Bankruptcy, the Flood and the Computer Virus

This post examines an opinion a bankruptcy court judge issued in an Ohio case:  U.S. Trustee v. Kandel, 2015 WL 1207014 (U.S. Bankruptcy Court for the Northern District of Ohio 2015).  As Wikipedia explains, bankruptcy in the United States

is a matter placed under federal jurisdiction by the United States Constitution (in Article 1,Section 8, Clause 4), which allows Congress to enact `uniform laws on the subject of bankruptcies throughout the United States’. The Congress has enacted statutes governing bankruptcy, primarily in the form of the Bankruptcy Code, located at Title 11 of the United States Code. . . .

This bankruptcy case was different from most in that the

United States Trustee for Region 9 (`UST’) brought the current adversary case against Bruce Edward Kandel (`Debtor’) seeking to deny Debtor's bankruptcy discharge under 11 U.S.Code § 727. Specifically, UST believes Debtor: concealed or transferred assets after filing for bankruptcy with the intent to harm creditors in violation of [11 U.S. Code] § 727(a)(2)(B); failed to maintain adequate business records in violation of § 727(a)(3); or failed to obey a court order in violation of § 727(a)(6). Debtor argues that UST has not sufficiently demonstrated he violated any portion of § 727, entitling him to a discharge.

U.S. Trustee v. Kandel, supra.  The judge also notes that this “is a core proceeding pursuant to 28 U.S. Code § 157(b)(2)(I) and (J).” U.S. Trustee v. Kandel, supra.

The judge then outlines the facts in the case.  I have edited the details he quite correctly includes in the opinion, as most of them are not relevant to the issue this post examines:

Debtor is a business owner with extensive trucking industry experience. Debtor started in the trucking business around age eight by sweeping floors and completing other low-level tasks, but moved up the hierarchy, first to mechanic, then driver, and finally business owner. Even after becoming the owner, Debtor nevertheless focused on driving trucks and trailers, leaving the daily management of his businesses to others. While Debtor's businesses were successful for a time, the combination of an expensive divorce, rising gasoline prices, and the `Great Recession’ of 2008 pushed Debtor into bankruptcy.

On August 9, 2011, Debtor filed his bankruptcy petition under Chapter 7 of the United States Bankruptcy Code. . . . Debtor's bankruptcy petition listed $755,111.00 in secured claims, $458,817.00 in unsecured priority claims, and $435,394.00 in general unsecured claims, for total debts of $1,649,322.00. Plantiff's Exhibit A. Of Debtor's liabilities, $750,000.00 is a divorce judgment, $449,594.00 relates to tax liabilities, $384,000.00 is a secured loan with First National Bank of Dennison . . ., $49,000.00 in credit card debt, along with other relatively immaterial debts. Id. Debtor's assets were significantly smaller, with real property valued at $300,000.00 and personal property valued at $636,734.00, the majority of which is Debtor's ownership in various business entities. . . .  

In the three years immediately preceding bankruptcy BVK was a large operation, generating average sales of approximately $3.1 million. According to tax records, in 2008 BVK reported $4,267,694.00 in revenue and $4,219,474.00 in expenses, leaving $48,220.00 in taxable income. . . . Business soured the following year, as BVK generated $2,492,097.00 in revenue, but after accounting for expenses, lost $172,888.00. . . . Business rebounded slightly in 2010, but revenues of $2,691,583.00 and expenses of $2,710,771.00 still resulted in an operating loss of $15,783.00. Id. at 27. Debtor filed for bankruptcy the next year.

One of Debtor's main liabilities at the time of his bankruptcy filing was a $384,000.00 loan from First National secured by thirty-four of Strasburg Leasing's trucks and trailers. In the months before Debtor's bankruptcy, First National, Debtor, and Christine Kinsey (Debtor's fiancée), began discussing various financial options. . . . Approximately four months before Debtor's bankruptcy filing, Kinsey created and became the 100% owner of KTS Transportation, LLC (`KTS’) and Ohio Carrier, LLC, an entity with a name very similar to Debtor's Ohio Carrier Corporation. . . . After obtaining use of the Strasburg Leasing assets, KTS appeared very similar to BVK, operating out of the same location, using much of the same equipment, and employing 80% of the same staff. . . .

