#2577               signed June 21, 2002

IN THE UNITED STATES BANKRUPTCY COURT

FOR THE DISTRICT OF KANSAS

ORDER DENYING MOTION FOR SUMMARY JUDGMENT, BUT

GRANTING SANCTIONS FOR IMPROPER SERVICE OF PROCESS

This proceeding is before the Court on defendant-debtor Kenneth Cardwell's motion for

summary judgment. The defendant-debtor (“the Debtor”) appears by counsel Eric C. Rajala. Plaintiff

The Mission Bank (“the Bank”) appears by counsel Robert A. Andrews of Andrews & Fowler,

Chartered. The Court has reviewed the relevant pleadings and is now ready to rule.

FACTS

Except as indicated, the following facts are not controverted.

Before he filed for bankruptcy, the Debtor was the president of a company called American

Reprographics, Inc. (“the Corporation”), for a number of years, and owned 70% of its stock. The

Corporation borrowed money from the Bank at various times, and the Debtor personally guaranteed

that debt. Around February 1, 1999, the Debtor submitted a personal financial statement to the Bank

in which he valued his interest in the Corporation at $1,000,000 as of January 1, 1999. He claims he

arrived at this value by using a formula that an accountant had given him in 1993 or so, although the

formula is not described in any of the materials submitted by the parties. The financial statement

included directions advising the Debtor to inform the Bank if his financial circumstances changed

materially.

The Corporation was required to submit annual financial statements to the Bank and it did so

for 1993 through 2000, although there is some dispute about the timeliness of the submissions. The

Corporation also provided the Bank with a financial statement for the period ending June 30, 1999.

The Bank renewed the Corporation's loan in July 1998, July 1999, and several times thereafter. The

financial statements show that the Corporation had net income of about $300,000 in 1993, $50,000 in

1994 and again in 1995, and $66,000 in 1996, but then had net losses of about $3,600 in 1997,

$1,000 in 1998, and $25,000 for the six-month period ending on June 30, 1999. By July 1999, the

Bank officer in charge of the Corporation's loan knew that the Internal Revenue Service had issued

levies against the Corporation's accounts in 1998 and that the Corporation had lost a valuable contract

with Xerox Corporation late in 1998 or early in 1999.

Because of the Corporation's business difficulties, the Debtor began negotiating with the

president of Western Blue Print Company, L.L.C. (“Western”), in 1998 for a possible sale of some of

the Corporation's assets. Some of the Corporation's equipment was of no interest to Western because

it was becoming technologically obsolete. The Corporation had no restrictions on employees leaving

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and using its customer list at other jobs, and around the middle of 1998, a sales representative had left

the Corporation and gone to work for Western, taking the customer list with her and contacting some

of those on the list on Western's behalf. Nevertheless, the Debtor's negotiations with Western led to a

lengthy proposed agreement under which Western would pay the Corporation up to $500,000 over

five years based almost entirely on Western obtaining business from the Corporation's then-current

customers. The proposal included a provision that the Debtor and another person would sign

employment agreements with Western. Ultimately, Western decided not to go through with the

purchase. The Corporation then lost its lease and essentially went out of business on August 31, 1999,

except that the Debtor continued to try to collect its accounts receivable and to liquidate its equipment

and inventory.

The Debtor went to work for Western, signing an employment agreement with it the same day

the Corporation stopped operating. Under this agreement, the Debtor was to be paid a salary and

commissions on business he obtained from new customers or new lines of business he obtained from

specified customers of the Corporation. He was also to be paid “Additional Compensation” of up to

$500,000 on essentially the same terms as the $500,000 that would have been paid to the Corporation

under the purchase agreement that Western finally declined. If the Debtor's position with Western was

terminated without cause, or because of his death or disability, he or his estate would still be entitled to

be paid the Additional Compensation. Despite these terms, the Debtor insists the Additional

Compensation would be paid only because of his contacts with and the personal services he would

provide to the Corporation's former customers who would provide the business that would generate

the Additional Compensation.

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The Bank contends that the Debtor did not disclose to it the Corporation's adverse financial

circumstances, and until early in 2000 concealed the fact that the business had been closed the previous

August. The Debtor alleges that he kept the Bank's officer informed of the Corporation's situation at

all relevant times. The Bank's officer claims that the Debtor first told him that the Corporation would

be sold to Western, then told him that the companies would merge, and finally told him in February

2000 that there had been no sale or merger and that the Debtor had signed the employment agreement

with Western.

