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December 11, 1978

In re GEM SLEEPWEAR COMPANY. In re Leo BATTINO, a/k/a Leon Battino. In re Leo NEGRIN, a/k/a Leon Negrin, Bankrupts. William S. BROWN, Trustee in Bankruptcy,
GEM SLEEPWEAR COMPANY, Leo Battino, a/k/a Leon Battino, Leo Negrin, a/k/a Leon Negrin

The opinion of the court was delivered by: GOETTEL

The trustee in bankruptcy appeals from an opinion and order of Bankruptcy Judge Babitt which granted the motions of the three bankrupts to dismiss the trustee's complaints seeking to bar their discharge.

Gem Sleepwear Company was a partnership owned by two equal partners, the individual bankrupts, Leo Battino and Leo Negrin. In October of 1973, Gem obtained a loan from Chase Manhattan Bank. The loan was for a term of one year, but Chase reserved the right to make a credit determination each quarter in order to decide whether the loan should be renewed or called in. It was Chase's practice to require a year-end written financial statement before renewing a loan if the maturity date was within two or three months of the borrower's ending fiscal date. The company's fiscal year ended May 31, 1974. A month or two thereafter its accountant, a Mr. Librach, prepared a typewritten financial statement. For reasons never adequately explained, there were two versions of the statement. One version had endorsed on it the legend "For use by management only." The other version did not have such a legend, although it was originally accompanied by a letter dated July 23, 1974, which concluded: "The enclosed statements are designed for use by the management only, they should not be construed as an inducement to the extension of credit."

On July 30, 1974, Negrin delivered to Chase the copy of the financial statement which did Not have the cautionary legend. It was also not transmitted with the accountant's letter. Chase's loan officer, John Haggerty, had Negrin sign this financial statement in his presence. Financial statements were also delivered to two other creditors, United Virginia Factors Corporation and Lowenstein & Sons, Inc. The version delivered to United Virginia contained the cautionary legend "For Management use only" and a copy of the accountant's covering letter. The copy submitted to Lowenstein did not have the legend, but was delivered with the accountant's covering letter. *fn1"

 The two versions of the financial statement contain the same figures. They were both unaudited and uncertified. They disclosed accounts receivable (net of reserves) of $ 233,405.57. Although not revealed by the statement, $ 206,921 of the receivables (I. e., 88 percent) were due from Feminette Loungewear, Inc. Feminette was a New York corporation wholly owned by Battino and Negrin. It filed its tax return as a small business corporation and distributed its profits and loss equally to them. It operated solely as a sales agent for Gem, from whom it purchased all of its finished garments. It had no independent or other activities. *fn2"

 In addition, the financial statement included investments in the total sum of $ 36,023.94. In fact, these investments were solely in affiliated companies, Feminette and Ringgold Industries, Inc., a Louisiana corporation in which Negrin and Battino owned two-thirds of the stock. Previous financial statements submitted by Gem had listed affiliated accounts receivable and affiliated investments separately. After this submission, Chase reviewed and extended the loan.

 As found by the learned Bankruptcy Judge (Opinion, at 11), the actions of the accountant, in failing to set forth separately accounts receivable from affiliated companies violated the rules of his profession as stated by the American Institute of Certified Public Accountants. See APB Accounting Principles, Original Pronouncements as of June 30, 1973, Vol. 2, p. 6007; See also Myer, Financial Statement Analysis 41 (1950). The accountant, Librach, had been employed by the three bankrupts for a number of years and was thoroughly familiar with their financial affairs. As stated earlier, there was no satisfactory explanation why two separate statements had been typed up, one with and one without the cautionary legend. His explanation for his accounting aberration in failing to separate transactions with affiliated companies was unconvincing. He said that he had proceeded in this way since the company's bookkeeper was behind in posting to the general ledger. (Why they should have been behind in light of their limited business activity was not explained.) Bankruptcy Judge Babitt found Librach's explanation to be "an inadequate reason for a professional to go forward in violation of elementary standards prescribed by a profession to govern the conduct of its people," (Opinion, at 11) and concluded that the whole situation was "indeed a puzzlement." (Opinion, at 19.) Nevertheless, Judge Babitt granted the bankrupts' motion to dismiss at the conclusion of the plaintiff's case without requiring them to testify, concluding that the financial statement was not false within the meaning of section 14c of the Bankruptcy Act and that, in any event, Chase (and the other creditors) did not rely on the financial statement.

