David Harwood v. FNFS, Limited

Citation: Not availableDocket: 10-40406

Court: Court of Appeals for the Fifth Circuit; April 21, 2011; Federal Appellate Court

Original Court Document: View Document

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David S. Harwood, a Chapter 7 debtor, appeals a district court ruling that affirmed the bankruptcy court's decision deeming certain debts nondischargeable under 11 U.S.C. § 523(a)(4). The bankruptcy court found that Harwood's debts, resulting from loans taken from FNFS, a limited partnership he managed, were incurred through defalcation while acting as a fiduciary. The appellate court agreed that Harwood willfully neglected his fiduciary duties regarding these loans and upheld the lower court's judgment.

The relevant background includes Harwood and Wayne McKinney purchasing B. W Finance in 1991, which reorganized into the limited partnership FNFS in 1996, with B. W serving as the sole general partner. Harwood held significant managerial power within B. W and FNFS, exercising near-total control over daily operations. Evidence presented during the bankruptcy trial indicated that Harwood improperly withdrew funds from FNFS for personal use, including a $200,000 loan in 1997 for a gymnasium construction on his property. He later formalized these loans through promissory notes, including a $700,000 "Master Note" and a $125,000 note, but failed to record the associated deeds of trust. From 1998 to 2005, he took 73 advances against these notes for various personal expenses, making sporadic interest payments and occasionally borrowing more funds from FNFS to cover interest obligations.

The bankruptcy court determined that Harwood did not adhere to the formal procedures outlined in the FNFS employee handbook for borrowing funds, leading to an accumulation of debt that exceeded the established limits. Harwood issued additional notes to FNFS without proper authorization, which resulted in the Master Note being extended to include these advances. Although the B. W board approved employee loans, they were only generally aware of Harwood’s increasing debt and his lack of efforts to repay the principal. McKinney assured the board he would cover any potential losses related to Harwood's debts.

Following a series of adverse events, including McKinney's death and financial struggles within the company, the board became more vigilant about their financial situation. An audit committee discovered that Harwood had not recorded deeds of trust securing his debts, compromising the partnership's claim to collateral. Additionally, he had pledged the Arp property to secure other loans, further jeopardizing FNFS's interests. Harwood’s employment was terminated in April 2005 due to disputes over unauthorized business expansions and lack of a repayment plan.

By the end of 2004, Harwood owed at least $843,969.73 in principal and $71,802.79 in interest. B. W and FNFS sued Harwood on June 7, 2005, shortly before he filed for Chapter 7 bankruptcy on June 15. They sought to determine the nondischargeability of certain debts under various sections of the Bankruptcy Code. The bankruptcy court found that Section 523(a)(4) applied to B. W's claim regarding payroll payments to Harwood’s ex-wife and Harwood's debts to FNFS, but ruled that the other exceptions to discharge were not proven. Harwood appealed the nondischargeability ruling concerning the Notes, which the district court affirmed, leading to his appeal to this court. The standard of review for the court includes de novo review for legal conclusions and clear error for factual findings.

Section 523(a)(4) of the Bankruptcy Code specifies that a discharge does not exempt an individual debtor from debts incurred due to fraud or defalcation while in a fiduciary capacity. This provision targets debts resulting from misuse of fiduciary positions and the unauthorized use of property. The burden of proof rests on the party asserting the exception to discharge, requiring evidence that the debt is nondischargeable, and exceptions are interpreted strictly against creditors.

Harwood contests the bankruptcy and district courts' findings that he acted in a fiduciary capacity toward FNFS and that his failure to record deeds of trust constituted defalcation. The term "fiduciary" is narrowly defined in this context, confined to "technical trusts" or traditional fiduciary relationships stemming from statutory or common law obligations. While federal law governs the definition of fiduciary, state law is critical in establishing the existence of such obligations.

Harwood acknowledges his fiduciary duty as an officer and director of B.W., which is required under Texas law. Corporate officers must prioritize corporate interests over personal interests. He does not dispute that B.W., as FNFS's general partner, also owes fiduciary duties to FNFS and its limited partners, which satisfies Section 523(a)(4). However, he argues that he personally owed no fiduciary duty to FNFS since he was not a partner in the limited partnership and lacked sufficient control over its affairs.

To evaluate whether Texas law imposes fiduciary obligations on Harwood to FNFS, a relevant case, LSP Investment Partnership v. Bennett, was cited, where the court examined if a managing partner owed fiduciary duties to limited partners. It referenced Crenshaw v. Swenson, which established that a managing partner of a general partner is bound by the highest fiduciary duty to the limited partners.

The Crenshaw court highlighted the importance of the business relationship's nature, concluding that a second-tier managing partner owed a duty to the underlying partners due to significant control over the partnership's operations. Under Texas law, control is a critical factor in determining whether fiduciary responsibilities apply to those influencing a general partner's conduct. In Bennett, the debtor, as the sole general partner with exclusive management authority, was deemed a fiduciary of the underlying partnership, thus overturning a bankruptcy court ruling that had suggested the multi-tiered partnership structure provided immunity from personal liability for misappropriation of funds. The court established that Bennett's fiduciary obligations were equivalent to those of a trustee, as defined by Section 523(a)(4).

