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Heritage Pacific Financial, LLC v. MacHuca (In Re MacHuca)
Citations: 483 B.R. 726; 68 Collier Bankr. Cas. 2d 1863; 2012 Bankr. LEXIS 5939Docket: NC-12-1081-MkHPa
Court: United States Bankruptcy Appellate Panel for the Ninth Circuit; December 14, 2012; Us Bankruptcy; United States Bankruptcy Court
Original Court Document: View Document
Heritage Pacific Financial, LLC (HPF) initiated a lawsuit against debtor Raul Machuca, Jr., claiming that a debt incurred by Machuca was nondischargeable. The bankruptcy court ruled in favor of Machuca, granting him summary judgment, which HPF did not appeal. Subsequently, Machuca sought approximately $9,000 in attorneys' fees under 11 U.S.C. § 523(d), which the bankruptcy court awarded. HPF appealed the fee order, but the appellate panel affirmed the bankruptcy court’s decision. The case stems from Machuca's purchase of a single-family residence in Salinas, California, in January 2007, financed through two secured loans: a $1 million senior loan and a $147,000 junior loan from National City Bank. During the loan application process, Machuca communicated with Westar Real Estate and Mortgage, providing financial information. Although he signed various loan documents without reading them, he later testified that the income stated in the application—$20,725 per month—was false, as he was actually earning significantly less. Both parties acknowledged this discrepancy, which was central to the litigation. Machuca made loan payments for over a year before defaulting and subsequently filed for Chapter 13 bankruptcy in May 2010. During this period, HPF acquired National City's rights related to the loan and initiated an adversary proceeding to classify the loan as a nondischargeable debt under 11 U.S.C. § 523(a)(2)(A) and (B). Machuca moved to dismiss the claim under § 523(a)(2)(A), which the bankruptcy court granted. He then sought summary judgment against HPF's claim, arguing a lack of reasonable reliance on the loan application due to discrepancies in reported income. The loan application and underwriting summary indicated Machuca's monthly income as $7,250 in base employment income and an additional $13,475 in "other income," with $3,725 from overtime wages. The remaining $9,750 in "other income" was unspecified, suggesting potential inaccuracies in the final application. Machuca contended that National City did not reasonably rely on his income representation, emphasizing that the loan was categorized as a "stated income" loan, which typically does not require verification of income through tax returns or pay stubs. In response, HPF contested Machuca's assertion regarding reasonable reliance, presenting evidence including the application language, a declaration from HPF’s managing partner, Ben Ganter, and an expert declaration. HPF argued that the application’s certification of truth supported reliance on Machuca’s income representation and pointed out that the application allowed lenders and their successors to rely on the information provided. Ganter's declaration aimed to demonstrate reliance by both National City and HPF but lacked clarity on how he knew about National City's reliance. Schuerman asserted that lenders and loan purchasers rely heavily on certifications and information in loan applications, which is vital in the secondary mortgage market. He emphasized the significance of income representations for junior secured debt holders, as they risk losing collateral if a senior lienholder forecloses. However, Schuerman did not assess how specific defects in Machuca’s loan application might impact reliance by lenders or successors. His declaration overlooked critical discrepancies, including: 1) income inconsistencies between the signed and unsigned applications, 2) an unrealistic base income claimed by a state corrections officer, 3) the late signing of the application prior to loan funding, 4) National City’s approval of the loan without verifying income, and 5) HPF’s purchase of the loan without income verification. The bankruptcy court, during the summary judgment hearing on November 28, 2011, adopted Machuca's argument of lack of reliance and granted summary judgment, citing Boyajian v. New Falls Corp., which limited the reliance element to the original lender. The court found that HPF failed to provide adequate evidence of National City’s reliance on Machuca’s income representations. HPF attempted to argue reasonable reliance based on loan document contents and an inference of intent by Machuca to induce reliance, but the court was not convinced. The court identified several reasons for rejecting HPF’s claims: 1) lack of competent evidence regarding National City’s loan practices, 2) the application being signed after the promissory note date, and 3) the presence of red flags that should have prompted further investigation into Machuca’s income claims. Ultimately, the court concluded that no lender could have reasonably relied on the application and evidence due to these red flags. Consequently, the court granted Machuca’s summary judgment motion, confirming the order on December 19, 2011. HPF did not appeal