Alle v. Gales (In re Alle)

In re: JOHN EMIL ALLE and MARY REILLY ALLE, Debtors.

JOHN EMIL ALLE; MARY REILLY ALLE, Appellants, v. EARL E. GALES, JR.; STARLA GALES; ROBERT L. OPPENHEIM;

LOIS J. OPPENHEIM, Appellees.

BAP No. CC-16-1412-LTaKu

Adv. No. 2:14-ap-01146-SK

UNITED STATES BANKRUPTCY APPELLATE PANEL OF THE NINTH CIRCUIT

Argued and Submitted: June 22, 2017

September 29, 2017

NOT FOR PUBLICATION

Bk. No. 2:13-bk-38801-SK

MEMORANDUM^*

Argued and Submitted on June 22, 2017 at Pasadena, California

Appeal from the United States Bankruptcy Court for the Central District of California

Honorable Sandra R. Klein, Bankruptcy Judge, Presiding

Appearances: David Brian Lally argued for Appellants; Anthony J. Napolitano of Buchalter Law Firm argued for Appellees.

Before: LAFFERTY, TAYLOR, and KURTZ, Bankruptcy Judges.

INTRODUCTION

This appeal challenges the bankruptcy court's determinations that certain claims are nondischargeable under § 523(a)(4)¹ as resulting from defalcation by a fiduciary and embezzlement. In brief, the bankruptcy court concluded that the defendant, who was the managing member of Shadow Mountain Properties, LLC ("SMP"), a California limited liability company ("LLC") in which plaintiffs were the only other members and which was formed for the express purpose of acquiring and operating for-profit real property, was a fiduciary to the plaintiffs via the application of California law governing LLCs. We agree with this conclusion.

The bankruptcy court also concluded that: (i) the defendant's failure to provide monthly bank statements and written accountings of the financial condition of the LLC and apparent misappropriation of SMP's funds were defalcations committed by defendant in his fiduciary capacity, and that SMP's loss of its real property through foreclosure supported nondischargeable claims against defendant of $800,000, their original investment; and (ii) SMP's loss of the real property also supported a claim for embezzlement against defendant, in the same damage amount of $800,000. We cannot agree with these conclusions.

As an initial matter, the bankruptcy court's ruling did notcontain a finding that defendant acted with the mental intent required to support a claim of defalcation. And the record does not support the bankruptcy court's ruling that the alleged defalcations - failure to report SMP's financial condition and misuse of funds - while certainly breaches of defendant's fiduciary duties, "caused" the damages here, as required by the law defining claims for defalcation under § 523(a)(4). Nor does the law support the bankruptcy court's finding that the defendant's misuse of funds adequately supported a judgment on the embezzlement claim in the amount of the plaintiffs' original investment. Indeed, neither the law nor the record support the conclusion that the proper measure of damages for the alleged defalcations or embezzlement was the amount of plaintiffs' initial investment in SMP.

Accordingly, we AFFIRM in part, REVERSE in part, VACATE the judgment, and REMAND.

FACTS²

A. Formation of Shadow Mountain Properties, LLC

In January 2006 Debtor John Alle and his wife Mary Alle, Earl and Starla Gales, and Robert and Lois Oppenheim formed SMP as a California LLC. Each couple owned a one-third interest in SMP. SMP was formed to purchase, operate, and manage a 12-unit residential income property on Shadow Mountain Drive in Palm Desert, California (the "Property"). Under the Operating Agreement ("OA") for SMP, Alle was designated managing memberwith direct and sole responsibility for the day-to-day management and operation of the Property.

Alle arranged for SMP to purchase the Property from the Humiston Family Trust ("HFT") for $1,600,000. The Gales and the Oppenheims (collectively, "Plaintiffs") each contributed $400,000 toward the acquisition of the Property, and HFT carried back a note and deed of trust for the $800,000 balance of the purchase price.

B. The Operating Agreement

The OA provided that Alle, as managing member of SMP, would have full authority in connection with the management of the Property, including tenant relations and services, vendor relations, record-keeping, accounting, and cash flow management. For his services, Alle was to be paid a management fee of $300 per month. He was also entitled to "reimbursement for any and all out-of-pocket expenses paid or incurred by him in connection with the Property," except costs associated with the formation of the LLC and the purchase of the Property, as well as funds required for the operation of the Property through December 31, 2010.

