Kassebaum v. Smith (In re Smith)

• Decision Date: 01 November 2018
• Docket Number: Adv. Proc. No. 18-05004- RJK,Case No.: 17-50808- RJK
• Citation: 591 B.R. 741
• Parties: IN RE: Douglas Eugene SMITH, Debtor. Mark Kassebaum, individually, and PDMM, Inc., derivatively, Plaintiff, v. Douglas Eugene Smith, Defendant.
• Court: U.S. Bankruptcy Court — District of Minnesota

591 B.R. 741

IN RE: Douglas Eugene SMITH, Debtor.Mark Kassebaum, individually, and PDMM, Inc., derivatively, Plaintiff,

v.Douglas Eugene Smith, Defendant.

Case No.: 17-50808- RJK

Adv. Proc. No. 18-05004- RJK

United States Bankruptcy Court, D. Minnesota.

Signed November 1, 2018

Colin M. Bruns, Richard G. Jensen, Fabyanske, Westra, Hart & Thomson, P.A, Minneapolis, MN, for Plaintiff.

John H. Bray, Maki & Overom, Ltd., Duluth, MN, for Defendant.

MEMORANDUM AND ORDER DETERMINING DISCHARGEABILITY OF A DEBT

ROBERT J. KRESSEL, UNITED STATES BANKRUPTCY JUDGE

This adversary proceeding came on for trial on July 23, 2018 on the plaintiff's complaint to determine the dischargeability of a debt under 11 U.S.C. § 523(a)(2)(A) and 11 U.S.C. § 523(a)(4). Richard G. Jensen appeared for the plaintiff. John H. Bray appeared for the defendant. This court has jurisdiction over this adversary proceeding pursuant to 28 U.S. §§ 157(b)(1) and 1334, and Local Rule 1070-1. This is a core proceeding within the meaning of 28 U.S.C. § 157(b)(2)(I).

FACTS

1. Plaintiff Mark Kassebaum is a Minnesota resident. He is one of the four shareholders of PDMM, Inc. He has been a shareholder and member of the board since 1994.

2. PDMM is a Minnesota corporation, founded in July 1994.It is a franchisee of Green Mill Restaurants, LLC, and operates a Green Mill restaurant located at 340 South Lake Avenue, Duluth, MN 55802.

3. Douglas E. Smith lives in Duluth and is a Minnesota resident. He is the debtor in this case.

4. The debtor is one of the four shareholders of PDMM and the general manager of PDMM's restaurant. He was also president of PDMM until September 14, 2016.

5. The shareholders of PDMM and their percentage of ownership are:

a. Kassebaum – 34%

b. Smith – 19%

c. Smith's father, Russell Smith II – 38%

d. Smith's brother, Russell Smith III – 9%

6. The parties refer to Russell Smith II as "Smith Sr." and Russell Smith III as "Smith Jr."

7. Smith Sr.'s wife, Karen Smith is the corporate secretary of PDMM.

8. The debtor organized Rivdogg, LLC, doing business as Avenue C, on January 15, 2015, to operate a restaurant of the same name in Cloquet, Minnesota. Avenue C opened in January of 2017 and closed in November of 2017.

9. The debtor originally owned 100% of Avenue C. He currently owns 70 percent of Avenue C. The other owners are Dave Rislov (20%) and Zack Wehr (10%).

10. When the debtor formed Avenue C, it did not have its own bank account and its money was deposited into PDMM's account. Because of this, Avenue C's employees were paid out of PDMM's account.

11. The debtor occasionally borrowed money from PDMM by writing checks and using the company credit card. Though he intended to pay all of the money he borrowed, the debtor did not pay all of it back. He repaid $107,351.62 to PDMM. PDMM's credit card was available for the use for PDMM restaurant's management team.

12. PDMM purchased a truck for $110,000 that the debtor and other employees used for work including delivery and other work-related business. The other company car was too big to be used for deliveries.

13. The debtor often obtained advances on his payrolls and dividends.

14. As a manager of the Green Mill restaurant, the debtor's day-to-day duties included giving bonuses to employees and management. He used a method of calculating bonuses based on a policy at a restaurant he previously worked for. He used 10% of profits to distribute to employees and management based on their ranking in a ratio of 4:3:2:1.

15. On September 14, 2016, at a special meeting of the board of directors of PDMM, the debtor made a motion to retroactively approve a 2014 loan from PDMM to the debtor for $23,000 with interest at 5%. Three shareholders voted for the motion while Kassebaum voted against it and the motion was approved. The debtor testified that he presented the loan for the board's approval "to help clean up" some of the transactions.

16. Because of his mental condition that affected his memory, Smith Sr. was not able to recall much of what happened during the relevant times.

17. Kassebaum testified that he expected the debtor to inform him and the other shareholders of all of the personal loans and charges made on PDMM's account. He stated that he did not believe the debtor was hiding those charges but that he placed the record of the transactions in places the shareholders could not find.