or challenge this order under Rule 9024. Machuca subsequently filed for attorney fees, which HPF opposed, claiming its actions in the adversary proceeding were justified based on a reasonable legal and factual basis. The bankruptcy court dismissed HPF's argument for substantial justification regarding its defense against a summary judgment motion, citing a lack of competent evidence to demonstrate reasonable reliance. The court emphasized that no admissible facts or personal knowledge were presented to support HPF’s claims. It noted that stated income loans often led to misrepresentations, allowing lenders to neglect due diligence. On January 26, 2012, the court granted Machuca’s fee motion, and HPF filed a notice of appeal on February 7, 2012, referencing only the fee order and not the summary judgment ruling. Consequently, the appeal was limited to the fee order, as the summary judgment was deemed final and could not be challenged. HPF's appeal also contested the bankruptcy court's ruling on substantial justification, a standard established in the context of 11 U.S.C. § 523(d). This standard, introduced in 1984, permits the awarding of attorneys’ fees only if the creditor's position is not "substantially justified," replacing a previous, broader standard that favored consumers in fee shifting. The original intent of § 523(d) was to deter groundless actions against debtors. To request attorneys’ fees under 11 U.S.C. § 523(d), a debtor must establish three elements: (1) the creditor sought to except a debt from discharge under § 523(a), (2) the debt in question is a consumer debt, and (3) the debt was ultimately discharged. Once these criteria are met, the burden shifts to the creditor to demonstrate that its actions were substantially justified, meaning it must show a reasonable factual and legal basis for its claim. This standard is higher than the frivolity standard used in other legal contexts, such as the Equal Access to Justice Act (EAJA). A creditor’s loss in a legal action does not automatically imply a lack of substantial justification; however, outcomes like summary judgment may indicate insufficient justification, necessitating close scrutiny by the bankruptcy court. The creditor does not receive a presumption of justification merely because it lost; rather, it can still be deemed justified if it presented a novel legal theory or relied on a reasonable interpretation of law, even amidst conflicting authority. HPF, the creditor in question, did not provide such justifications and instead defended its position based on the bankruptcy court's record that led to the summary judgment against it, specifically regarding reliance under § 523(a)(2)(B)(iii). HPF did not appeal the summary judgment ruling, resulting in the preclusive effect of that judgment under the doctrine of collateral estoppel. This principle, as established in Steen v. John Hancock Mut. Life Ins. Co., indicates that a determination made in a judgment on the pleadings or summary judgment meets the 'litigated' requirement for issue preclusion. The bankruptcy court's summary judgment order is final, and HPF cannot attack it collaterally through the § 523(d) proceeding. HPF's failure to appeal or seek relief under Rule 9024 means that the summary judgment must be taken at face value, indicating HPF's complaint lacked genuine issues regarding reliance under § 523(a)(2)(B)(iii). The doctrine of issue preclusion prevents HPF from contesting the bankruptcy court's correctness or asserting undisclosed bases for its reliance claim, thereby undermining its position on the fraud claim. Additionally, even if HPF could overcome the issue preclusion, it would confront a significant challenge due to the abuse of discretion standard applied to § 523(d) orders. Under this standard, the court first verifies if the bankruptcy court applied the correct legal rule and then assesses whether its factual findings were illogical, implausible, or unsupported. The inquiry into reasonable reliance, which is not explicitly defined in the Bankruptcy Code, requires the bankruptcy court to apply a "prudent person" test to determine if the creditor exercised the expected care in a business transaction. This assessment necessitates an objective evaluation of the creditor’s conduct in similar circumstances. Bankruptcy courts assess creditor reliance on statements on a case-by-case basis, considering the totality of circumstances. Creditors cannot ignore red flags that question the truth of the statements they claim to rely on; they must provide evidence of reasonable reliance despite these red flags. In this case, HPF's arguments for reasonable reliance were undermined by undisputed red flags associated with the loan, including significant discrepancies in income documentation, implausible income claims, and the lack of income verification prior to loan approval. The court found that HPF's claims were so discredited by the evidence that no reasonable jury could accept them, affirming that the reliance element under 523(a)(2)(B) was not satisfied. The bankruptcy court correctly applied the legal standard, and its decision to grant Machuca’s fee motion was upheld.