The current bankruptcy court, lacking direct authority on the duties of a corporate general partner's officer to a limited partnership, found Bennett's reasoning relevant. It underscored that the actual control exercised by a corporate officer over the general partner should determine whether fiduciary duties are owed to the limited partnership, rather than the organizational structure itself. The court referenced Harwood and Park v. Moorad, affirming that a corporate officer who fully controls the corporate actions cannot evade fiduciary responsibilities. Additionally, in McBeth v. Carpenter, it was established that managing partners owe trust obligations to the partnership, emphasizing a duty of loyalty, care, and good faith. The court ruled that these fiduciary obligations extend to the president of a corporate general partner, who is in control of the partnership's operations and agreements.

Carpenter was identified as the principal figure in a partnership, acting as the general partner and exerting control over two limited partners. His management role established him as a fiduciary under Texas law, as affirmed by case references to Bennett and Crenshaw. The analysis extends to Harwood, determining whether he similarly exercised control over FNFS, which would implicate a fiduciary duty. It is highlighted that a fiduciary relationship requires a trust-type connection that exists independently of any wrongdoing that creates debt, as stipulated under Section 523(a)(4). The court clarified that evidence of control surrounding the Notes could be considered in establishing Harwood’s fiduciary duty, separate from the loans themselves. The bankruptcy court found that Harwood had managerial control over FNFS from the partnership's inception, a determination deemed not clearly erroneous despite Harwood's claims of limited authority and eventual termination from his position.

Harwood maintained near-total control over FNFS and its management until shortly before his termination, despite B. W's role in overseeing FNFS. The bankruptcy court determined that the B. W board delegated complete authority to Harwood for day-to-day operations, with minimal oversight from McKinney, the other managing shareholder, due to his lack of banking expertise. The board did not impose limits on Harwood’s management until 2004, largely approving his actions without thorough scrutiny. The court found little concern from B. W or FNFS regarding Harwood's increasing indebtedness until September 2004, indicating a high level of trust in Harwood's management of the partnership and its funds. He effectively held executive power over FNFS, managing operations from Tyler, Texas, and made unilateral decisions regarding hiring and employee management, with no challengers to his authority.

Harwood presented himself as FNFS's president, despite not holding that title formally, and demanded advances on partnership funds, which were processed unquestioningly by subordinates. The board's delegation of management responsibilities to Harwood created a fiduciary relationship akin to that of a trustee to beneficiaries, establishing that he acted in a fiduciary capacity under Section 523(a)(4). Concerning allegations of defalcation, the court defined it as willful neglect of duty rather than fraud, noting that Harwood's actions regarding loans to himself were not hidden and were generally known and approved by the board, thus failing to meet the standard for willful neglect.

Harwood’s failure to maintain a manageable debt ceiling was considered by the bankruptcy court in evaluating whether his actions constituted defalcation. The court determined that the evidence presented by B.W. and FNFS established Harwood’s culpability as no greater than negligence, which was insufficient for defalcation. However, given his fiduciary duty to protect FNFS from financial harm and his awareness that he would personally benefit from any failure to record the deeds of trust, the court concluded that Harwood’s neglect in ensuring proper recordation amounted to willful neglect of duty. Consequently, his remaining debts related to the Master Note and Frazier Note were deemed nondischargeable.

The court noted that Harwood, being a sophisticated banker, understood the implications of failing to properly record deeds of trust under Texas law and the necessary actions to secure FNFS’s first-lien position on collateralized properties. Harwood knew that the failure to record benefited him by allowing him to use unencumbered collateral to obtain additional funds. Specifically, after executing a deed of trust in FNFS's favor, he granted liens on the same property to Hibernia National Bank, which were properly recorded, thus giving Hibernia a senior secured position.

Additionally, the bankruptcy court found that Harwood pledged his B.W. stock as collateral for the Master Note without placing the stock certificates in the loan file, leading to complications in recovery for FNFS. This lack of recordation jeopardized FNFS’s ability to collect on the Notes, culminating in a settlement with the Chapter 7 trustee for less than the potential recovery had the deeds been recorded timely. Harwood did not contest the court's factual findings, which were not found to be clearly erroneous.

Harwood contends that if taking the loans does not amount to defalcation, he should not be denied a discharge for attempting to secure the loans for FNFS’s benefit. The district court rejected this, stating that Harwood's obligation to protect FNFS included properly securing over $800,000 in loans withdrawn from FNFS funds, and emphasized that partial efforts do not absolve him of responsibility. The court concluded that Harwood's insufficient actions regarding securing the loans represented willful neglect of his fiduciary duties to FNFS. A fiduciary must not position himself to benefit from violating his obligation to manage partnership affairs exclusively for the partnership's benefit. An officer’s responsibilities include ensuring that any loans to himself or his controlled entities are conducted at arm's length. Even if the loans themselves were not deemed defalcation, the bankruptcy court rightfully determined that Harwood recklessly breached his duty by not safeguarding FNFS from the heightened financial risks posed by the loans and failing to perfect liens on collateral, particularly since this neglect benefited him. Consequently, the district court affirmed the bankruptcy court's ruling that Harwood's debt on the Notes is nondischargeable under Section 523(a)(4). The judgment of the district court is affirmed.