Sai Supermarkets, Inc. v. Soto

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FOR PUBLICATION
UNITED STATES BANKRUPTCY COURT
EASTERN DISTRICT OF CALIFORNIA
In re:
RAUL MIRAZO SOTO, JR.,
Debtor.
________________________________
SAI SUPERMARKETS, INC. dba DEL
VALLE SUPERMARKET,
Plaintiff,
v.
RAUL MIRAZO SOTO dba SOTO
REFRIGERATION & BEVERAGE CO.,
Defendant.
________________________________
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Case No. 24-21939-C-7
Adversary No. 24-02174
OPINION
CHRISTOPHER M. KLEIN, Bankruptcy Judge
Is the essential element of “circumstances indicating fraud”
for nondischargeable embezzlement under 11 U.S.C. § 523(a)(4)
satisfied when a licensed contractor fails to account for, and
does not refund, advances for labor and special-order equipment
that were not ordered before the contract was terminated?
A California licensed contractor’s failure to refund and
substantially to account for advances and deposits is a ground
for discipline, including restitution orders, by the California
Contractors State License Board and, if willful, is an offense
under the California Penal Code.
To the narrow question whether the “circumstances indicating
fraud” essential element for nondischargeable embezzlement is
satisfied in such circumstances, the answer is, “yes.”
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Jurisdiction
Jurisdiction is founded on 28 U.S.C. § 1334(b). This civil
proceeding arising under Title 11 is a core proceeding. Id.,
§ 157(b)(2)(I). The parties agree that, to the extent it may ever
be determined not to be a core proceeding, it may be heard and
determined by a Bankruptcy Judge.
Proceedings
Findings of Fact and Conclusions of Law were rendered orally
on the record after trial pursuant to Civil Rule 7052(a)(1). Fed.
R. Civ. P. 52(a)(1), incorporated by Fed. R. Bankr. P. 7052. This
Opinion supplements those findings and conclusions.
Facts
Defendant Debtor Raul Mirazo Soto is licensed by the
California Contractors State License Board to contract for
installation of warm air heating, ventilation, air-conditioning
systems, and refrigeration (categories C-20 and C-38). At all
relevant times he did business as a sole proprietorship under the
name Soto Refrigeration & Beverage Company.
Soto contracted in February 2021 with Plaintiff SAI
Supermarkets, Inc. dba Del Valle Supermarket to acquire and
install refrigeration and ventilation equipment meeting food
handling and storage requirements in a building that was being
renovated for supermarket purposes from a different use.
As it was an ongoing renovation project, the installation
schedule was uncertain and design incomplete. The precise
specifications for refrigeration and ventilation were subject to
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modification before construction reached the installation stage.
It was understood that changes in specifications might require
price increases.
There were two components to Soto’s duties under the
contract: (1) order and deliver the equipment; and (2) provide
the labor to install the equipment.
Soto’s purchase orders specified “There are NO refunds on
deposits” and “All materials are special order items and there is
no return on special order items.” E.g., Ex. 4-1.
Between February 12, 2021, and September 21, 2021, SAI made
six advances at Soto’s demands totaling $149,741.68. Some of the
demands were based on unilateral price increases by Soto.
In seeking advances of $149,741.68, Soto represented that
all funds were needed for and would be used in SAI’s project.
Soto’s bank records reflect that during the period February-
August, 2021, Soto withdrew $142,112.74 from his business
checking account ($54,732.74 cash and $87,380.00 transfers to his
personal checking account). As of July 31, 2021, his business
checking account had a negative balance (-$422.59).
After an advance in September with no apparent work having
been accomplished, SAI lost confidence in Soto, terminated the
contract, and demanded refund of all advances.
Soto responded to SAI by invoking the “no-refund” language
in his purchase orders. Soto later admitted that, except for
$7,562.00 spent for 2000 feet of copper pipe, he neither
purchased nor installed the required equipment.
Soto testified at trial that SAI funds were used on non-SAI
projects or for personal purposes. On June 14, 2021, Soto spent
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$4,443.38 from his business checking account for a Louis Vuitton
purse for his wife.