18. In the spring of 2016, Kassebaum and Smith Sr. agreed that an audit of PDMM's operations, including accounting records, should be conducted and agreed that PDMM would pay the cost of the audit.

19. Kassebaum and Smith Sr. retained a forensic accountant, Frances M. McCloskey, to conduct the audit.

20. McCloskey conducted the audit and issued a preliminary report on May 27, 2016.

21. McCloskey gathered documents and interviewed individuals to prepare her analysis. She did not speak with the debtor because he was not present at the restaurant when she was conducting the interviews.

22. McCloskey testified that in her professional opinion, the documents gathered are not easy to discern and transactions and payments were difficult to track. She opined that most of the checks written to the debtor and the credit card charges were outside of the ordinary course of business. She has also found evidence that the debtor had paid back to PDMM some of the payments made to him.

23.

The plaintiff commenced a lawsuit against the debtor, Smith Sr. and Smith Jr. on July 1, 2016, in St. Louis County, MN, district court, File No. 69-DU-CV-16-2229. The plaintiff subsequently amended his complaint to add Avenue C as a defendant.

24. The debtor filed his Chapter 7 bankruptcy petition on November 28, 2017.

25. The plaintiff commenced this adversary proceeding on March 5, 2018 seeking to except from discharge the claims asserted against the debtor.

ANALYSIS

The plaintiff asserts that his claims should be excepted from discharge under 11 U.S.C. § 523(a)(2)(A) and 11 U.S.C. § 523(a)(4). He argues that the debt is excepted from discharge under 11 U.S.C. § 523(a)(2)(A) because the debtor made false representations of material facts to the plaintiff and falsified the books and records of PDMM to conceal his conduct, on which the plaintiff reasonably relied and failed to take appropriate action to investigate and stop his actions. The plaintiff also argues that the debt is excepted from discharge under 11 U.S.C. § 523(a)(4) because the debtor obtained and benefited from money and other assets of PDMM through embezzlement and larceny.

Nondischargeability under 11 U.S.C. § 523(a)(2)(A)

Section 523(a)(2)(A) of the Bankruptcy Code provides that:

(a) a discharge under section 727...of this title does not discharge an individual debtor from any debt-

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained by -

(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's or an insider's financial condition.

11 U.S.C. § 523(a)(2)(A).

Exceptions to discharge under section 523 are narrowly construed against the creditor and liberally in favor of the debtor to facilitate the debtor's fresh start. E.g., Reshetar Systems, Inc., v. Thompson (In re Thompson) , 686 F.3d 940, 944 (8th Cir. 2012). For a debt to be excepted from discharge under section 523(a)(2)(A), the creditor must prove the elements of fraud by a preponderance of the evidence. Grogan v. Garner , 498 U.S. 279, 288, 111 S.Ct. 654, 112 L.Ed.2d 755 (1991).

The plaintiff does not allege that the debt should be excepted from discharge under this section based on false pretense or actual fraud. He argues that the debt is excepted from discharge because of false representations.

To establish fraud under section 523(a)(2)(A), the plaintiff must show:

(1) The debtor made a representation; (2) at the time the representation was made the debtor knew it was false; (3) the debtor made the representation deliberately and intentionally with the intent and purpose to deceive the creditor; (4) the creditor justifiably relied upon such representation; and (5) the creditor sustained injury as a proximate result of the representation.

The Merchants Nat'l Bank of Winona v. Moen (In re Moen ), 238 B.R. 785, 790 (8th Cir. BAP 1999).

1. False Representation

To qualify as a false representation under section 523(a)(2)(A), the statement must relate to a present or past fact. Shea v. Shea (In re Shea ), 221 B.R. 491, 496 (Bankr. D. Minn. 1998). A debtor's promise relating to a future action, which does not purport to depict current or past fact, cannot be defined as a false representation. Id. A debtor's promise related to a future act can constitute actionable fraud where the debtor possesses no intent to perform the act at the time the debtor's promise is made. Id. at 497. A silence regarding material fact can also constitute a false representation as an omission. In re Moen , 823 F.2d at 791.

The plaintiff claims that the debtor committed fraud by representing to PDMM that he did not receive bonuses. The plaintiff also alleges that the debtor committed fraud by intentionally failing to disclose (1) the payments paid to him by PDMM, (2) the personal loan he caused PDMM to incur to purchase a vehicle, (3) causing PDMM to pay expenses of Avenue C, and (5) the payroll and dividend advances that he was not entitled to.

The plaintiff argues that the bonuses were employee benefits and required the approval of the board of directors in accordance to the bylaws. The plaintiff does not cite to a specific provision of the bylaws.

The debtor admitted that he paid himself and other managers bonuses. However, he disputes that bonus required the board's approval. He stated that he exercised his managerial duties in implementing a bonus system similar to one at a previous restaurant he managed and payed bonuses to himself and other employees. The debtor cited to section 4 of Article V, titled "Officers" of the bylaws to argued that bonuses are not employee benefits....