NICKERSON, District Judge.
Collateral estoppel applies in bankruptcy court on the basis of a prior judgment on the issue of whether the debtor's fraud prevents discharge of a debt, especially in a case like this where the previous judgment was entered by a federal court in a securities fraud lawsuit. The rationales for the exclusivity of bankruptcy court jurisdiction over dischargeability questions, that of protecting the debtor against sharp collection practices and that of assuring that only judges with experience on discharge issues hear such matters, are not undermined by giving collateral estoppel effect to pre-bankruptcy judgments. The requirements of a searching scrutiny of the record should prevent any conflation of bankruptcy and tort standards. See Sec. 523(c) at ¶ 9237.
Discharge of Debts — Fraud — Collateral Estoppel — Prior Litigation of Issue
A debtor was bound by collateral estoppel in bankruptcy court on the issue of whether certain of his debts were nondischargeable for fraud even though in an earlier federal securities fraud lawsuit he only appeared, answered, gave deposition testimony, but did not defend at trial. The size and nature of the civil claims gave the debtor a powerful incentive to contest them, and the possibility of a dischargeability issue developing was certainly within his contemplation. See Sec. 523(c) at ¶ 9237.
Discharge of Debts — False Representations — Subrogation — SEC Raising Claims of Clients
The Securities and Exchange Commission may raise the claims of a debtor-former stock broker's clients as to the claims' nondischargeability for fraud because Section 523(a)(2)(B) may benefit a subrogee. See Sec. 523(a)(2) at ¶ 9228.
Sol Freedman, Freedman May, New York, New York, attorney for the debtor. Russell E. Brooks and Paul T. Shoemaker, Milbank, Tweed, Hadley McCloy, New York, New York, attorneys for the New York Stock Exchange, Inc.
[Opinion of the Court]
This is an appeal from an order of the United States Bankruptcy Court in this district, C. Albert Parente, J., dated May 19, 1982. On consent, the filing of briefs is excused. William Wiese moves to have the appeal dismissed as untimely. Wiese, however, is not a party to the present appeal. It does not appear that a notice of appeal was filed in his action (Adv. No. 881-0251-18). The appellees do not assert the untimeliness of this appeal.
Plaintiffs in the adversary proceeding sought a declaration that the debts owed them by the debtor are nondischargeable, and judgment in the amount of those debts plus interest and attorneys' fees. Plaintiffs moved for summary judgment and the motion was granted in a decision dated April 20, 1982; the order from which the debtor appeals was based on that decision, and it declared the debts to be nondischargeable.
The following facts are not in dispute. The debtor was the managing partner of a stock brokerage firm called Orvis Brothers Co. (Orvis). In 1971 appellees brought an action against him and others in the Southern District of New York. The second amended complaint alleged among other things that the debtor had committed violations of securities laws and regulations, violations of a New York Stock Exchange rule, and common law fraud. Judge Broderick dismissed the claims based on securities law violations.
After a nine-week trial in 1979, the jury found the debtor and other liable for common law fraud, breach of fiduciary duty (which was charged though not pleaded), and violation of a stock exchange rule. Judge Broderick then dismissed the claims based on the stock exchange rule, and judgment was entered on the others. No appeal was taken.
On December 31, 1980, the debtor filed a voluntary petition for relief under Chapter 7 of the Bankruptcy Code. Plaintiffs filed this adversary proceeding on March 3, 1981. The debts which plaintiffs sought to have declared nondischargeable were those resulting from the judgment in the civil action.
Plaintiffs argued that the debtor was collaterally estopped from denying jury determinations of issues actually litigated in the civil action, and that those determinations established nondischargeability under various provisions of 11 U.S.C. § 523(a). Section 523(a)(2)(A) precludes discharge of debts for obtaining money or credit by false pretenses, a false representation, or actual fraud, other than a statement respecting the debtor's or an insider's financial condition. Section 523(a)(2)(B) applies to materially false written statements respecting the debtor's or an insider's financial condition on which the creditor reasonably relied and which the debtor caused to be made with intent to deceive. Section 523(a)(4) makes nondischargeable a debt for fraud while acting in a fiduciary capacity. Section 523(a)(6) makes nondischargeable debts for willful and malicious injury by the debtor to another entity or to the property of another entity.