SAI sued Soto in state court in January 2022, which action
was pending when Soto filed his chapter 7 case on May 6, 2024.
This adversary proceeding ensued.
Analysis
The Complaint alleges two counts: § 523(a)(4) embezzlement
and § 523(a)(2) fraudulent misrepresentation. SAI contends that
§ 523(a)(4) embezzlement squarely fits the facts. Analysis here
focuses on the law regarding embezzlement.
Decisions on § 523(a)(4) embezzlement are relatively scarce.
I
§ 523(a)(4) Embezzlement
The § 523(4) discharge exception applies to any debt “for
fraud or defalcation while acting in a fiduciary capacity,
embezzlement, or larceny.” 11 U.S.C. § 523(a)(4).
A
Embezzlement Basics
No fiduciary relationship is required to except embezzlement
debt from discharge. As the Supreme Court explains, the syntax of
§ 523(a)(4) separates “embezzlement” and “larceny” from “fraud or
defalcation while acting in a fiduciary capacity.” Bullock v.
BankChampaign, NA, 569 U.S. 267, 275 (2013) (construing fiduciary
defalcation); 4 COLLIER ON BANKRUPTCY ¶ 523.10[1] n.14 (Richard
Levin & Henry J. Sommer, eds) (“COLLIER”).
The term “embezzlement” in the Bankruptcy Code is a federal
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law concept. Hence, federal law, not state law, controls the
meaning of “embezzlement” in § 523(a)(4). First Del. Life Ins.
Co. v. Wada (In re Wada), 210 B.R. 572, 576 (9th Cir. BAP 1997).
The Supreme Court’s classic statement of the meaning of
“embezzlement” in a federal statute is that “embezzlement” is the
fraudulent appropriation of property by a person to whom the
property has been entrusted or into whose hands it has lawfully
come. Moore v. United States, 160 U.S. 268, 269 (1895). Moore
remains good law. See 4 COLLIER AT ¶ 523.10[2].
The three essential elements of “embezzlement” are: (1)
property rightfully in the possession of a nonowner; (2)
nonowner’s appropriation of the property to a use other than
which it was entrusted; and (3) circumstances indicating fraud.
Transam. Comm. Fin. Corp. v. Littleton (In re Littleton), 942
F.2d 551 (9th Cir. 1991); Wada, 210 B.R. at 576-77; accord,
COLLIER ¶ 523.10[2].
All three essential elements – possession by nonowner,
misappropriation, and circumstances indicating fraud – are
questions of fact for the trial court to determine by
preponderance of evidence. See Grogan v. Garner, 498 U.S. 279,
291 (1991) (§ 523(a)(2)).
The first two essential elements are straightforward and
ordinarily easily established.
The third essential element, circumstances indicating fraud,
is a question of fact focused on knowledge and intent of the
actor. Littleton, 942 F.2d at 556.
The analyses by the Ninth Circuit and its Bankruptcy
Appellate Panel in Littleton and Wada regarding the fraud-related
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element were essentially validated by the subsequent Supreme
Court decision in BankChampaign that fraud in this connection
means positive fraud, or fraud in fact, involving moral turpitude
or intentional wrong, leading to the imputation of bad faith or
immorality. BankChampaign, 569 U.S. at 274-76.; Neal v. Clark, 95
U.S. 704, 709 (1877).
Putting a finer point on the pencil, and comparing
defalcation to embezzlement, the Supreme Court explained in
BankChampaign that defalcation includes conscious disregard of or
willful blindness to a substantial and unjustifiable risk of a
violation. The risk “must be of such a nature and degree that,
considering the nature and purpose of the actor’s conduct and the
circumstances known to him, its disregard involves a gross
deviation from the standard that a law-abiding person would
observe in the actor’s situation.” BankChampaign, 569 U.S. at
274, quoting ALI Model Penal Code § 2.02(2)(c), p. 226 (1985).
