Default Judgments Are (Sometimes) Nondischargeable Under Issue Preclusion

Two decisions handed down on successive days under Illinois law explain when a default judgment will or will not result in a nondischargeable debt as a result of issue preclusion, or collateral estoppel.

Bankruptcy Judge Thomas M. Lynch of Rockford, Ill., confronted the more typical case. The debtor and the plaintiff were riding their motorcycles together after dark. The front wheel of the debtor’s motorcycle hit the back of the plaintiff’s, causing both to fall off their bikes and resulting in injuries to the plaintiff.

The plaintiff filed suit in Illinois state court, alleging negligence. The debtor did not respond to the complaint. The plaintiff’s counsel submitted a $1 million judgment by default, in which he inserted a handwritten section stating that the judgment was for willful and malicious conduct.

The debtor filed a chapter 7 petition after entry of the judgment. The plaintiff filed a complaint alleging that the $1 million default judgment was nondischargeable under Section 523(a)(6) as a “willful and malicious injury.”

In an opinion on August 6, Judge Lynch said that the debtor had not received notice that the plaintiff would base the default judgment on “willful and wanton” conduct. Calling for a trial on the merits, he denied the plaintiff’s motion for summary judgment based on issue preclusion.

After trial, Judge Lynch explained why the facts would not invoke Illinois law on issue preclusion. He said that language about “willful and malicious conduct” was “unnecessary to the judgment on a complaint for negligence.” Also, he said that the debtor “received no notice that the judgment may have included such a finding and the Plaintiff failed to show that the issues of maliciousness and willfulness were actually litigated.”

In an August 7 opinion also under Illinois law, the Eleventh Circuit explained when issue preclusion can result in nondischargeability following a default judgment. However, the facts were different in critical respects.

The plaintiffs sued in Illinois state court, alleging that the defendants violated state securities laws by making misrepresentations and selling unregistered securities. The complaint also claimed common law fraud.

The defendants answered the complaint, asserted affirmative defenses, submitted affidavits and exhibits, and filed a motion to dismiss and a motion for summary judgment. Later, the trial court entered a judgment by default when the defendants refused to respond to interrogatories and produce relevant documents.

After the entry of judgment, the defendants filed chapter 7 petitions in Florida. The plaintiffs responded with an adversary proceeding to render the judgment nondischargeable under Section 523(a)(19). That section makes debts nondischargeable if based on a “judgment” or “order” for violation of state or federal securities laws.

Invoking issue preclusion, Bankruptcy Judge Cynthia C. Jackson of Orlando, Fla., ruled that the debt was nondischargeable. The district court affirmed, and so did the Eleventh Circuit in an 11-page, unpublished opinion on August 7. The circuit court interpreted Illinois law on issue preclusion because it was the state in which the judgment was entered.

Illinois applies the usual rules on issue preclusion. The issues in the prior proceeding must have been (1) identical with those in the subsequent proceeding, (2) actually litigated, (3) necessarily decided in a final judgment on the merits, and (4) asserted against the same party or someone in privity.

The circuit court surveyed Illinois caselaw and reported that the common type of default judgment — where the defendant never appears — does not give rise to issue preclusion.

The Eleventh Circuit was obliged to make a so-called Erie guess because the Illinois Supreme Court has not ruled on whether issue preclusion can apply to default judgments. However, the Atlanta-based appeals court said there were no Illinois cases saying that “issue preclusion could never apply to a default judgment.”

The circuit court concluded that Illinois would not adopt a rule where a default judgment would never have preclusive effect. The appeals court found a distinction between cases where the defendant never appeared and those where the defendant litigated, asserted defenses, and filed motions.

The circuit court concluded that the issue was “actually litigated,” with the result that “the default judgment qualified for issue preclusion under Illinois law.”

Were the rule otherwise, the appeals court said that a defendant could engage in “gamesmanship” by litigating until “the case was not going their way” and then drop out, hoping to “escape the preclusive effect of that judgment because it was entered by default.”

The Eleventh Circuit upheld the judgment of nondischargeability. Because the complaint specifically alleged violations of state securities law, the appeals court ruled that “the default judgment was necessarily for the violation of securities laws.”

In Judge Lynch’s case, by the way, he entered judgment after trial in favor of the debtor discharging the debt. He said that the plaintiff had failed to prove that the debtor was anything other than negligent or reckless. Of significance, he said that the debtor’s lack of a motorcycle license and insurance were not material to whether the debtor intended to injure the plaintiff.

Observation: Neither opinion is inconsistent with Brown v. Felsen, 442 U.S. 127 (1979), where the Supreme Court held that res judicata, or claim preclusion, does not bar the bankruptcy court from looking behind a stipulated judgment in state court to determine whether the debt was nondischargeable.

The Eleventh Circuit opinion is Creech v. Viruet (In re Creech), 18-12584 (11th Cir. Aug. 7, 2019); the Illinois bankruptcy court opinion is Draka v. Andrea (In re Andrea), 18-96014 (N.D. Ill. Aug. 6, 2019).