Summary of a Recent
Judicial Development in
Bankruptcy

Farmer's Debt Excepted from Bankruptcy
for Making False Financial Statements

Jay Kiiha
National AgLaw Center Graduate Fellow

The United States Bankruptcy Court for the District of Kansas has held that $8,409.65 of a farmer's debt was excepted from discharge in bankruptcy under Bankruptcy Code § 523(a)(2) because the farmer made false financial statements regarding a debt owed to the farmer's bank. In re Diel, 277 B.R. 778, 780 (Bankr. D. Kan. 2002). The court also determined that the farmer's sale of hay for $4,797.12 would have constituted "willful and malicious injury" to the bank, in violation of Bankruptcy Code § 523(a)(6), if the land on which the hay was grown had been sufficiently described in the bank's security agreement pursuant to Kan. Stat. Ann. § 84-9-203(1)(a). See id. The court also ruled that it would not except from discharge the proceeds of the farmer's sale of other crops under § 523(a)(2) or (a)(6) because the bank failed to demonstrate that the farmer had damaged the bank's property interests. See id. Finally, the court ruled that the sale of an anhydrous applicator was not in violation of § 523(a)(2) or (a)(6) because the bank did not prove that the farmer profited from the sale or was personally involved in the sale. See id.

In 1992, Lanny Diel ("Diel") started a farming operation independent of his father, Virgil Eugene Diel, that was comprised entirely of land that he leased from his father and several other individuals. See id. In addition to running his farm operation, Diel "also engaged in custom bailing work, custom cattle work, and he worked for wages in the farming operation of Mike Yazel." Id.

In 1997, Diel entered a period of financial difficulty. See id. At that time, Farmers State Bank of Hardtner ("FSB") had two security agreements, one dated June 30, 1992, and the other dated January 20, 1995. See id. The 1992 agreement was executed only by Diel's father "and purport[ed] to hypothecate to Farmer's State Bank an interest in [Virgil Diel's] anhydrous ammonia applicator and a New Holland Swather." Id. This agreement was executed to secure Diel's notes. See id. The 1995 agreement granted FSB "a security interest in all of . . . Lanny Diel's livestock, machinery, equipment, crops and general intangibles." Id. The 1995 agreement did not reference any accounts and did not give a description of the land on which Diel's crops were grown. See id.

Diel and his former loan officer, who no longer worked for FSB, testified that "the course of dealing between them was that when Diel sold collateral of any kind, he was to bring the proceeds to the bank for application on his notes." Id. at 781. They also testified that Diel was occasionally allowed to use some of the proceeds to pay farming bills. See id. As Diel's financial situation worsened, however, the Bank often did not allow Diel to use the proceeds to pay bills. See id.

In 1999, Diel and his wife, Christine, opened a checking account at the Alva State Bank and Trust Company in Alva, Oklahoma. See id. Diel stated "that he opened [the] account after [FSB] refused to either advance him funds for his operation or allow him to use any collateral proceeds." Id. Diel also stated that "he used the account to avoid the Bank taking all of his deposits." Id.

After Diel harvested his wheat crop in June, 1999, he knew that he would no longer be able to farm and that he would soon have to file for bankruptcy. See id. Diel's father took over his leased ground soon thereafter, and Diel began working entirely as a cattleman, a custom bailer, and as an employee of Mark Yazel. See id.

On April 2, 2002, FSB filed a complaint with the bankruptcy court to determine whether Diel's debts were dischargeable. See id. at 780. FSB argued that Diel's debt should be "excepted from discharge under 11 U.S.C. § 523(a)(2) for making false financial statements and under § 523(a)(6) for willful and malicious injury to the Bank's property." Id. FSB also asserted that Diel's discharge should be denied because "Diel defrauded the bank under § 727(a)(2), concealed and falsified recorded information from which his financial condition or business transactions might be ascertained under § 727(a)(3), and [because he] knowingly and fraudulently made a false oath or account in connection with his case under § 727(a)(4)." Id.

FSB based these allegations on "several specific transactions which it contends demonstrate either Diel's fraudulent conduct or his willful and malicious damage to [its] security interest." Id. FSB first complained that in July, 1998, Diel sold hay to Cody Boevers for $8,409.65. See id. Boevers paid for the hay with two checks, one written for $4,048.20 and the other for $4,361.45. See id. The checks were returned for insufficient funds. See id. FSB advised Diel to initiate a collection action on the checks and to file bad check charges against Boevers. See id. Although Diel advised the bank that he would do so, he instead collected cash in the amount of the bad checks from Boevers. See id. Diel originally testified at the evidentiary hearing that "he had made no sales of hay for cash," but later admitted at trial that "he had not accounted to the Bank for the cash because he did not want the Bank to know he had spent the money." Id.

