United States: Importance Of Margin-Call Issues Increases As Stock Market Declines

In an unpublished report from the United States Court of Appeals for the Fourth Circuit, the Court dealt with the issue of whether a Chapter 7 debtor, who has incurred a debt of $321,000 for a margin call, can discharge the obligation.

In the matter of Lind-Waldock & Company, an Illinois corporation v. Catherine P. Morehead; Raymond A. Morehead, decided on January 3, 2001, the Court of Appeals affirmed the decision of the United States District Court for the Northern District of West Virginia and denied the broker’s objection to discharge. The debtors opened a brokerage account in 1995 with an initial deposit of $370,000. The application required the Moreheads (debtors) to inform the brokerage firm of any material change to the provided information.

Within one year of opening the account, the debtors lost the entire $370,000. Within two months after losing this sum, the debtors obtained an unsecured bank loan in the amount of $50,000, and deposited it in the brokerage account. Obviously, at the time of this deposit their net worth was considerably less than the one million dollars, and, in fact, was probably about $20,000. The debtors never informed the brokerage firm of the drastic reduction in their net worth, nor did the brokerage firm ever make any further inquiry.

In April of 1997, the debtors began to trade the account on margin, and made a profit of $470,000 in 20 days. All good things come to an end, and, within a two day period, the debtor lost $370,000. Within several days thereafter, the debtors lost the remaining balance of the equity in the account, leaving a margin call in the amount of $850,000. The debtors agreed to cover the call, but reality set in and they were unable to cover the call, leaving a negative balance in the account of $321,000. Shortly thereafter, the debtors filed Chapter 7, seeking to discharge the margin call. The brokerage firm objected on the basis that the claim was non-dischargeable by reason of Section 523 (a) (2) (A), in that it was based upon false pretense. Section 523 (a) (2) (A) provides that a debt is non-dischargeable if it arose from "false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor’s. . . financial condition."

After a bench trial in the Bankruptcy Court, the court dismissed the Complaint, concluding that Section 523 (a) (2) (A) did not apply, as there was no representation known to be false, and that the objection to discharge under 523 (a) (2) (C), which deals with purchase of consumer debt of luxury goods and services within 60 days did not apply, as the margin call was not a consumer debt. The matter was appealed to the District Court, which affirmed, and subsequently to the Fourth Circuit.

The Court of Appeals stated "In bankruptcy cases we review de novo the decision of the district court, ‘effectively standing in its place to review directly the findings of fact and conclusions of law made by the bankruptcy court.’ " Butler v. David Shaw, Inc., 72 F.3d 437, 440 (4th Cir. 1996). We may not set aside findings of fact unless they are "clearly erroneous, and due regard shall be given to the opportunity of the bankruptcy court to judge the credibility of the witnesses."

Furthermore, the Court of Appeals indicated that the creditor who objects to discharge bears the burden of proving that the debt is non-dischargeable by a preponderance of the evidence. Fed. R. Bankr. p. 8013. The creditor bears the burden of proving that a debt is nondischargeable by a preponderance of the evidence." See Grogan v. Garner, 498 U.S. 279, 287 (1991).

The Fourth Circuit set forth the five elements necessary to establish that the debt is non-dischargeable by reason of false pretense, to wit: "A creditor must establish five elements under this section: (1) that the debtor made a representation; (2) that at the time the representation was made, the debtor knew it was false; (3) that the debtor made the false representation with the intention of defrauding the creditor; (4) that the creditor justifiably relied upon the representation; and (5) that the creditor was damaged as the proximate result of the false representation." See Foley & Lardner v. Biondo (In re Biondo), 180 F.3d 126, 134 (4th Cir. 1999); MBNA Am. v. Simos (In re Simos), 120 B.R. 188, 191 (Bankr. M.D.N.C. 1997).

In reviewing the Bankruptcy Court’s dismissal, the Court of Appeals must look to the finding of fact reached by the Bankruptcy Court, and that the Moreheads did not intend to defraud the brokerage firm. Unless the finding of the Bankruptcy Court and District Court were clearly erroneous, such finding of fact could not be set aside. The fundamental issue in the nondischargeability analysis is determining whether or not the debtor possessed fraudulent intent. Absent confession by debtor of his state of mind, debtor’s fraudulent intent must be inferred through his conduct. The Bankruptcy Court refused to equate debtors’ inability to pay with fraudulent intent. At the trial, the debtors testified that they never considered the prospect that this account balance might drop below zero. In fact, he stated that "he felt like he had a pretty good idea where the market was going." (What unwise investor has never assumed the same?).

The Bankruptcy Court gave credence to the debtor’s testimony and the Court of Appeals stated that it must defer to the lower court’s findings because it had "unique ability" to assess the credibility of the testimony. In finding that debtors did not manifest an intent to defraud, the court placed great weight on the sudden and profound drop in the market value of the account. At the close of the market on May 8th, the Moreheads account had a liquidation value of $158,000. By 10:00 A.M. the next day it had a negative balance of $321,000. The court concluded that the Moreheads did not have the time to formulate an intent to defraud the brokerage firm. Because the brokerage firm was unable to prove the actual intent to defraud under Section 523 (a) (2) (A), the Court of Appeals could not dismiss on that basis alone.

Furthermore, the debt at issue did not fall within the presumption exception of 523 (a) (2) (C) which provides that consumer debts for luxury goods or services incurred within 60 days of filing for bankruptcy are presumed to have been obtained through fraud. The court held that a consumer debt is one incurred by "an individual primarily for personal, family, or household purposes. 11 U.S.S. 101(a). A debt incurred for purely a profit motive does not fall within that category, and courts have concluded uniformly that debt incurred for a business venture or with a profit motive does not fall into the category of debt incurred for ‘personal, family, or household purposes."

The Moreheads’ debt was admittedly incurred while speculating in the futures market. Therefore, it is not a consumer debt. The Court of Appeals affirmed the Bankruptcy Court and the District Court on the basis of the inability of the brokerage firm to establish fraud. The creditor was not entitled to the presumption of nondischargeability as the unsecured bank loan at issue. The conclusion reached by the Fourth Circuit may have been different, however, if the brokerage firm had inquired into the financial status of the debtors prior to trading the account or requested supplemental financial information to confirm that the debtors’ net equity was consistent with the accounts originally represented in the application. However, this did not occur and the debtor was discharged from his obligation under the margin call.

Sometimes when you lose in the market, you may be able to recover in the real world.