Case Name: In re Kenneth L. PANCAKE, Debtor. Kenneth L. PANCAKE, Appellant, v. RELIANCE INSURANCE COMPANY, Appellee
Court: United States District Court for the Northern District of Texas
Jurisdiction: United States
Decision Date: 1996-05-17
Citations: 199 B.R. 350
Docket Number: No. 3:96-CV-0642-T
Parties: In re Kenneth L. PANCAKE, Debtor. Kenneth L. PANCAKE, Appellant, v. RELIANCE INSURANCE COMPANY, Appellee.
Judges: 
Reporter: West's Bankruptcy Reporter
Volume: 199
Pages: 350–357

Head Matter:
In re Kenneth L. PANCAKE, Debtor. Kenneth L. PANCAKE, Appellant, v. RELIANCE INSURANCE COMPANY, Appellee.
No. 3:96-CV-0642-T.
United States District Court, N.D. Texas, Dallas Division.
May 17, 1996.
Order Denying Rehearing June 4, 1996.
William Paul Rossini, Law Office of William P. Rossini, Dallas, TX, for appellant.
Robert Leighton Lipstet, Lipstet Singer & Hirsch, Houston, TX, for appellee.

Opinion:
ORDER REVERSING JUDGMENT OF BANKRUPTCY COURT
MALONEY, District Judge.
Appellant Kenneth L. Pancake appeals from an order granting Appellee's motion for summary judgment and the corresponding final judgment entered by the Honorable Robert C. McGuire in a nondischargeability proceeding filed in U.S. Bankruptcy Court. After considering the order of the bankruptcy court, the parties' briefs, and the record on appeal, the Court is of the opinion that the order and final judgment of the bankruptcy court should be reversed.
Appellee Reliance Insurance Company filed a complaint for determination of nondis-chargeability in the bankruptcy proceeding of Appellant Kenneth L. Pancake. Reliance Insurance sought an order that a debt owed by Pancake to Reliance Insurance as evidenced by a judgment entered December 18, 1992, in the 280th Judicial District Court of Harris County, Texas, was nondischargeable under the provision of the bankruptcy code rendering nondischargeable any debt arising from an act of fraud committed while the debtor was acting as a fiduciary for a financial institution. Reliance Insurance issued the blanket bond for Sunbelt Savings Association. The state court petition alleged, and he acknowledges, that Pancake was a loan officer for Sunbelt. The petition also alleged that Pancake had engaged in fraud by accepting kickbacks and other benefits in return for making loans to nominee borrowers.
In the underlying state court action, the court entered final default judgment against Pancake after striking his pleadings as a sanction for failing to comply with the court's discovery orders. On this appeal, Pancake contends that the state court judgment is not entitled to preclusive effect because it is a sanctions order and no evidence indicates that the state court based the judgment on evidence presented to it.
On Reliance Insurance's motion for summary judgment, the bankruptcy court ruled that the state court judgment is entitled to collateral estoppel effect under the Full Faith and Credit Act. 28 U.S.C. § 1738; Marrese v. American Academy of Orthopaedic Surgeons, 470 U.S. 373, 380, 105 S.Ct. 1327, 1331-32, 84 L.Ed.2d 274 (1985) (holding a federal court is required to accord a state court judgment full faith and credit in accordance with the state law of preclusion). The party seeking to invoke collateral estop-pel must establish: (1) that the facts sought to be litigated in the second action were fully and fairly litigated in the first; (2) that those facts were essential to the judgment in the first; and (3) that the parties were adversaries in the first action. Bonniwell v. Beech Aircraft Corp., 663 S.W.2d 816, 818 (Tex.1984). The bankruptcy court ruled that the second two prongs were easily met and that the only real issue concerned the first or "actually litigated" prong.
In addressing "actually litigated" issue, the bankruptcy court started with the general rule that an issue is litigated when it is properly raised by the pleadings, submitted for a determination, and actually determined. In re Garner, 56 F.3d 677, 680 (5th Cir.1995) (citing Restatement (Second) of Judgments § 27 cmt. d (1982)). Reliance Insurance raised the relevant issues in the state court pleadings and submitted them to the court for determination. Pancake filed an answer, but the state court subsequently struck his pleadings as a sanction for failure to comply with its discovery orders.
