United States: Debtors May Be Denied Discharge For Inadequate Financial Records

In Harrington v. Simmons (In re Simmons), 513 B.R. 161 (Bankr. D. Mass. 2014), the U.S. Bankruptcy Court for the District of Massachusetts considered the U.S. trustee's request that a Chapter 7 debtor be denied a discharge for his failure to maintain adequate financial records or satisfactorily explain the loss of his assets. In its decision on the trustee's motion for summary judgment, the court noted that the debtor was unable to justify his inadequate financial recordkeeping; was remarkably uncooperative in connection with the trustee's attempts to obtain a satisfactory picture of his financial condition; did not produce an accurate account of various real estate transactions; and provided virtually no detail of his chronic losses. Consequently, the court granted the U.S. trustee's motion and denied the debtor's discharge.

Facts

Michael J. Simmons, the debtor in this case, dropped out of college in the 1990s to pursue residential real estate investments with a business partner named Kai Kunz. For a period spanning about 10 years, Simmons turned over to Kunz virtually all of his income from various low-paying jobs in order to help finance Kunz's purchases of income-producing real property. During a Federal Rule of Bankruptcy Procedure 2004 examination of Simmons by the U.S. trustee, Simmons testified that he did not know how much money he had given to Kunz during this period. In 2006 and 2007, acting on Kunz's advice, Simmons undertook to acquire 27 of his own residential properties. Based on the opinion, Simmons' involvement in his own residential real estate business was defined by his lack of financial sophistication and a staggering amount of blind trust in his partner, Kunz, who identified the properties for Simmons to buy, arranged for financing, and retained property managers to handle rents and disburse profits to Simmons. In his Rule 2004 examination, Simmons alluded to his faith in Kunz, who had convinced Simmons to grant second and third liens on various of the properties that Simmons purchased, telling Simmons that "this was the way to go."

By 2010, however, all but five of Simmons' properties had been sold, most of them through short sales and foreclosures. Simmons filed a Chapter 7 petition and listed over $1.5 million in debt secured by his five properties, together with $3.4 million in unsecured debt: The unsecured portion of this debt was composed in largest part of deficiencies on various of the mortgages that Simmons had executed.

The U.S. trustee asked Simmons to provide documents related to Simmons' financial condition, together with detail of all of Simmons' business transactions. The trustee asked for bank account statements, canceled checks and tax returns. In response, Simmons provided three years' worth of tax returns, each of which listed only a single rental property, for which gross income of $3,000, $6,000 and $11,400, respectively, was reported. Following Simmons' Rule 2004 examination, the trustee began making repeated requests for rent rolls or ledgers evidencing the rents collected from the debtor's other rental properties, as well as an accounting of income earned and the disposition of rental proceeds. The trustee's requests for this information and documentation were repeated several times during a two-year period. Because Simmons did not respond to the trustee's requests in any meaningful way, the trustee commenced an adversary proceeding against Simmons seeking a denial of Simmons' Chapter 7 discharge. The trustee eventually filed a motion for summary judgment on his complaint.

After the filing of the trustee's summary judgment motion, Simmons produced some supplemental records, but even these were not labeled or organized in any meaningful way. Although Simmons submitted an affidavit asserting that he had produced all documents in his possession, together with all of his bank statements for the relevant period of time, the trustee complained that Simmons had failed to produce comprehensive bank records, failed to document income received from the properties, and failed to disclose any proceeds arising from the disposition of any properties for the two years leading up to Simmons' petition date.

The Court's Analysis

The bankruptcy court noted that the bankruptcy process is designed to grant "honest but unfortunate" Chapter 7 debtors a discharge of their debts in order to facilitate a financial fresh start. To further this goal, exceptions to discharge are narrowly construed, with "all doubts resolved in favor of the debtor." At the same time, the court noted that an inherent policy of the Bankruptcy Code "'is to make certain that those who seek the shelter of the Bankruptcy Code do not play fast and loose with their assets or the reality of their affairs.'"

The two exceptions asserted by the trustee to deny Simmons a discharge are found in 11 U.S.C. Section 727(a)(3) (denying discharge where a debtor unjustifiably fails to, inter alia, keep or preserve sufficient records from which his or her financial condition or business transactions might be ascertained) and Section 727(a)(5) (denying discharge where a debtor fails to satisfactorily explain his or her loss or deficiency of assets). The Simmons court acknowledged that while the first exception "does not require flawless recordkeeping," debtors must still produce sufficient records to allow their financial picture to be ascertained. Moreover, the court noted, while the second exception allows for a debtor to explain the ultimate disposition of assets, the explanation must be corroborated by sufficient evidence.

In light of the benefit afforded the non-moving party to a motion for summary judgment, the court viewed the facts in the light most favorable to Simmons, assuming Simmons' assertions—no matter how unlikely—to be true. Even under this standard, the court concluded that Simmons' bankruptcy case was the "exceptional circumstance" in which the court was unable to construe either exception in the debtor's favor. The court was not satisfied by Simmons' cursory affidavit asserting that Simmons was a "dupe" to Kunz and his associates. Rather, Simmons' inability to account for the income and expenses for properties he owned, financed and managed, and for which he collected rents for a number of years was, in the court's opinion, "shocking and disturbing." Even had Simmons been "so foolish or naive" as to think that he might be excused from the basic responsibilities of a real estate owner, the court concluded that Simmons was nonetheless subject to the consequences of his own poor judgment. The court accordingly denied Simmons his Chapter 7 discharge.

Warning to Debtors

Section 727 of the Bankruptcy Code enumerates several exceptions to a Chapter 7 debtor's right to a discharge, including a debtor's unjustified failure to keep or preserve sufficient records from which the debtor's financial condition or business transactions might be ascertained, or the debtor's failure to satisfactorily explain his or her loss or the disposition of assets. These exceptions to discharge are, by design, narrowly construed, with virtually any reasonable doubt resolved in favor of the debtor. However, there is a limit to this deference, and the court's decision in Simmons provides sufficient warning: Individual debtors seeking a discharge of their debts must provide some coherent explanation of profit and loss, together with an explanation of the disposition of assets. It will most probably not suffice to complain that they blindly and willingly took the bad advice of a third party. Even the most unsophisticated individual debtors must be able to adequately account for the financial straits in which they find themselves, and they should go to all reasonable lengths to maintain adequate records or be prepared to justifiably explain their failure to do so.

This article originally appeared in The Legal Intelligencer

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