The Debtor filed a chapter 7 bankruptcy petition in May 2000. The Corporation also filed a

chapter 7 bankruptcy petition that same month, listing assets of about $190,000 and debts of about

$600,000. The assets included about $100,000 in accounts receivable and $43,000 in machinery and

equipment. The Bank's officer in charge of the Corporation's loan apparently concluded in February

2000 when the Debtor told him of the employment agreement with Western that the Corporation's

stock was then worthless.

When the Bank commenced this adversary proceeding on September 28, 2000, a summons to

the Debtor was issued under which the Debtor's answer would have been due on October 30

(because October 28 was a Saturday that year). See Fed. R. Bankr. P. 7012(a) & 9006(a).

However, the summons and complaint were not served on the Debtor until October 24, when it was

finally mailed to him. A non-file-stamped copy of the complaint had been mailed to the Debtor's

attorney on the day the complaint was filed, but no summons was ever served on him. On October 26,

the Debtor's counsel obtained a Clerk's ten-day extension of the answer time, and filed the Debtor's

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answer on November 8. Among other things, the answer asserted the defenses of insufficiency of

process and of service of process.

The Bank's complaint seeks to except the Debtor's debt to it from discharge, and is divided

into two counts, although the first count appears to assert what the Court would classify as two claims.

In the first count, the Bank alleges the written financial statement that the Debtor gave it in February

1999 was false, a claim that the Court believes must fall under 11 U.S.C.A. §523(a)(2)(B) to make the

debt nondischargeable. The count also alleges that the Debtor failed to disclose the Corporation's

adverse financial circumstances to the Bank and concealed until about February 2000 that the business

had been closed on August 31, 1999, a claim that the Court believes must fall under §523(a)(2)(A) to

make the debt nondischargeable. In the second count, the Bank alleges that the debtor committed a

fraud or defalcation while acting in a fiduciary capacity or embezzlement by appropriating the

Corporation's customer list and in effect selling it to Western, in violation of §523(a)(4).

The Debtor has now moved for summary judgment on the entire complaint. He contends: (1)

the complaint should be dismissed for insufficiency of process and insufficiency of service of process;

(2) there is no evidence that his financial statement was materially false when he submitted it to the Bank

on February 1, 1999; (3) the Bank did not reasonably rely on his financial statement; (4) the Bank's

complaint fails to state a claim on which relief may be granted under §523(a)(2)(A); (5) he did not

breach any fiduciary duty to the Corporation or its creditors; and (6) he did not embezzle the

Corporation's customer list. The Bank opposes all these claims.

DISCUSSION AND CONCLUSIONS

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The Court will begin with the Debtor's attack on the sufficiency of process and service of

process. Federal Rule of Bankruptcy Procedure 7004(e) provides in pertinent part: “If service is by

any authorized form of mail, the summons and complaint shall be deposited in the mail within 10 days

after the summons is issued. If a summons is not timely delivered or mailed, another summons shall be

issued and served.” The reason for this requirement is made apparent by Rule 7012(a), which fixes the

time for a defendant to answer a complaint as 30 days after the issuance of the summons, unless the

court prescribes a different time. Requiring a new summons insures that the defendant has a minimum

of twenty days (plus three days when service is by mail, Rule 9006(f), minus the time it takes for mail to

be delivered) to file an answer. The Bank violated Rule 7004(e). Rather than mailing the summons

within 10 days after it was issued, counsel mistakenly placed the summons and complaint in a file and

noticed the oversight only when checking for the Debtor's answer date. On discovering the error,

instead of obtaining a new summons, counsel simply mailed the stale one six days before the answer

date fixed by that summons. Counsel also mailed the summons and complaint only to the Debtor,

neglecting to serve his attorney, as required by Rule 7004(b)(9). Although the Debtor's attorney had

been provided a copy of the complaint before it was filed, obviously no summons accompanied that

premature service. The Rule presumably requires service on a debtor's attorney: (1) to help insure that

the debtor is not prejudiced by failing to recognize the significance of the complaint; (2) because the

debtor is not likely to be aware that an adversary complaint is different from all the other documents

connected with his or her bankruptcy case and would not be sent to the attorney but for Rule

7004(b)(9); and (3) in case the debtor has moved from the last address included in a filed pleading, on

the theory that the debtor is likely to keep his or her attorney informed how to contact him or her.

