Scarlata, Matter of

• Decision Date: 26 March 1993
• Docket Number: No. 91-2304,91-2304
• Parties: 27 Collier Bankr.Cas.2d 1494, 23 Bankr.Ct.Dec. 1075, Bankr. L. Rep. P 75,021 In the Matter of Richard C. SCARLATA, Debtor. GOLDBERG SECURITIES, INC., Appellant, v. Richard C. SCARLATA, Debtor-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

Page 521

979 F.2d 521

27 Collier Bankr.Cas.2d 1494, 23 Bankr.Ct.Dec. 1075,

Bankr. L. Rep. P 75,021

In the Matter of Richard C. SCARLATA, Debtor GOLDBERG SECURITIES, INC., Appellant, v. Richard C. SCARLATA, Debtor-Appellee.

No. 91-2304.

United States Court of Appeals Seventh Circuit.

Argued Feb. 13, 1992.

Decided Nov. 9, 1992.

Rehearing and Rehearing En Banc

Denied March 26, 1993.

Donald C. Shine, Michael H. Moirano (argued), Nisen & Elliott, Chicago, Ill., for appellant Goldberg Securities, Inc.

Andrew B. David (argued), William G. Gigler, Sugar, Friedberg & Felsenthal, Chicago, Ill., for debtor, appellee Richard C. Scarlata.

Before COFFEY and FLAUM, Circuit Judges, and ESCHBACH, Senior Circuit Judge.

ESCHBACH, Senior Circuit Judge.

Richard Scarlata, a market maker who formerly traded options at the Chicago Board of Exchange (CBOE), seeks a discharge in bankruptcy from a $4 million debt owed to the firm who cleared his accounts at the CBOE, Goldberg Securities, Inc. (Goldberg). The bankruptcy court barred Scarlata from discharge under 11 U.S.C. § 523(a)(2)(A) but found § 523(a)(6) inapplicable to this case. In re Scarlata, 112 B.R. 279 (B.C.N.D.Ill.1990). The district court reversed the bankruptcy court's finding under § 523(a)(2)(A), affirmed under § 523(a)(6), and granted Scarlata a discharge. In re Scarlata, 127 B.R. 1004, 1011 (N.D.Ill.1991). On appeal, Goldberg argues that Scarlata is not entitled to a discharge because 1) he tendered a check for which he did not have sufficient funds in his bank account, creating a false pretense that he had greater funds with which to trade; 2) he misrepresented his trading intentions, falsely stating that he would reduce his risk exposure; and 3) he willfully and maliciously injured Goldberg's property by trading contrary to his representations and with Goldberg's money. Although we differ with a portion of the district court's opinion, we affirm its judgment granting Scarlata the discharge.

Facts

Scarlata was once a professional market maker at the CBOE. For four years, he traded options on an account through Goldberg. According to the various arrangements between Scarlata, Goldberg, and the CBOE, Goldberg received fees on Scarlata's transactions, as well as interest on money loaned to him; in exchange, Scarlata received certain services. The most important of these was that Goldberg guaranteed Scarlata's losses in excess of the equity in his account. As a result, Goldberg was potentially liable for 100% of Scarlata's losses in excess of his equity, even though it was not entitled to receive a share of his profits. Despite its one-sided exposure, Goldberg, like other clearing houses, had no electronic means of controlling Scarlata's trades once he was in the pit; when Scarlata (or any other market maker) traded, Goldberg relied on him to adhere to a "haircut requirement" which obliges him to have funds in his account to cover potential losses from unliquidated outstanding securities positions. The haircut requirement thus limits traders' ability to take positions in excess of their personal ability to cover trading losses. Goldberg considered a trader's position to be risky if the trader had a haircut requirement over $100,000, had an equity deficit in his account, or had a haircut-to-equity ratio greater than 2-1. R. 2-2 at 19. ¹ Based on these three factors, Goldberg would monitor its traders at the end of every day; if the trader's position was considered risky, the firm might require him to reduce his positions, deposit more capital in his account, or, in an extreme case, liquidate his holdings.

Cut to the morning of October 19, 1987--"Black Monday"--when the Dow Jones Industrial Average lost approximately 22% of its value. The Dow had dropped more than 100 points the previous Friday, leaving Scarlata, as well as numerous other traders, in precarious positions. Scarlata had only $22,000 of equity in his account, but held 84 naked short puts amounting to a $150,000 risk exposure. ² Despite this 7-1 ratio, Scarlata wanted to trade that day. He wrote Goldberg a check for $30,000, even though he did not have sufficient funds in his bank account to cover the $30,000. Scarlata also told Goldberg's risk managers, the employees who monitor the traders, that he would reduce his positions. Yet Scarlata exponentially increased his exposure during the first rotation on the market floor. Over the course of the rest of the day, Scarlata never managed to reduce his positions. Although he began trading with an exposure of just over $100,000, he ultimately lost approximately $5 million. ³ Because it had guaranteed Scarlata's trades, Goldberg paid the bulk of these losses.