The OA authorized the managing member to require members under appropriate circumstances to make capital contributions in ratio to their ownership interests. It further obligated the managing member to deposit partnership monies into the partnership bank account, to provide members with monthly financial reports and bank statements and annual financial statements, and to distribute profits on a monthly basis.

C. SMP's Cash Flow Problems

Sometime during 2008, the Property began experiencing cash flow problems. Over the next several years, Alle communicated several times with Gales and Oppenheim,³ orally and in writing, to inform them that the Property was no longer making money and that he recommended they sell it. Alle initially approached Gales and Oppenheim in 2008 about selling the Property, but they did not want to sell because, according to Alle, they "had no place else to put their money, . . . did not want to pay capital gains taxes . . . [and] they didn't want to give up their monthly/annual cash-on-cash returns of 9% per month."

Although Alle was communicating generally with Gales and Oppenheim regarding SMP's financial condition, sometime in 2010 Alle stopped sending monthly operating reports and bank statements to them. Alle also fell behind on sending distribution checks.

Around 2010 to 2011, the Property's revenues decreased because tenants either moved out or were evicted. Also, some units became uninhabitable due to tenant damage. Alle requested that Plaintiffs pay expenses for plumbing, eviction fees, legal fees, insurance, taxes, trash, monthly maintenance, remedial expenses (such as paint, appliance repairs, broken fixtures, accounting, and bookkeeping), but Plaintiffs refused, insisting that Alle should pay for those expenses from his personal funds.As noted, the OA provided that Alle was entitled to be reimbursed for his out-of-pocket expenses related to the Property.

Gales admitted in his deposition testimony that Alle told Plaintiffs that the Property was losing money and that they should sell it, but "we never received any documentation." Gales also testified that during 2010, in an attempt to determine the value of the Property, he personally investigated comparables near the Property.

Over the next several months, Gales and Oppenheim requested monthly reports and distribution checks; despite promises to do so, Alle did not provide any financial reports. Alle also continued to broach the subject of selling the Property, but Gales and Oppenheim were opposed to the idea.

Eventually, in July 2011, Alle met personally with Gales and Oppenheim at his office and warned them about the financial challenges facing SMP. The parties reviewed bills and rent rolls. Alle told Gales and Oppenheim that there was insufficient cash in the operating account to maintain the building properly, fix units for new tenants, and pay taxes and that, even if the Plaintiffs' distributions were reduced, SMP could not afford to maintain the Property.

D. Alle uses SMP funds for his personal expenses.

According to bank statements and check copies admitted in the bankruptcy court, during 2009, 2010, and 2011, Alle withdrew from the SMP bank account $44,529.84 in cashier's checks, $15,097.84 in unidentified checks, and $7,924.10 in cash withdrawals, along with $26,921.86 of expenditures that appearedto be solely for Alle's personal expenses or expenses related to other properties he owned.

E. The Notice of Default

In the meantime, SMP fell behind on payments on the debt secured by the Property. As early as May 2009, HFT informed Alle that late payments on the note would no longer be tolerated. Alle did not inform Plaintiffs of this default or his correspondence with the creditor.

Eventually, in August 2011, HFT recorded a Notice of Default and Election to Sell ("NOD"), which stated that the reinstatement amount was $12,478.33. Alle admitted that he received a copy of the NOD shortly after it was recorded and asserted that the next day, he met with Gales and Oppenheim in his office and notified them that he had received the NOD. Alle testified that at that meeting Gales and Oppenheim told Alle that they were unwilling to contribute further capital and were unwilling to accept less than $3,000 per month in distributions from SMP, and they instructed Alle to negotiate a settlement with HFT. Gales and Oppenheim, however, asserted that Alle never informed them of the NOD.

According to Alle, a few weeks later, Alle met with Gales and Oppenheim again to discuss the foreclosure, delinquent property taxes, a cut-off notice from utilities, outstanding rents, and timing of distribution checks.

F. Alle's Attempts to Negotiate a Loan Modification

Beginning in October 2011, HFT's attorney and Alle began negotiating a potential loan modification. It is undisputed that Alle did not notify Plaintiffs of any of thesenegotiations. The final modification proposed by HFT in December 2011 provided that HFT would cancel the trustee's sale on satisfaction of various conditions, including the payment by December 21 of $16,666.65, representing interest payments due on the note, along with legal fees and trustee's fees, reimbursement for insurance premium advances, payment of current property taxes, and proof of an installment agreement with Riverside County for the payment of property tax arrears. Alle did not accept this proposal but requested additional time to pay the property...