FSB further complained of transactions that arose from Diel's employment relationship with Mark Yazel. See id. As part of his employment, Diel cared for Yazel's cattle by allowing them to graze "on his leased land while it was planted in wheat." Id. The wheat that the cattle did not consume was cut and converted into "wheatlage" so that it could be saved for cattle feed. See id. In addition, on December 10, 1999, a check was deposited in the Diels' bank account at the Alva State Bank for $4,797.12. See id. Diel testified that the deposit represented the proceeds of the sale of hay to Mark Yazel. See id. As with the wheat and wheatlage, FSB claimed a security interest in the hay through the crops provision of the 1995 security agreement. See id. FSB asserted that because it had a security interest in Diel's crops via the 1995 security agreement, it therefore had an interest in the wheat that Diel fed to Yazel's cattle, the wheatlage that he saved, and the proceeds from the sale of hay to Yazel. See id.

Finally, FSB complained that "Diel should be held accountable for the proceeds of the anhydrous applicator his father sold at a farm auction." Id. at 782. The applicator had been pledged by Diel's father as security for Diel's debt at FSB. See id.

Because FSB subsequently withdrew its § 727 objections, the bankruptcy court stated that it was only necessary to consider the issue of "whether Farmer State Bank's debt should be discharged under §§ 523 (a)(2)(A) and (a)(6)." Id. The bankruptcy court concluded that "Diel's debt to Farmers State Bank is excepted in the amount of $8,409.65, the sum of the Boevers checks as funds obtained by actual fraud." Id.

The court first considered the checks for the sale of the hay in the amounts of $4,048.20 and $4,361.45 under the discharge provisions of § 523(a)(2). The court stated that:

[t]o prevail on a nondischargeability claim under 11 U.S.C. § 523(a)(2)(A), a creditor must prove by a preponderance of the evidence that (1) the debtor made a false representation; (2) the debtor had the intent to deceive the creditor; (3) the creditor relied on the debtor's conduct; (4) the creditor's reliance was justifiable; and (5) the creditor was damaged as a proximate result.

Id.

Applying § 523(a)(2), the court held that "Diel committed actual fraud by retaining [the] checks and seeking payment in cash which was not turned over to the bank." Id. at 783. The court noted that Diel contradicted his earlier testimony at the evidentiary hearing when he stated at trial that "he did not want the Bank to know he spent the funds on something other than debt service." Id. Thus, the court ruled that the full amount of $8,409.65 was excepted from discharge. See id.

Next, the court considered the December 10, 1999, sale of hay to Mark Yazel for $4,797.12. Bankruptcy Code § 523(a)(6) excepts from discharge "any debt for willful and malicious injury by the debtor to another entity or to the property of another entity." Id. (citing 11 U.S.C. § 523(a)(6)). The court noted that "[u]nless the creditor can prove not only that the debtor knew of the security interest, but also that the debtor knew that a transfer of the property was wrongful and certain to cause financial harm to the creditor, the debt should not be found nondischargeable." Id. (citing COLLIER'S ON BANKRUPTCY § 523.12[1] (15th ed. rev. 2001)).

Applying § 523(a)(6) the court concluded that, as a result of Diel's failure to inform FSB of the proceeds of the sale of the hay to Yazel, "Diel's depositing of Mark Yazel's check for hay at Alva State Bank [constituted] malicious damage, provided the Bank's security interest was valid." Id. The court concluded, however, that FSB did not have a valid security interest in Diel's crops because the security agreement failed to include a description of the land concerned, in violation of Kan. Stat. Ann. § 84-9-203(1)(a). See id. at 784. As such, the court ruled FSB's interest in the check from Yazel for $4,797.12 was unenforceable. See id.

Addressing FSB's argument that it had an interest in Diel's wheat and wheatlage, the court stated that "the details of the Yazel cattle care transactions are not sufficiently fleshed out in the evidence to support judgments under either §§532(a)(2) or (a)(6)." Id. The court noted that FSB did not provide definitive evidence on the total amount of Diel's wheat that was fed to Yazel's cattle. See id. The court concluded that FSB, "at least where the Yazel transactions [were] concerned," failed to demonstrate that "its property interests [were] damaged at all." Id.

The court also rejected FSB's claim that it suffered a "willful and malicious" injury when Diel's father sold the anhydrous applicator. See id. The court stated that because "Diel did not participate in the sale or share in the proceeds[,] Lanny Diel cannot be said to have 'injured' the bank." Id. The court explained that Virgil Eugene Diel's failure to account was not a willful and malicious injury for which Lanny Diel could be held responsible. See id. The court added that "[i]f the Bank has a claim or cause of action concerning the applicator, it would appear to be against [Virgil Eugene] Diel and not the debtor." Id.

The case was decided on May 16, 2002; this summary was prepared in October, 2002.