Now Scarlata is in bankruptcy, seeking a discharge from his debt to Goldberg. As discussed above, the district court granted the discharge, reversing the bankruptcy court's findings that Scarlata had misrepresented his trading intentions and created a false pretense. The district court erred by applying the clear and convincing standard of proof, and the bankruptcy court's finding that Scarlata misrepresented his trading intentions may not have been clearly erroneous. Nevertheless, Goldberg did not prove that it relied on Scarlata's representation that he intended to reduce his positions. Further, we agree with the district court that Scarlata did not make a false pretense when he tendered the check. Finally, Goldberg has not explained how or whether the bankruptcy court and district court erred in concluding that Scarlata's actions were not malicious. Thus, we affirm.

Analysis

In bankruptcy, "exceptions to discharge are to be constructed strictly against a creditor and liberally in favor of the debtor." In re Zarzynski, 771 F.2d 304, 306 (7th Cir.1985). The burden is on the objecting creditor to prove exceptions to discharge. Minnick v. Lafayette Loan & Trust Co., 392 F.2d 973, 976 (7th Cir.), cert. denied, 393 U.S. 875, 89 S.Ct. 170, 21 L.Ed.2d 146 (1968). Although Goldberg may have proved that Scarlata misrepresented his trading intentions, we do not believe it carried its burden to prove reliance or to prove the applicability of the "willful and malicious injury" exception.

Count I--s 523(a)(2)(A)

The bankruptcy court held that Scarlata had made a "false pretense" by tendering a check for which he did not have any assets, and that he had misrepresented his trading strategy by promising to reduce his positions but immediately escalating them instead. 112 B.R. at 287. The district court reversed both holdings. We agree with the district court as far as the check is concerned. In Williams v. United States, 458 U.S. 279, 102 S.Ct. 3088, 73 L.Ed.2d 767 (1982), the Supreme Court held that knowingly passing a bad check is not a "false statement" within the meaning of 18 U.S.C. § 1014. The Court reasoned that "a check is not a factual assertion at all"; a check "serve[s] only to direct the drawee banks to pay the face amounts to the bearer...." Id. 458 U.S. at 284, 102 S.Ct. at 3091. Although Williams involved a criminal statute and construed the word "statement", its reasoning governs whether Scarlata's check was a false pretense in this civil bankruptcy case. See, e.g., In re Hunt, 30 B.R. 425, 438 (M.D.Tenn.1983) ("creditor cannot rely solely on the existence of an NSF check ... to establish a misrepresentation for § 523(a)(2) purposes"); In re Horwitz, 100 B.R. 395, 398 (B.C.N.D.Ill.1989) (acknowledging split on this issue, but persuasively noting that contrary cases have ignored Williams). Moreover, even if passing a bad check were a false pretense within § 523(a)(2)(A), Scarlata's check was not bad. The day after writing the check, Scarlata withdrew sufficient cash from his credit cards and deposited it in his checking account. The check did not bounce.

As for Scarlata's statement that he would reduce his positions, Goldberg needed to prove 1) that Scarlata made a statement either knowing it to be false or with reckless disregard for the truth; 2) that in making this misrepresentation Scarlata possessed "scienter, i.e., an intent to deceive" Goldberg; and 3) that Goldberg actually and reasonably relied upon the misrepresentation. In re Kimzey, 761 F.2d 421, 423 (7th Cir.1985). Because Scarlata was making a statement of future intention, it is possible that Scarlata's statement was true when made; intervening events may have caused his future actions to deviate from his prior intentions. W. PAGE KEETON ET AL., Prosser and Keeton on The Law of Torts § 109, at 764-65 (5th ed. 1984). Scarlata claims that he truly intended to reduce his positions, but that exceptional circumstances prevented him from doing so. The bankruptcy court found that Goldberg proved Scarlata's fraud by clear and convincing evidence. 112 B.R. at 286-87. The district court held that this conclusion was clearly erroneous because "[t]here is no evidence in the record to support the bankruptcy court's conclusion that Scarlata had formulated a plan over the weekend to substantially increase the size of his short put position." 127 B.R. at 1011. But the district court applied the wrong standard of proof; a few months before the district court's opinion, the Supreme Court held that "the standard of proof for the dischargeability exceptions in 11 U.S.C. § 523(a) is the ordinary preponderance-of-the-evidence standard." Grogan v. Garner, 498 U.S. at 279, ----, 111 S.Ct. 654, 661, 112 L.Ed.2d 755 (1991). ⁴ We are thus faced with a curious question: was the bankruptcy court's conclusion that Goldberg proved the exception by clear and convincing evidence clearly erroneous even under a preponderance standard?

We need not answer this question. Even if Scarlata did misrepresent his trading intentions to Goldberg, Goldberg did not prove that it relied on Scarlata's statement. ⁵ The bankruptcy court held that Goldberg had proved reasonable and actual reliance, but it did not specify any facts in support of this conclusion. 112 B.R. at...