U.S. Trustee v. Kandel, supra.

The judge then explains that KTS could not

generate sufficient income to make payments on First National's loan. First National repossessed the trucks and trailers and held a public auction in January of 2013. . . . The auction resulted in a total sale price of $426,820.00, allowing $158,976.48 to be distributed to Debtor's creditors after satisfying First National's lien. . . . A few months after the First National auction, around February or March of 2013, Debtor and Kinsey, supposedly acting on behalf of KTS, began quietly marketing trucking equipment and supplies located at 6531 McCracken Drive in Dover, Ohio. . . . [which] is owned by STAB, one of Debtor's business entities. . . .

Before the sale could be finalized, Ziegler backed-out after . . . realizing that many of the McCracken Trailers were tilted in the name of Strasburg Leasing, not KTS. . . .  Anne Silagy, the [bankruptcy] trustee  . . . only learned of the McCracken Trailers after Ziegler informed her of the proposed sale. . . . Trustee quickly inserted herself into the sale as a representative of Debtor's bankruptcy estate. Debtor, Recycling Concepts, and Trustee eventually agreed on a $90,000.00 sale price. . . . At least a portion of the trailers sold to Recycling Concepts with Trustee's oversight contained the same registration numbers as the vehicles Debtor and Ms. Kinsey previously attempted to sell outside bankruptcy. . . .

 The sale price was to be paid directly from Recycling Concepts to Trustee, with the money being used to pay Debtor's bankruptcy creditors. Debtor alleges that the contract between Debtor, Recycling Concepts, and Trustee was originally for $100,000.00, but the theft of ten vehicles (a police report or other substantiating information was never presented to the court) reduced the sale price to $90,000.00. . . . As of the writing of this opinion, Recycling Concepts has not paid the entire purchase price, and mediation regarding the unpaid balance is ongoing.

U.S. Trustee v. Kandel, supra.  The judge then says that

[b]ased on the information provided, much of it contradictory, the court is completely incapable of accurately determining Kinsey's ownership of trailers previously owned by Strasburg Leasing. The court is also unsure of the number of vehicles owned by Debtor or Debtor's businesses on his petition date. . . . Testimony at the evidentiary hearing also suggests that Debtor has property, in addition to the McCracken Trailers, that was never disclosed to Trustee. . . . While Debtor and Kinsey both testified that the property being moved did not belong to Debtor, it is another unusual coincidence regarding potential bankruptcy estate property.

The vast majority of the disputes relating to the McCracken Trailers, as well as Debtor's other assets, could have been completely eliminated if Debtor had maintained even mediocre financial records. . . . The court is also skeptical of a number of Debtor's justifications for his inability to provide the asset list. For example, at different times during the discovery process, Debtor informed Trustee that a roof collapse, a flood, a computer virus in Mr. Franz's computer system, or a computer virus within Debtor's computer system destroyed his records. . . . Debtor failed to provide any evidence substantiating these claims. It is incredibly unlikely that both Debtor and Debtor's distant and unreachable accountant would each have their records destroyed by independent events. Similarly perplexing is Debtor's ability to generate certain reports from his allegedly virus-laden accounting software that were not particularly relevant to the bankruptcy proceeding. . . .

U.S. Trustee v. Kandel, supra.  The judge includes more information in his opinion, but the information above gives an overview of how Kandel was conducting business.

He then took up the legal issue in the case, explaining that because Kandal’s

lack of business records may form the basis for a denial of discharge under § 727(a)(3), the burden initially rests with UST to identify the records Debtor should have been able to provide, but failed to do so. . . . The party seeking a denial of discharge must also demonstrate that the missing documents `might’ provide insight into `the debtor's financial condition or business transactions.' 11 U.S. Code § 727(a)(3). Therefore, the initial inquiry does not look into a debtor's justifications for his lack of records, but instead only if a debtor failed to produce information that might give creditors an insight into the debtor's financial situation. . . .

