Lender's Lack of Diligence Prevents It From Blocking Borrower's Discharge of Indebtedness
 
October 19, 2006
 
Michael Weissman - Chicago

In 1999, acting on behalf of Purcell Assisted Living, Inc., Ray Cribbs applied for a construction loan from a bank to finance an assisted living facility in Purcell, Oklahoma. He submitted a financial statement dated April 26, 1999. The application was rejected because Cribbs’ financial statement did not show enough liquidity.

Undaunted, Cribbs induced two other investors, whose personal financial statements showed significant liquidity and net worth, to join him. He reapplied for a loan at the bank and submitted a second financial statement dated March 1, 2000. This financial statement was presented as a joint statement of Cribbs and his wife but she did not sign it. Although purporting to be a March 1, 2000 statement, Cribbs’ signature and the signature of the witness to Cribbs’ signature were both dated April 26, 1999. The bank never questioned the dating or the absence of Mrs. Cribbs’ signature.

In addition, most of the assets listed on the financial statement belonged to Cribbs’ closely-held businesses or by a trust created by Mrs. Cribbs. Omitted from the statement was a note for $483,630 that Cribbs claimed was due him from another one of his assisted living projects. But there was no note.

While the bank was in the throes of the loan approval process, no effort was made to get a copy of the note or to take a security interest in it.

The bank made a construction loan of $2,838,904 in November 2000 that Cribbs and his two co-investors guarantied. The bank made an additional loan of $101,050 for fixtures and equipment that Cribbs guaranteed.

The loans went into default and the bank demanded payment from Cribbs. He declined. The bank obtained an Oklahoma state court judgment and that induced Cribbs to file a petition for relief under Chapter 7 of the Bankruptcy Code in March 2004.

The bank petitioned the court to have the debt Cribbs owed the bank exempted from any discharge he might obtain based on his fraudulent financial statement. The court refused to do so because it felt that the bank had not shown it actually and reasonably relied on Cribbs’ March 2000 financial statement, Cribbs v. First National Bank, No. 05-6225 (10th Cir. July 7, 2006).

Although Cribbs admitted that the financial statement contained materially false representations about his financial condition, the court said that the bank did not, in fact, rely on the nonexistent note in deciding to extend credit. The decision to grant the loans, said the court, was clearly motivated by the additional guaranties provided by Cribbs’ co-investors.

But the court went on to explore the question of whether the bank’s reliance on the nonexistent note was reasonable and held that it was not. In response to the testimony of a bank officer that (a) it was the bank’s policy never to request evidence to support customer representations on financial statements, and (b) in evaluating the loan requests the bank did not investigate whether the note was bona fide since it was not being assigned, the court said that the bank “should have undertaken at least a minimal investigation into the legitimacy of the Note in order to show ordinary diligence.” Indeed, on the facts of the case, the court said that when the bank followed its own standards in evaluating the loan requests its due diligence was inadequate.

What’s the Point?

The court was careful to say that what constitutes due diligence sufficient to sustain a finding of reasonable reliance on a loan applicant’s financial statement depends on the particular facts of each case. But the court’s opinion clearly second-guesses the due diligence procedures employed by the bank, thereby creating a standard that may be too stringent in the real world of banking.

For more information, e-mail Michael L. Weissman at michael.weissman@hklaw.com or call toll free, 1-888-688-8500.