 With respect to the element of reliance, the bankruptcy court concluded that the financial statements were not crucial to renewal of the loan and that they were, at most, a partial inducement to it. It has long been the law in this circuit, however, that reliance need not be proved by direct testimony. The fact that a statement is made to support an application for credit and that the credit is thereafter given creates an inference of reliance. Industrial Bank of Commerce v. Bissell, 219 F.2d 624 (2d Cir. 1955). While not debating this point the court below distinguished the instant case as one dealing with a renewal of credit and not the original extension of a loan. This distinction, however, does not appear meaningful, and it would appear that the bankruptcy court misapplied the law with respect to the standard of reliance required to establish a Prima facie case barring discharge in bankruptcy.

 The cases cited below do not support the distinction between original and renewal applications. In Berberich v. Northern Illinois Corp. 190 F.2d 53 (7th Cir. 1951), the bankrupt had first borrowed from the HFC in 1945. The false statement was presented to the same lending institution in 1949. In In re Savarese, 56 F. Supp. 927 (E.D.N.Y.1944), the facts do not indicate whether this was an application for new or renewed credit. In In re Sheridan, 34 F. Supp. 286 (D.N.J.1940), the false statement was presented to obtain renewal of a previous loan. Reliance was proved by circumstantial evidence and the court concluded that the creditor parted with the merchandise on the strength of the false statement because of the closeness in time between the presentation of the statement and the shipment of merchandise. Moreover, other cases clearly establish that credit extensions based in part upon false statements can be used to bar a discharge. Yates v. Boteler, 163 F.2d 953 (9th Cir. 1947); In re Robinette, 117 F. Supp. 367 (N.D.Ohio 1953); In re Axel, 103 F. Supp. 810 (S.D.N.Y.1951), Aff'd, 196 F.2d 217 (2d Cir. 1952); In re Philpott, 37 F. Supp. 43 (S.D.W.Va.1940).

 Nonetheless, the opinion below argues that the absence of the cautionary legend was a reason for not relying upon the statement and that Chase might have been more justified in believing that the statement was accurate if the cautionary legend had been included. The logic leading to this conclusion is difficult to follow. Since the loan officer required Negrin to sign the statement when he delivered it, the court below concluded that this shows Chase was not relying on the statement. The basis for this logical inference is not evident.

 Moreover, the course of dealing with Chase would seem consistent with the claim of reliance. In October of 1972 Chase had refused to renew a loan with Gem because the affiliated accounts receivable, including those from Feminette, constituted too large a portion of the receivables. All prior statements submitted to the bank had segregated associated company receivables and investments. The bank officer testified that he questioned Negrin about the change in receivables and was assured that Feminette receivables were not included therein. The bank officer claimed that he had been advised that Feminette was separated from Gem and that there were no inter-company or affiliated receivables. For purposes of the burden of proof on a motion to dismiss, that was the extent of the record. In the final analysis, the only reason for rejecting the loan officer's claim of reliance was the fact that his contemporaneous reports made no reference to these oral representations. While this is undoubtedly a factor to be taken into consideration where there is a conflict in the evidence, at the point the motion to dismiss was granted the bank officer's version of what had occurred stood unrebutted.

 It has been held that where the bankrupt gave financial information which is false, the burden is on the bankrupt to show that the lender did not rely on the information. Morris Plan Industrial Bank v. Parker, 79 U.S.App.D.C. 164, 143 F.2d 665, 666 (1944). This is a burden of proof to overcome the inference of reliance by the creditor, and not merely the burden of going forward. 1A Collier on Bankruptcy § 14.43, n.10, and cases cited. The Court concludes, therefore, that the court below was in error in finding as a matter of law an absence of reliance.

 Returning to the question of whether the financial statement was false within the meaning of section 14c(3), the requirements are that the bankrupt must have: (1) obtained the money or property on credit, or an extension or renewal of credit; (2) that he did so on a materially false statement respecting his financial condition; (3) that such statement was in writing; (4) that the statement was made or published, or caused to be made or published, by the bankrupt or someone duly authorized by him; and (5) that the bankrupt was engaged in business and the money was obtained for the business. 1A Collier on Bankruptcy, § 14.39, at 1388.

 The bankrupts argue that there was no proof that the accounts receivable were not collectible even though from an affiliated company. There was evidence, however, that Feminette had already factored the accounts and, therefore, would have no source of income with which to pay the receivables. Ultimately, when the bankruptcy occurred, the receivables were found to be old, uncollectible and worthless. This is not surprising when one considers the fact that the associated company was merely a sales unit of Gem. In fact, the bankrupts owed this money to themselves.

 In addition, the prior statements had shown a substantial receivable from associated companies, and the bank officer testified that he was quite concerned about it. He further testified that he was relieved to learn that Feminette was now a separate operation and that the indebtedness had been eliminated. The plaintiff, therefore, had met its burden of producing evidence ...

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