The debtor argued that there is no collateral estoppel on dischargeability issues in bankruptcy court. In the alternative, he argued, the relevant issues were not actually litigated, in that he did not participate at the trial. Third, he argued as to each of these provisions that the jury's determination of liability failed to establish all the necessary elements of nondischargeability.
The bankruptcy court decided that collateral estoppel does apply to dischargeability issues, and applies in this case, relying largely on its prior decision in Wiese v. Sloan, Adv. No. 881-0251-18 (Bankr. E.D.N.Y. April 2, 1982). Judge Parente found that the record and jury determination in the civil action supported a conclusion of nondischargeability for fraud. Since the judge stressed the identity of issues between this case and Wiese v. Sloan, supra, it seems clear that in this case he found the same basis for a finding of nondischargeability as in that one, namely, 11 U.S.C. § 523(a)(2).
Courts are divided on the application of collateral estoppel to section 523 determinations. The court of appeals in this circuit has not ruled on the question. The cases and commentators are surveyed in Spilman v. Harley, 656 F.2d 224, 227 (6th Cir. 1981), and Massachusetts v. Hale, 618 F.2d 143, 146 (1st Cir. 1980).
In Brown v. Felsen, 442 U.S. 127 (1979), the petitioner sought to have declared nondischargeable a claim previously reduced to judgment in state court. The state judgment, reached by stipulation, did not specify whether liability rested on petitioner's fraud claim. The Supreme Court held that principles of res judicata would not apply to preclude petitioner from offering proof, beyond the state court record, of nondischargeability for fraud. The Court distinguished the application of collateral estoppel principles to dischargeability decisions. It explained that a state court determination of factual issues actually and necessarily decided would bar relitigation "in the absence of countervailing statutory policy," and it reserved the question of whether the bankruptcy law contained such countervailing policy. 442 U.S. at 139 n. 10.
Several lower court cases, both before and after Brown v. Felsen, have held that a prior state judgment does not have full collateral estoppel effect, although it is competent evidence and suffices to make out a prima facie case of nondischargeability. E.g., Carey Lumber Co. v. Bell, 615 F.2d 370, 377-78 (5th Cir. 1980); Houtman v. Mann, 568 F.2d 651 (9th Cir. 1978); Rolls Tools, Ltd. v. Herman, 6 B.R. 352 (S.D.N.Y. 1980). Judge Parente relied on the latter two of these cases, examined the record of the fraud trial, and concluded that the evidence and jury determination in that trial gave "ample support" to plaintiff's motion for summary judgment. Wiese v. Sloan, Adv. No. 881-0251-18, decision at 10 (Bankr. E.D.N.Y. April 2, 1982). Such use of the prior judgment, as evidence rather than as an estoppel, may well reflect the majority rule.
The Houtman and Herman cases limited the collateral estoppel effect of prior determinations on the grounds that bankruptcy law is federal law and that Congress had vested exclusive jurisdiction over dischargeability questions in bankruptcy court. The exclusivity provision, which is currently codified at 11 U.S.C. § 523(c), was first enacted as part of the 1970 amendments to the Bankruptcy Act. The legislative history of those amendments gives little support to limiting the effect of collateral estoppel in this case.
The primary purpose of assigning exclusive jurisdiction over dischargeability to bankruptcy court was to end certain abusive collection practices. Creditors would bring suits in state court in the hope that the debtor would fail to appear and thereby waive the defense of discharge. H.R. Rep. No. 1502, 91st Cong., 2d Sess., reprinted in 1970 U.S. Code Cong. Ad. News 4156, 4156. That rationale would not counsel against giving preclusive effect to pre-bankruptcy judgments, even ones from state tribunals.