The bankruptcy court ruled that the state court determined the relevant issues even though it did not make specific findings of fact. It noted that the state court ruled that Pancake was liable to Reliance Insurance on action for fraud, "after hearing the evidence and arguments of counsel." The fraud action falls squarely within the provision of the bankruptcy code rendering non-disehargeable any debt provided for in a final judgment of a state court arising from a fiduciary's fraud against a financial institution. 11 U.S.C. § 523(a)(11). Because a state court is empowered to sanction a party for discovery abuses, Tex.R.Civ.P. 215, and a judgment rendered as a sanction can constitute a decision on the merits, In re Besing, 981 F.2d 1488, 1493 (5th Cir.1993), cert. denied, 510 U.S. 821, 114 S.Ct. 79, 126 L.Ed.2d 47 (1993), the bankruptcy court ruled that the state court determined the relevant issues for purposes of collateral estoppel.
The Court will review the bankruptcy court's conclusions of law de novo. United States v. Grayson County State Bank, 656 F.2d 1070, 1075 (5th Cir.1981), cert. denied sub nom. First Pentecostal Church v. United States, 455 U.S. 920, 102 S.Ct. 1276, 71 L.Ed.2d 460 (1982). As the summary judgment ruling concerns only issues of law, the Court will review all the issues in this dischargeability proceeding de novo. Besing, 981 F.2d at 1491-92.
On this appeal, Pancake contends that no evidence shows that the factual allegations underlying Reliance Insurance's claims in the state court action were fully and fairly litigated. Bonniwell, 663 S.W.2d at 818. To rule that the state court judgment represented a nondischargeable debt, the bankruptcy court must have found that it arose from an act of fraud committed while he was a fiduciary of Sunbelt. He points out that the summary judgment record does not indicate that the state court held a trial in his absence, held a prove-up hearing, or otherwise took testimony from witnesses. Pancake would distinguish the cases relied upon by the bankruptcy court and Reliance Insurance, in which the courts used state court default judgments for purposes of collateral estoppel, on the ground that those eases indicated that the state court took evidence before rendering a final default judgment. Garner, 56 F.3d at 677, 679 (state court took evidence against a defendant who failed to respond to requests for admissions and to appear for trial); In re Camp, 59 F.3d 548, 554 (5th Cir.1995) (judicial admissions used as evidentiary basis for state court default judgment). He contends that Reliance Insurance failed to present to the bankruptcy court any evidence upon which the state court based its default judgment.
Additionally, Pancake contends that it would be erroneous to presume that the state court must have held a prove-up hearing before it entered final default judgment because the Texas rules provide that a trial court may enter a default judgment as a discovery sanction. Tex.R.Civ.P. 215 2.b.(5).
In contrast, Reliance Insurance contends that the bankruptcy court properly entered summary judgment in its favor. It notes that the state court ruled in its final judgment that Pancake was liable to Reliance Insurance on its fraud claims, "after hearing the evidence and arguments of counsel." Reliance Insurance also contends that a state court judgment rendered as a sanction constitutes an adjudication on the merits. It relies on Mossler v. Shields, 818 S.W.2d 752, 754 (Tex.1991) and Logan v. First Bank of Houston, Texas, 736 S.W.2d 927, 930-31 (Tex.App.—Beaumont 1987, writ ref' d n.r.e.) to support this contention. In Mossier and Logan, the courts held that a party was estopped from raising in a second suit issues raised by that party in claims brought in an earlier suit which had been dismissed with prejudice for that party's discovery abuses.
Additionally, Reliance Insurance contends that Pancake would be precluded from mounting a collateral attack on the state court judgment in another state court proceeding. It relies on a Texas decision that a default judgment, as long as it is unreversed and unappealed, cannot be collaterally attacked. Allen-West Comm'n Co. v. Gibson, 228 S.W. 342, 344 (Tex.App.—Dallas 1921, writ ref'd) (holding a pre-answer default judgment establishes the allegations in the petition and cannot be attacked in a collateral proceeding); see also Long v. Chapman, 151 S.W.2d 879, 881 (Tex.App.—Fort Worth 1941, no writ) (stating that a final judgment is binding on the parties regardless of whether it is correct or not).
On its motion for summary judgment in the bankruptcy court, Reliance Insurance did not show that it was entitled to judgment as a matter of law. As the bankruptcy court noted, the preclusive effect to be accorded the state court default judgment must be determined under Texas law. Marrese, 470 U.S. at 380, 105 S.Ct. at 1331-32; Brown v. Felsen, 442 U.S. 127, 139 n. 10, 99 S.Ct. 2205, 2213 n. 10, 60 L.Ed.2d 767 (1979). Again, under Texas law, the facts to be accorded preclusive effect under collateral estoppel must be fully and fairly litigated in the earlier action. Sysco Food Svcs., Inc. v. Trapnell, 890 S.W.2d 796, 801 (Tex.1994); see also United States v. Shanbaum, 10 F.3d 305, 311 (5th Cir.1994) (stating that issues in earlier lawsuit must have been "fully and vigorously litigated" under federal law of collateral es-toppel).
