank's evidence fails to show a malicious injury, however defined. There was absolutely no evidence that Debtors intended to injure Bank. Debtors intended to repair the residences and to pay the loans. There is no basis to conclude that any injury to Bank was substantially certain to follow from Schupbach Investments' use of the loan proceeds for its general business operations. Prior loans from Bank for repair of residences had been paid or refinanced, even though the loan proceeds were not dedicated to the repair of the specific property securing the note. Assuming a conversion, it was an ordinary tort; it was not malicious.
For the foregoing reasons, the Court denies Bank's claim for denial of discharge of its claim for conversion damages under § 523(a)(6). Bank's evidence is insufficient to find that Debtors caused injury to Bank by converting Bank's property and, even if the evidence were sufficient to find such an injury, Bank has not proven that any damages it suffered were the result of a willful and malicious injury, as required for denial of discharge of its claim under § 523(a)(6). Bank's claim of nondischargeability for false pretenses, false representations, and actual fraud under § 523(a)(2) was previously dismissed as untimely. Finding no basis for denial of discharge, the Court concludes the count of the Complaint for determining the amount excepted from discharge is moot. Therefore, Bank is not
The foregoing constitutes Findings of Fact and Conclusions of Law under Rule 7052 of the Federal Rules of Bankruptcy Procedure which makes Rule 52(a) of the Federal Rules of Civil Procedure applicable to this proceeding. A judgment based upon this ruling will be entered on a separate document as required by Federal Rule of Bankruptcy Procedure 7058 which makes Federal Rule of Civil Procedure 58 applicable to this proceeding.