In other words, there must be a showing of “wrongful
intent.” BankChampaign, 569 U.S. at 27. Accord, Kim v. Kim (In re
Kim), 2025 WL 3654696, at *5 (9th Cir. BAP 2025); Newman v. Lee
(In re Newman), 2022 WL 2100905, at *7 (9th Cir. BAP 2022).
The Supreme Court’s willful blindness analysis of
defalcation in BankChampaign likewise informs the analysis of
“circumstances indicating fraud” in § 523(a)(4) embezzlement.
As with other forms of fraud-related intent, the trier of
fact may draw inferences from circumstantial evidence. Particular
circumstances surrounding nonpayment/nonremittance of entrusted
property may suffice to persuade the court to infer the requisite
fraudulent intent.
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For example, in Wada a false statement regarding the reason
for improper appropriation and failure to refund warranted
inferring circumstances indicating fraud. Wada, 210 B.R. at 577.
Finally, it should be emphasized that the “circumstances
indicating fraud” essential element lies in the penumbra of
fraud, is not congruent with actual fraud, and does not require
proof of actual fraud. Rather, it suffices to establish a gross
deviation from the standard that a law-abiding person would
observe in the actor’s situation.
II
This Defendant’s Context
The context of the applicable nonbankruptcy law regime in
which California licensed contractors operate is crucial to
understanding the embezzlement theory in this case and what a
law-abiding licensed contractor would do.
The California Business and Professions Code proscribes
diversions by licensed contractors of funds received from
contracting parties and failures to account for application or
use of funds. Discipline for violations is authorized.1
The permitted forms of discipline under § 7108 include
1 The Business and Professions Code § 7108 (Diversions of
funds or Property) provides:
Diversion of funds or property received for prosecution
or completion of a specific construction project or
operation, or for a specified purpose in the prosecution or
completion of any construction project or operation [...]
for which such funds or property were received constitutes a
cause for disciplinary action.
Cal. Bus. & Prof. Code § 7108.
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license suspension, restitution, just terms and conditions
regarding continued operations, and payment of costs of
investigation.2
Worse, a contractor’s willful failure to complete the
improvement for which funds were provided, willful failure to pay
for services, labor, materials or equipment provided incident to
such construction, or willful diversion of funds to a use other
than that for which the funds were received constitutes criminal
construction fraud under California Penal Code § 484b.3
2Business & Professions Code § 7095 (Mode of Discipline)
provides in part:
(a) The decision may:
(1) Provide for the immediate complete suspension by
the licensee of all operations as a contractor during the
period fixed by the decision.
...
(3) Impose upon the licensee compliance with such
specific terms and conditions as may be just in connection
with the licensee’s operations as a contractor disclosed at
the hearing and may further provide that until those terms
and conditions are complied with no application for
restoration of the suspended or revoked license shall be
accepted by the registrar.
...
(b) The specific terms and conditions imposed pursuant to
paragraph (3) or (4) of subdivision (a) may include, but are
not limited to, any of the following:
(1) Payment of restitution to persons injured as a
result of the violation
(2) Payment of the costs of investigation and enforcement
pursuant to Section 125.3.
Cal. Bus. & Prof. Code § 7095 (emphasis supplied).
3California Penal Code 484b provides:
§ 484b. Any person who receives money for the purpose of
obtaining or paying for services, labor, materials or
equipment and willfully fails to apply such money for such
purpose by either willfully failing to complete the
improvements for which funds were provided or willfully
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As part of the licensing process, California contractors are
trained in these provisions and agree to be held responsible for
obeying state law regarding permitted uses of funds. They know
they cannot divert project funds for other uses. They know they
must be prepared to account for uses of project funds.
III
Essential Elements of § 523(4) Embezzlement
A
Possession by Nonowner
The element of possession by nonowner is admitted and beyond
dispute in this case. SAI is the owner of the subject funds,
which it delivered into the possession of Soto.
B
Misappropriation
The element of misappropriation is likewise beyond cavil.
Soto testified that project funds were used on other projects.
