Generally, a default judgment is not grounds for invoking collateral estoppel because the underlying issue was not actually litigated, the Second Circuit said.
However, the Manhattan-based appeals court joined four other circuits by finding an exception to the rule: When the default judgment results from “bad conduct,” and the defaulting party had an opportunity to litigate, Circuit Judge Rosemary S. Pooler said that “the default judgment has preclusive effect when determining the nondischargeability of a debt in a bankruptcy proceeding.”
Default for Discovery Violations
The case involved two couples who had been friends. The defendants were home builders. They borrowed a total of $375,000 from the plaintiffs, ostensibly to build two homes that were to be sold. The defendants promised the plaintiffs a 20% return on their investments.
Having received nothing on their investments, the plaintiffs sued in the Eastern District of New York, alleging that the defendants has used the investments for personal expenses, not to build homes. The plaintiffs asserted claims including breach of contract, conversion, fraudulent inducement, and breach of fiduciary duty.
The suit in the EDNY proceeded for three years with little progress as a result of the defendants’ refusal to comply with discovery orders. As Judge Pooler said in her September 12 opinion, the record “conclusively establishes that the [defendants] repeatedly failed to comply with their discovery obligations.”
The defendants succeeded once in having the EDNY vacate a default judgment entered as a consequence of the defendants’ shortcomings in discovery. On the plaintiffs’ second motion to strike the answer and enter judgment, the magistrate judge recommended entering a default judgment. The magistrate judge also entered proposed findings of fact and conclusions of law justifying an award to the plaintiffs of more than $630,000, including compensatory damages for breach of contract on the two projects, plus prejudgment interest.
In the absence of objection, the district court entered judgment as recommended by the magistrate judge.
A few months later, the defendants filed a chapter 11 petition in Connecticut that was converted to chapter 7. The plaintiffs filed an adversary proceeding followed by a motion for summary judgment aiming to bar the discharge of the judgment based on collateral estoppel, also known as issue preclusion.
The bankruptcy judge granted the motion for summary judgment based on defalcation, embezzlement and willful and malicious injury under Sections 523(a)(4) and (a)(6). The district court affirmed, providing Judge Pooler with an opportunity to decide whether a default judgment can result in nondischargeability based on collateral estoppel.
The Exception to the Rule on Default Judgments
Among the four elements necessary for invoking collateral estoppel, Judge Pooler focused on the requirement that the underlying issue be “actually litigated.” Ordinarily, she said, that requirement “bars a court from giving a default judgment preclusive effect.”
However, Judge Pooler joined the Third, Ninth, Tenth and Eleventh Circuits by “recognizing an exception to that rule: where the default judgment is entered as a sanction for bad conduct, and the party being estopped had the opportunity to participate in the underlying litigation, the default judgment has preclusive effect when determining the nondischargeability of a debt in a bankruptcy proceeding.”
Judge Pooler explained that the exception “furthers the goal of imposing the sanction in the first instance because it deprives the sanctioned party [of] an opportunity to relitigate an issue that could and should have been decided in the first litigation.”
Since the defendants had “repeatedly failed to comply with their discovery obligations,” Judge Pooler ruled that they were “bound by the facts decided by the [EDNY] and necessary to the entry of the [EDNY] Judgment, including that (1) the [defendants] entered, and breached, agreements with the [plaintiffs] regarding the [building projects]; and (2) both [defendants] are liable for the resulting damages.”
Next, Judge Pooler examined whether the facts found in the EDNY could support a judgment of nondischargeability, even though the New York court had only entered judgment for breach of contract. Of course, breach of contract in itself is not grounds for nondischargeability.
Parsing the EDNY’s fact-findings, Judge Pooler said that the undisputed facts demonstrated that the plaintiffs and defendants had entered into a joint venture, where the parties as a matter of law have fiduciary duties to one another. But having breached that duty by using the money for personal expenses was not enough.
To show defalcation while acting in a fiduciary capacity under Section 523(a)(4), Judge Pooler said, the evidence must also show a “culpable state of mind” that can be proven by “conscious misbehavior or extreme recklessness.” To satisfy that requirement for collateral estoppel, she said the EDNY had found that the defendants acted with “gross recklessness in using monies intended . . . for purchasing” one of the two properties.
Judge Pooler therefore upheld the nondischargeability of the debt associated with one project. As to the other project, she remanded the case for the lower courts to decide whether the record in the EDNY established similar recklessness with respect to the second project.
Click here to read an ABI report on two decisions handed down on successive days in August under Illinois law, one where a default judgment did not qualify for collateral estoppel, and a nonprecedential decision from the Eleventh Circuit where discovery abuses did result in a default judgment that became nondischargeable.
Generally, a default judgment is not grounds for invoking collateral estoppel because the underlying issue was not actually litigated, the Second Circuit said.
However, the Manhattan-based appeals court joined four other circuits by finding an exception to the rule: When the default judgment results from “bad conduct,” and the defaulting party had an opportunity to litigate, Circuit Judge Rosemary S. Pooler said that “the default judgment has preclusive effect when determining the nondischargeability of a debt in a bankruptcy proceeding.”
Default for Discovery Violations
The case involved two couples who had been friends. The defendants were home builders. They borrowed a total of $375,000 from the plaintiffs, ostensibly to build two homes that were to be sold. The defendants promised the plaintiffs a 20% return on their investments.
Having received nothing on their investments, the plaintiffs sued in the Eastern District of New York, alleging that the defendants has used the investments for personal expenses, not to build homes. The plaintiffs asserted claims including breach of contract, conversion, fraudulent inducement, and breach of fiduciary duty.
The suit in the EDNY proceeded for three years with little progress as a result of the defendants’ refusal to comply with discovery orders. As Judge Pooler said in her September 12 opinion, the record “conclusively establishes that the [defendants] repeatedly failed to comply with their discovery obligations.”