There were, however, other legislative aims at work. The House Committee incorporated into its report a memorandum from the body that drafted the bill stating that "[o]ne of the strongest arguments in support of the bill" was that bankruptcy courts would be able to develop expertise in dischargeability questions. "The State court judges, however capable they may be, do not have enough cases to acquire sufficient experience to enable them to develop this expertise . . . . . Since this is a Federal statute, the Federal courts necessarily have the final word as to the meaning of any terms contained therein." National Bankruptcy Conference explanatory memorandum, H.R. Rep. No. 1502, supra, 1970 U.S. Code Cong. Ad. News at 4163; id. at 4160 (quoted in letter from Chief, Bankruptcy Division, Administrative Office of the U.S. Courts).
It is not clear why the need for bankruptcy court expertise on dischargeability questions would argue against relying on prior court determinations as to fraud. The requirement of issue identity should be adequate protection against the conflation of bankruptcy and tort standards. Thus the court finds persuasive the reasoning of the Sixth Circuit in Spilman v. Harley, supra, 656 F.2d at 227.28. Nothing in Brown v. Felsen, supra, or the bankruptcy law would seem to undercut the usual rationales for the issue preclusion doctrine.
But even if there is a "countervailing statutory policy" against full application of collateral estoppel to dischargeability questions, that policy, as has been seen, is in large part inapplicable to prior determinations by federal courts. In such cases, there is no need to reduce collateral estoppel to the status of mere evidence, and no need to assess the quality of the evidence in the prior proceeding or otherwise subject the record to greater scrutiny than is usual in issue preclusion cases. Of course, it will still be necessary to examine the record of the prior federal proceeding to determine whether the usual criteria for collateral estoppel are met, and the court now turns to that inquiry.
The debtor argues that the issues were not actually litigated because, in his counsel's words, he "was forced to default before trial and thus did not participate in any manner" at the trial. Appellees' reply affidavit in support of summary judgment states that the debtor "appeared, answered, and participated in the pretrial proceedings in the prior action" and that he "testified, by way of deposition testimony read into the record, at the trial." The docket sheet reveals that the debtor appeared rather than defaulted, and that he participated in the early phases of litigation, but it suggests that his participation ended considerably in advance of the trial.
Since the debtor answered appellees' claims, it was necessary for appellees to prove them at trial, even though the debtor did not participate. No bright line rule has emerged on application of collateral estoppel to determinations reached after appearance but without a fully contested trial of the merits. The predominant approach has been to apply the doctrine when the first proceeding presented sufficient incentive to litigate and the second proceeding was reasonably foreseeable. See United States v. Martin, 395 F. Supp. 954, 959 (S.D.N.Y. 1975); 18 Wright, Miller Cooper, Federal Practice and Procedure § 4442 at 376-77 (1981); cf. Fairchild, Arabatzis Smith, Inc. v. Prometco (Prod. Metals) Co., 470 F. Supp. 610, 616-17 n. 8 (S.D.N.Y. 1979) (New York and British law). But see Allen v. Zurich Ins. Co., 667 F.2d 1162, 1166 (4th Cir. 1982).
Applying the prevalent and, the court believes, the sounder approach, there can be little doubt that collateral estoppel applies to this case. The size and nature of the civil claims carried an acute incentive to contest them, and a subsequent determination of whether there should be a discharge could not possibly have caused any surprise.
The debtor argues that several elements of nondischargeability are absent from the jury verdict. The court need only consider the arguments as to section 523(a)(2)(B), which is sufficient to sustain Judge Parente's conclusion.
In arguing that appellees could not possibly have relied on his misrepresentations, the debtor merely seeks to relitigate an issue decided by the jury. Moreover, the jury found that Orvis's customers relied, and appellees are subrogated to their claims. As to the amount of appellees' payments to the customers that is attributeable to such reliance, the debtor is again bound by the civil judgment. Finally, there is not merit to the argument that section 523(a)(2)(B) cannot benefit a subrogee.
The bankruptcy court's order is affirmed. So ordered.