U.S. Trustee v. Kandel, supra. 

He then found that to succeed on the

element of a § 727(a)(3) claim, UST must explain Debtor's business structure and identify missing business records. UST's exhibits, as well as testimony from Trustee and Debtor, sufficiently outlined Debtor's trucking businesses. . . .  Debtor failed to provide an adequate fixed asset listing. The listings provided by Debtor and Mr. Frantz only covered a small portion of Strasburg Leasing's fixed assets, and are woefully insufficient. Debtor also produced business tax returns, but failed to provide the level of documentary support the court would expect from businesses of the size and complexity seen in the current case.

While not completely clear, it appears that Debtor closed the doors of his businesses only weeks or months before filing for bankruptcy, reducing the likelihood that Debtor inadvertently lost or destroyed business records in the period between business closing and bankruptcy filing.

U.S. Trustee v. Kandel, supra. 

He also noted that the Trustee (UST) must also

demonstrate that the missing records `might’ allow a creditor to better ascertain Debtor's financial situation. 11 U.S. Code § 727(a)(3); In re Devaul, 318 B.R.824 (U.S. Bankruptcy Court for the Northern District of Ohio 2004). While each entity is legally separate from Debtor, to the extent a corporation has equity (assets exceed liabilities), that business equity is an asset of a debtor's bankruptcy estate. . . .

Debtor allegedly attempted to sell Strasburg Leasing property to KTS, and if not discovered by Trustee, would have reduced Strasburg Leasing's equity and improperly moved property outside the bankruptcy process. Additionally, Debtor's recollection of the number of trucks and trailers owned by Strasburg Leasing continually changed, further obfuscating any creditor's view into Debtor's business equity. The fixed asset listing Debtor was unable or unwilling to provide prevented creditors from having an accurate representation of Debtor's business equity. UST satisfies its initial burden under § 727(a)(3).

U.S. Trustee v. Kandel, supra.  

The judge then found that the Trustee had “established that” Kandel

failed to keep or preserve recorded information. Indeed, the acknowledgment that [Kandel’s] friend threw out some of the records that had originally been provided to Hill, and that were then given by [Kandel] to his friend to organize, is probably alone sufficient to meet Plaintiff's burden of proof. 

U.S. Trustee v. Kandel, supra.  He therefore took up the next issue:  “whether [Kandel] has met his burden of proving that his acts or failure to act insofar as his records were justified under all of the circumstances of the case.” U.S. Trustee v. Kandel, supra. 

The judge began his analysis of that issue by explaining that Kandel articulated

four justifications for his lack of business records. First, Debtor argues that his records are adequate for an unsophisticated debtor with little formal education. Closely related to the first justification, Debtor secondly argues that the records he provided give creditors a sufficient window into his financial picture. Third, Debtor argues that the combination of a roof collapse, flood, and computer virus destroyed his records. Finally, Debtor believes he justifiably relied on others to maintain his financial records, and the court should not deny his discharge based on the failure of others.

U.S. Trustee v. Kandel, supra. 

The judge then noted that when a court is evaluating

a debtor's justifications, the court applies a hybrid objective and subjective standard, where the adequacy of a debtor's records are based on what a reasonable person with the same level of financial sophistication would maintain while also managing a business of similar size and complexity. In re Shattuck, 2012 WL 2884830 (U.S. Bankruptcy Court for the Northern District of Ohio 2012).

For example, a normal consumer debtor is not required to maintain in-depth financial records, and providing the trustee with bank and credit card statements is normally sufficient. U.S. v. Shattuck, supra. . . . However, a financially sophisticated debtor running a business is require to maintain more complete records. In re Roller, supra.

U.S. Trustee v. Kandel, supra. 

