Daily Development for
Friday, January 17, 1997

by: Patrick A. Randolph, Jr.
Professor of Law
UMKC School of Law

BANKRUPTCY; DISCHARGE; FRAUD: Bankrupt sublessor's debt to sublessee is not dischargeable in bankruptcy when it arises from fraudulent representations that the master landlord had approved the sublease, and sublessee's reliance on those representations is "justifiable" even where sublessee never saw any written evidence of master landlord's approval.

In re Apte, 96 C.D.O.S. 7281 (9th Cir. B.A.P. 1996)

Apte leased a medical office building with the notion of subletting to other doctors, but was not successful in doing so. Landlord terminated Apte's lease when the building was more than a million dollars delinquent in lease payments, and filed an unlawful detainer action. This resulted in negotiations to restructure the lease payments, and during that time Apte remained in possession. It was during this time that subtenant had the misfortune to happen on the scene. Subtenant negotiated for space in the building. Although subtenant had some real estate background, he was primarily a medical doctor, had never negotiated a sublease and was not represented by counsel. Apte told subtenant nothing of his problems with landlord.

Subtenant insisted on a priority provision protecting his sublease even if Apte were terminated. Subsequently, Apte told subtenant that landlord had approved the sublease with this provision, even though landlord has specifically disapproved the sublease because of the provision. Subtenant commenced $138,000 in improvements to his leased premises. Landlord, learning of the work, instructed Apte to stop subtenant from proceeding with it, but Apte in fact encouraged completion of the improvements while telling landlord that construction had stopped.

Finally, Apte was unable to meet the restructured lease repayment schedule, and landlord terminated Apte's lease and, shortly thereafter, evicted subtenant.

Apte declared bankruptcy, and subtenant filed a claim for damages based upon the above events, arguing that its claim was nondischargeable because of fraud. The bankruptcy court held the claim was dischargeable because it viewed subtenant's reliance upon Apte's misrepresetentation as neither reasonable nor justifiable in accordance with the requirements of Section 523(a)(2)(A).

On appeal, held: Reversed. The Ninth Circuit Appeals Panel observed that the Supreme Court does not require that reliance in such cases be both reasonable and justifiable, but that justifiable reliance is sufficient. Field v. Mans, 116 S.Ct. 437, 446 (1996).

The court noted that the landlord, for its own reasons, had refused communication with subtenant, and had elected to communicate with subtenant entirely through Apte. Thus it was difficult for Apte to discern the truth through the thicket of lies which Apte established. Subtenant really had no reason to know that there was any reason to believe that landlord would have any difficulties approving the sublease, as subtenant knew nothing of Apte's financial difficulties prior to the sublease.

It may be relevant that the court here elects to apply standards used in federal securities fraud standards to determine what constitutes a justifiable reliance upon a misrepresentation in a bankruptcy case. In a nutshell the court seems to say that where a misrepresentation goes to a material fact that the party making the representation has a duty to describe accurately, justifiable reliance is assumed.

The opinion gets somwhat muddy when it discusses the substance of the misrepresentations. Although it first asserts that Apte affirmatively misrepresented certain pertinent facts, it later seems to evaluate the case as if Apte had done nothing more than withhold these facts. The court, citing the Restatement of Torts, applied the rule that a party with knowledge of facts that he knows will materially affect the conduct of a party with whom he is in a business negotiation has the duty to disclose those facts if he thinks the other party is expecting him to make such disclosure if the facts exist. Here, the subtenant was counting upon Apte to tell him if the master landlord had problems with the sublease.

Apte, apparently, would have been liable for fraud even if Apte had said nothing.

Comment 1: The result seems appropriate here, and perhaps that is all that we should study. The court's analysis of what constitutes justifiable reliance and, more particularly, when a party has a duty to disclose, seem a bit askew. If, in fact, Apte had said nothing about the landlord's disapproval of the lease, and the subtenant had proceeded ahead with $138,000 in improvements, would the court have found "justifiable reliance" upon Apte's silence?

Comment 2: DIRT readers for the past few weeks have been asserting that the only thing predictable in judicial review of bankruptcy results is that the bankrupt always wins. Here, note that the bankrupt lost (albeit only on appeal.)

In the editor's experience, a more accurate generalization of bankruptcy opinions is that they cavalierly ignore either bankruptcy precedent or local precedent in order to reach results that they deem appropriate in the context of the particular case, leading to utter chaos in evaluating the precedent. In the rents area, for instance, courts have gone from a strong pro-debtor position to a strong pro-creditor position as they have grown more and more skeptical of the bona fides of single asset bankruptcy reorganizations. The only consistent theme is inconsistency.

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