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Despite the Bank's failure to properly serve the Debtor and his attorney with the summons and

complaint, the protections the Rules were intended to provide were accomplished. Apparently the

Debtor quickly advised his attorney that he had received the summons and complaint, and the attorney

obtained a clerk's extension of time and was able to file a timely answer.

The Bank blithely argues that the Court should excuse its improper attempt at service or else

permit it to perform proper service now because the Bank had no way of knowing how the service was

insufficient until the Debtor explained the problem in his motion for summary judgment. In essence, the

Bank suggests that although the Debtor raised in his answer the propriety of the service of process, it

could not have been expected to review the Rules and the case file, or to contact the Debtor's attorney

in an effort to discover its error before the Debtor sought summary judgment. Just reading the

summons alone would have given counsel a good clue to the problem because it states that the Debtor

had to respond “within 30 days after the date of issuance of this summons.”

The Bank's failure to serve the summons and complaint in accordance with the Bankruptcy

Rules forced the Debtor to seek an extension of the time to file his answer. The Bank's subsequent

failure to investigate and correct its service errors encouraged the Debtor's counsel to seek, in the

summary judgment motion, to have this proceeding dismissed. The Court can perceive no other

prejudice to the Debtor as a result of the Bank's mistakes, particularly no impairment of his ability to

defend the case on the merits. Consequently, the Court concludes that the extreme sanction of

dismissal would not be appropriate. Instead, the Court will require the Bank to pay the fees and

expenses of the Debtor's counsel that were generated by the errors, that is, those required to obtain the

extension of the answer time and to ask for summary judgment on the grounds of insufficiency of

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process and service of process. The Debtor's counsel is directed to submit an itemization of those fees

and expenses within 30 days of the date of this order. The Bank will have 10 days from the date the

itemization is served on it to file a written objection specifying any line items it believes should be

excluded from this sanction.

The Court will now turn to the substance of the Debtor's summary judgment motion.

As indicated, the first count of the Bank's complaint cites §523(a)(2)(A) and (B). These

provisions except from discharge any debt:

(2) for money, property, services, or an extension, renewal, or refinancing of credit, to the extent obtained, by—

(A) false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's or an insider's financial condition; [and]

(B) use of a statement in writing—

(i) that is materially false;

(ii) respecting the debtor's or an insider's financial condition; 
(iii) on which the creditor to whom the debtor is liable for such money,

property, services, or credit reasonably relied; and

(iv) that the debtor caused to be made or published with intent to deceive.

The Debtor contends that the Bank's complaint fails to state a claim for relief under

§523(a)(2)(A) because the allegations that the Debtor failed to disclose the Corporation's “adverse

financial circumstances” and concealed the closing of the Corporation's business accuse the Debtor of

misrepresenting the financial condition of an insider, allegations that are covered, if at all, only by

§523(a)(2)(B). The Court agrees with the Debtor that an allegation of failure to disclose “adverse

financial circumstances” concerns the Corporation's financial condition and therefore cannot be

covered by subsection (A). However, while the fact a business has closed would certainly affect its

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financial condition, the Court believes concealing that fact could fall under subsection (A), so the

Bank's allegation on that point is sufficient to state a claim for relief under (A).

The Debtor claims that the Bank has no evidence that his February 1, 1999, financial statement

was materially false. The Bank officer in charge of the Corporation's loan may have testified (some

interpretation of the testimony appears to be required to reach that conclusion) that the only evidence

the Bank has to show that the $1 million value listed on that financial statement for the Debtor's interest

in the Corporation was false when the statement was submitted is the fact the stock was worthless one

year later. The Debtor suggests that such evidence is insufficient as a matter of law to establish that the

value on his financial statement was false. He then points to other evidence that he contends shows that

the Corporation's value decreased precipitously during the year after he gave the Bank the financial

statement. In effect, in the Court's view, such an argument concedes that the evidence under attack

could support the Bank's claim, but that the fact finder should not make the permissible inference that

stock now worth nothing was not worth $1 million one year earlier. The argument might be successful

at trial, but does not justify summary judgment in the Debtor's favor.