As to Kandal’s first justification, the judge found that he

does not have a college education, but was nevertheless able to move from an entry level laborer to the owner of numerous business entities. [His] trucking operations are also quite large, topping four million dollars in annual revenues and expenses. Such success indicates a level of financial sophistication and business savvy. However, [he] attempts to paints himself as an unsophisticated business person who avoided the financial aspects of his business as much as possible, delegating recordkeeping responsibilities and instead focusing on driving trucks. Information from trial partially undercuts Debtor's argument. Ziegler testified that he negotiated the purchase of the McCracken Trailers with Debtor.

Debtor also convinced First National, a successful local bank, to extend significant business financing. While the court has no evidence disputing Debtor's claim that he spent the majority of his time on the road, he still maintained a good handle on the overall financial health of his companies. Based on the above considerations and Debtor's testimony and demeanor at trial, the court finds that Debtor is reasonably sophisticated in financial matters, requiring records above that required by a normal consumer debtor. . . .  able to provide, but has failed to do so. Debtor's argument that his lack of financial sophistication excuses his failure to provide business records fails. These are records one must have to file tax returns.

Trustee v. Kandel, supra. 

The judge quickly disposed of Kandel’s claim that the fact he produced a

large amount of records entitles him to a discharge. This justification can be quickly disposed of. The question is not what records a debtor produced, but what records a debtor failed to produce. In re Bailey, 375 B.R. 420 (U.S. Bankruptcy Court for the Southern District of Ohio 2007).  Some courts have even gone so far as to deny a debtor's discharge based on the production of excessive and unorganized records. In re Scott, 172 F.3d at 970. In any event, the records Debtor produced are not an adequate substitute for the lack of a fixed asset listing. The court finds this justification insufficient.

Trustee v. Kandel, supra. 

He then took up Kandal’s third justification, i.e., that “some combination of a roof collapse, flood, or computer virus destroyed [his] records”. Trustee v. Kandel, supra.  The judge found

inconsistencies, unlikely `coincidences,’ and difficult to believe explanations within Debtor's narrative. For example, in pretrial communications between Debtor, UST, and Trustee, Debtor claimed that a flood, roof collapse, or computer virus destroyed his records. Any of these justifications, if sufficiently based in evidence and testimony, might protect Debtor from a § 727(a)(3) discharge denial. However, Debtor provided no evidence at trial substantiating these justifications. Debtor also provided no evidence or testimony substantiating his accountant's independent loss of the same records.

Similarly perplexing, even after the alleged computer virus ruined Debtor's computer system, is Debtor's ability to produce periphery financial reports with little importance to the bankruptcy case. Coincidentally, all the information pertaining to the heart of Debtor's enterprises that would most help creditors construct Debtor's financial activities, was destroyed. 

Trustee v. Kandel, supra. 

The judge then addressed Kandel’s

justification that a roof collapse, flood, or computer virus destroyed his records. As noted above, Debtor's failure to provide any documentary evidence substantiating any of these claims is incredibly unusual. The court would expect Debtor to produce photographs or an insurance document if a flood or roof collapse actually occurred. Based on Debtor's lack of credibility and lack of evidence, the court rejects these justifications.

Trustee v. Kandel, supra. 

As to the fourth factor, the judge assumed,

only for the sake of the foregoing analysis, that Debtor's delegation of recordkeeping responsibilities was reasonable. However, the court finds that Debtor did not take the necessary actions to assure his employees or agents maintained financial records. The court believes Debtor's testimony that he spent the majority of his time dealing with the operational side of his business. However, being heavily involved in one aspect of a business does not alleviate a business owner's responsibility to monitor his company's overall financial health. 

Trustee v. Kandel, supra (emphasis in the original).  He found, therefore, that a “debtor owning a multi-million dollar business should not be able to hide behind his employees or agents when justifying a lack of financial records.”  Trustee v. Kandel, supra.  So the judge denied Kandal’s bankruptcy discharge.  Trustee v. Kandel, supra.