Nor did he contest that project funds were transferred to his
personal account and used for personal purposes, including
failing to pay for services, labor, materials or equipment
provided incident to such construction, and wrongfully
diverts the funds to a use other than that for which the
funds were received, shall be guilty of a public offense and
shall be punishable by a fine not exceeding ten thousand
dollars ($10,000), or by imprisonment in a county jail not
exceeding one year, or by imprisonment pursuant to
subdivision (h) of Section 1170, or by both that fine and
that imprisonment if the amount diverted is in excess of two
thousand three hundred fifty dollars ($2,350). If the amount
diverted is less than or equal to two thousand three hundred
fifty dollars ($2,350), the person shall be guilty of a
misdemeanor.
Cal. Penal Code § 484b.
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payment of $4,443.38 for a Louis Vuitton purse.
C
Circumstances Indicating Fraud
As to the “circumstances indicating fraud” essential
element, BankChampaign provides the matrix for analysis.
One begins with the premises that licensed contractors know
their duties under state law governing their licenses and that no
law-abiding contractor would violate those duties.
The question in any particular case is whether, in the words
of the Supreme Court, the contractor consciously disregarded or
was willfully blind to a substantial and unjustifiable risk of a
violation of contractor duties of such a nature and degree that,
considering the nature and purpose of the actor’s conduct and the
circumstances known to him, its disregard involves a gross
deviation from the standard that a law-abiding person would
observe in the actor’s situation.
Circumstances “known to the contractor” include the state-
law criminal prohibition of diverting funds, the duty to account,
and the exposure to a restitution order as disciplinary action.
The burden of proof is preponderance of evidence. The
unsupported contrary assertion by Soto’s counsel that clear and
convincing evidence is required is rejected as lacking merit in
light of the Supreme Court decision in Grogan that preponderance
of evidence is the standard of proof in § 523 dischargeability
litigation. Grogan, 498 U.S. at 291. If preponderance is the
standard for proof of actual fraud, then a higher standard cannot
apply to the lower showing of “circumstances indicating fraud.”
While the precise degree of fraud “indications” required for
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§ 523(a)(4) embezzlement may be uncertain, at a minimum, facts
that could support an actual criminal prosecution are sufficient.
This Court is persuaded, and finds as fact, that Defendant
Soto consciously disregarded or was willfully blind to a
substantial and unjustifiable risk of violation of his California
contractor duties of such a nature and degree that, considering
the nature and purpose of his conduct and the circumstances known
to him, its disregard involved a gross deviation from the
standard that a law-abiding licensed contractor would have
observed in Soto’s situation.
The reality is that Soto was using SAI as, in effect, an
automatic teller machine in a manner not permitted by the law
governing licensed contractors.
The debt of Soto to SAI is excepted from discharge as an
embezzlement by virtue of 11 U.S.C. § 523(4).
IV
§ 523(a)(2) Fraud
SAI asserts that 11 U.S.C. § 523(a)(2) arguably provides a
ground for excepting at least some of Soto’s debt from discharge
but candidly concedes that its case is not so strong as its
§ 523(a)(4) case. This Court agrees.
Evidence probative of fraudulent intent at the time of
formation of the SAI-Soto contract, the time of some of the early
representations, and knowledge of their falsity is ambiguous.
To be sure, each advance made by SAI to Soto during the
contractual relationship came with a representation by Soto that
the funds needed to be advanced would be used for project
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purposes. But their untruth and Soto’s knowledge of the untruth
evolved over time and would require a stretch of inferences that
could affect the measure of nondischargeable damages.
Moreover, time limitations imposed by this trier of fact
during the management of the trial attenuated SAI’s and Soto’s
presentations of § 523(a)(2) evidence to an extent that could
merit further proceedings that would be wasteful in light of the
embezzlement determination. Fed. R. Bankr. P. 1001(a).
Accordingly, the prudent course is to dismiss the
§ 523(a)(2) count without prejudice.
Conclusion
This Court is persuaded by preponderance of evidence that
the debt of Defendant Raul Soto to Plaintiff SAI in the amount of
$149,741.68 represents embezzlement within the meaning of
§ 523(a)(4) and is to be excepted from discharge.
An appropriate separate judgment shall be entered.
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