Memorandum of Decision Re: Fraud Damages

IN THE UNITED STATES BANKRUPTCY COURT FOR THE NORTHERN DISTRICT OF CALIFORNIA
In re MURRAY D. KATZ and                                           No. 1-89-00156 BEATRICE KATZ,      Debtors. ___________________________/ STANLEY BLUMENFELD,      Plaintiff,    v.                                                                              A.P. No. 1-89-0114 MURRAY D. KATZ,      Defendant. ______________________________/
Memorandum of Decision
     Plaintiff Stanley Blumenfeld is a retired attorney and a successful real estate investor. At the request of a friend, in March, 1985, he became involved with and purchased an interest in a closely held corporation known as Hi Line Paint Company.      Bloomenfeld regretted becoming involved in Hi Line almost from the moment he made the purchase. He soon discovered that the business was being poorly managed and needed repeated infusions of cash just to keep the doors open. There was also a significant toxic waste problem. Blumenfeld considered several options to extricate himself from Hi Line, including shutting its doors and liquidating, and determined that the best way to get out was to find a buyer for the business.      In the Spring of 1986, a business broker put Blumenfeld in contact with James Zetz, who owned a business called Ryan Paint Company. Blumenfeld and the other owners of Hi Line agreed to sell their shares Zetz and his partner. The ageement they negotiated was somewhat unusual; not only was no cash down payment required of the buyers, but Blumenfeld agreed to loan Zetz $110,000.00. Thus Blumenfeld, as a seller, was actually paying out $110,000.00 in cash in order to make the sale work.      Even though Blumenfeld agreed to part with $110,000.00 in cash, his incentives for entering into the agreement are clear. He was personally liable to the former owner of Hi Line for $144,000.00 in promissory notes; one of the conditions of the sale to Zetz was that Zetz would obtain Blumenfeld's release on these notes. Thus, for a cash outlay of $110,000.00 Blumenfeld got rid of a cash-draining albatross from around his neck, was released from $144,000.00 in personal liability, and was promised $66,667.00 plus a right to buy back into Hi LIne if Zetz made it profitable. The transaction therefore made economic sense even though the only cash which changed hands went from sellers to buyers.      Defendant Murray Katz was the attorney who represented Zetz in the transaction. However, there was considerably more than a normal attorney-client relationship between Katz and Zetz. Zetz and his enterprises were Katz' primary, if not only, clients. Katz worked out of Zetz' business premises, kept all his business records with Zetz' records, and drove a car supplied by Zetz. It is very clear that Katz totally depended on Zetz for his livelihood.      As part of the transaction, Blumenfeld was to review Zetz' personal financial statement. Zetz produced a financial statementwhich contained several outright lies. It stated that one of his projects had an appraised value of $660,000.00, when in fact the appraisal was for developed property and the property was in fact undeveloped. It stated that one project had a significant equity when in fact Zetz did not even own the projecty and had never owned it. It stated that Zetz had two college degrees when if fact he had none.      Katz knew that some of the information in the financial statement was false. However, he personally represented to Blumenfeld and his attorney that the financial statement was truthful and accurate and that Zetz was worth the $1 million it stated. As anxious as Blumenfeld was to sell Hi Line, he would not have done so if he had known the truth. While his reliance on Katz' representations was not very smart, it was reasonable under the circumstances, as Katz was an attorney and his representations gave the financial statement more credibility than it would have otherwise had.      The court accordingly finds that Katz owes Blumenfeld a nondischargeable debt due to his misrepresentations, pursuant to section 523(a)(2) of the Bankruptcy Code. It is not necessary to determine if an insider relationship existed between Katz and Zetz, as there is liability under section 523(a)(2)(A) if there was no such relationship and liability under section 523(a)(2)(B) if there was an insider relationship. Moreover, although the court finds that Katz knew that the financial statement contained false information, his representations to Blumenfeld were so reckless that he would still be liable for making them even if he did not specifically know of the falsity. In re Houtman (9th Cir.1978) 568 F.2d 651, 656.      However, even with a finding of fraud, Blumenfeld is not entitled to anything near the damages he seeks. Under section 523(a)(2), not all damages flowing from fraudulent conduct are nondischargeable. The language of that section specifically limits nondischargeable debts to debts for money or property to the extentsuch was obtained by fraud. This limiting language means that damages not actually based on out-of-pocket losses, such as benefit of the bargain damages or punitive damages, are not allowed even if such items could be included in a fraud award under state law. In re Ellwanger (9th Cir.BAP 1989) 105 B.R. 551, 555; In re Anguiano (9th Cir.BAP 1989) 99 B.R. 436. The evidence clearly established that Blumenfeld's primary motivation in entering into the agreement to sell his interest in Hi Line was to get out from further involvement in that corporation. Both the Bankruptcy Code and principles of equity require the court to consider the benefits Blumenfeld actually got from the transaction in determining the net amount of his damages.      Blumenfeld was induced to part with his shares of stock and $110,000.00 in cash. The only evidence of the value of the stock is the contract price of $66,667.00; while the court has its doubts that the stock was actually worth this much, it gives Blumenfeld the benefit of the doubt in the absence of evidence to the contrary. Thus, at most Blumenfeld was induced to part with money or property having a value of $176,667.00.      In return, Blumenfeld got released from liability on two of his notes, totalling $144,100.00, given to the former owner when he purchased Hi Line. He also got $13,352.27 in payments which Blumenfeld concedes are a proper credit, was repaid $10,156.69 owed to him by Hi Line, and was released from $1,020.00 in liability for Hi Line's delinquent rent, as he had personally guaranteed Hi Line's lease. Thus, Blumenfeld actually got $168,628.96 in benefits from the sale to Zetz.      The court notes that Katz has a tenable argument that Blumenfeld's benefits exceeded his losses because Blumenfeld was also released from liability under Hi Line's long-term lease. However, the court accepts Blumenfeld's uncontested assertion that the lease was below market and had a value of $300,000.00, so that he had no real exposure on account of it. Why Blumenfeld did not seek to become whole by taking over the lease is a question the court declines to grapple with.      The court rejects entirely Blumenfeld's assertion that he is entitled to an additional $150,000.00 which he paid pursuant to a term in his contract with Zetz making him responsible for certain Hi Line notes. There was no evidence presented that Blumenfeld was personally liable on those notes, and it is abundantly clear that he made the payments because he felt personally responsible for getting the note holders into the Hi Line mess and not because he was obligated to pay under the contract.      The court declines to give Katz a credit for the $18,000.00 broker's commission. Blumenfeld was out these funds regardless of how they were applied, and would not have incurred the fee but for Katz' misrepresentations.      For the foregoing reasons, Blumenfeld is entitled to a nondischargeable judgment in the amount of $8,038.04. He shall also recover his costs of suit.      Blumenfeld shall submit an appropriate form of judgment, which counsel for Katz has approved as conforming to this decision. This memorandum constitutes findings and conclusions pursuant to FRCP 52(a).
Dated: February 1, 1990                                                                              _______________________                                                                                                                      Alan Jaroslovsky                                                                                                                      U.S. Bankruptcy