The Debtor also argues that the Bank did not reasonably rely on the valuation in his financial

statement when it renewed and increased the amount of the Corporation's loan. This is so, he says,

because the Bank had other information that made clear the Corporation was not worth the amount

listed in his financial statement. The Bank responds that it reasonably relied on the financial statement

because the Debtor subsequently represented to the Bank's officer that he was going to sell the

Corporation for $2 million. The Court believes this is sufficient to preclude resolving the question by

summary judgment.

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The second count of the Bank's complaint alleges that the Debtor violated §523(a)(4), that is,

he committed “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” In

effect, the Bank seems to be claiming that when the Debtor's negotiations with Western changed from a

sale of the Corporation for up to $500,000 to an employment contract with him under which he could

receive up to $500,000 on the same terms, the Debtor in effect sold the Corporation's goodwill,

customer list, or both for his own benefit. The Debtor responds that the possible $500,000 in

compensation is available to him only if he services the accounts of the customers whose business can

make him eligible for the compensation. This claim seems to ignore the fact the compensation is still

payable based on the business the relevant customers give to Western even after the Debtor becomes

disabled or dies. The Court is convinced that the terms of the proposed sale contract and the

employment contract raise a permissible inference that the Debtor has taken something that belonged to

the Corporation and sold it for his own benefit, although it is somewhat unclear what that something

might have been.

The Tenth Circuit has construed §523(a)(4) more narrowly than the Bank would like the Court

to do here. In Fowler Brothers v. Young (In re Young), 91 F.3d 1367, 1371-72 (10th Cir. 1996),

the Circuit said:

The existence of a fiduciary relationship under § 523(a)(4) is determined under federal law. However, state law is relevant to this inquiry. Under this circuit's federal bankruptcy case law, to find that a fiduciary relationship existed under § 523(a)(4), the court must find that the money or property on which the debt at issue was based was entrusted to the debtor. Thus, an express or technical trust must be present for a fiduciary relationship to exist under § 523(a)(4). Neither a general fiduciary duty of confidence, trust, loyalty, and good faith, nor an inequality between the parties' knowledge or bargaining power, is sufficient to establish a fiduciary relationship for purposes of dischargeability. Further, the fiduciary relationship must be shown to exist prior to the creation of the debt in controversy.

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91 F.3d at 1371-1372 (citations and internal quotation marks omitted). The Court believes that the

ordinary “fiduciary duties” that a corporate officer of a Kansas corporation may owe to the corporation

or its creditors are the kind of “general fiduciary duty of confidence, trust, loyalty, and good faith” that

the Tenth Circuit meant was not sufficient to constitute the kind of fiduciary relationship that is covered

by §523(a)(4). The Bank has also failed to show that the Debtor held whatever asset he may be

considered to have sold to Western in any express or technical trust, as required under the fiduciary

portion of §523(a)(4).

On the other hand, embezzlement does not require a fiduciary relationship. The Tenth Circuit

has said for purposes of §523(a)(4), “[E]mbezzlement is defined under federal common law as 'the

fraudulent appropriation of property by a person to whom such property has been entrusted or into

whose hands it has lawfully come.'” Klemens v. Wallace (In re Wallace), 840 F.2d 762, 765 (10th

Cir. 1988) (quoting Great American Ins. Co. v. Graziano (In re Graziano), 35 B.R. 589, 594

(Bankr.E.D.N.Y. 1983), which was quoting Gribble v. Carlton (In re Carlton), 26 B.R. 202, 205

(Bankr.M.D.Tenn. 1982)). Clearly the Debtor was properly in control of the Corporation's assets.

Whatever the asset may have been that the proposed sale contract and the employment contract

indicate may have belonged to the Corporation but the Debtor in essence sold to Western for his own

benefit, the Court believes sufficient evidence has been presented to permit the fact finder at trial to find

that the Debtor embezzled the asset from the Corporation.

For these reasons, the Debtor's motion for summary judgment must be denied, except to the

extent that the Bank will be required to reimburse the attorney fees and expenses he incurred because

of the Bank's improper service of process.

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IT IS SO ORDERED.

Dated at Topeka, Kansas, this _____ day of June, 2002.

__________________________________ 
JAMES A. PUSATERI

CHIEF BANKRUPTCY JUDGE

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