Generally, a default judgment does not meet the "actually litigated" test for application of collateral estoppel. In re Turner, 144 B.R. 47, 51-53 (Bankr.E.D.Tex.1992) (refusing to collaterally estop a debtor from challenging fraud allegations in a discharge-ability proceeding even though the creditor had obtained a default judgment on his fraud claims in a Texas state court); In re Shuler, 722 F.2d 1253, 1257 n. 6 (5th Cir.1984) (noting this general rule as applied in other circuits but specifically leaving the issue open in the Fifth Circuit under federal law of collateral estoppel), cert. denied, 469 U.S. 817, 105 S.Ct. 85, 83 L.Ed.2d 32 (1984). However, a final default judgment entered after a party files an answer can serve as the basis for collateral estoppel in a subsequent bankruptcy proceeding to determine the dis-chargeability of the debt evidenced by the state court judgment. Garner, 56 F.3d at 680 (applying collateral estoppel on the basis of a default judgment entered after a trial held in the absence of defendant who failed to appear for trial).
In this ease, Reliance Insurance filed in state court a petition alleging facts, which if true, bring this case under the nondis-chargeability provision for debts arising out of a fiduciary's fraud against a financial institution. 11 U.S.C. § 523(a)(11). Although Pancake filed an answer, the state court struek his pleadings as a discovery sanction. It entered a default judgment against him ruling that he was liable to Reliance Insurance on its fraud claims. However, no evidence on the record shows the evidentiary basis on which the state court based its judgment. As Pancake points out, the summary judgment record does not indicate that the state court held a trial in his absence, held a prove-up hearing, or otherwise took testimony from witnesses. The only indication that the state court considered evidence is its statement that it heard "the evidence and arguments of counsel."
This single line referencing the evidence and arguments of counsel is insufficient summary judgment evidence to conclude that the "actually litigated" prong of the test for collateral estoppel has been met. Other courts employing collateral estoppel have found this prong to be met when the default judgment is supported by evidence bearing on the facts on which litigation in the second action is barred. Garner, 56 F.3d at 680 (basing collateral estoppel on evidence presented at the trial held in the defendant's absence in the underlying state court case); Camp, 59 F.3d at 549, 553-54 (preventing a debtor from contending that her residence was a homestead in a bankruptcy proceeding on the basis of a pre-answer default judgment entered in an earlier action supported by the debtor's deemed admission that she had abandoned her homestead claim); In re Browning, 182 B.R. 913, 915 (Bankr.M.D.Fla.1995) (applying collateral estoppel where state court fully litigated issues). Likewise, courts have examined the evidentiary state of the record in the previous action in assessing whether to apply collateral estoppel on the basis of a consent decree in a subsequent discharge proceeding in bankruptcy court. In re Lacy, 947 F.2d 1276, 1277 (5th Cir.1991) (applying federal law of collateral es-toppel); see also Shuler, 722 F.2d at 1255-57.
Similarly, a bankruptcy court has applied collateral estoppel to preclude a debtor from asserting that her debt was nondischargeable as it arose from a "willful and malicious injury" on the basis of a state court judgment entered after her pleadings had been stricken as a discovery sanction. In re Limbaugh, 155 B.R. 952, 955 (Bankr.N.D.Tex.1993). The bankruptcy court applied collateral es-toppel, in large part, because the defendant participated in the damages hearing held in state court after default had been entered as to liability. Id. at 956. The court prevented litigation of the "willful and malicious injury" issue, necessary for a ruling of nondiseharge-ability, because the state court was required to, and actually did, receive evidence "that the degree and type of [debtor's] conduct warranted punitive damages." Id. at 958 (also noting that the state court took evidence on both liability and damages issues at the damages hearing). The evidence establishing that the debtor's conduct warranted punitive damages in state court was sufficient on the nondischargeability issue. In contrast, no summary judgment evidence in this case shows that the state court received comparable evidence on the issue of whether Pancake defrauded Sunbelt while acting as one of its fiduciaries.
The rule of Mossler, Logan, and Besing that a final judgment entered against a plaintiff as a sanction for discovery abuses can preclude that plaintiff from asserting those claims in a subsequent action does not resolve the "actually litigated" issue. A similar type of judgment served as the basis for collateral estoppel in Garner. Again, the defendant failed respond to requests for admissions and to appear for trial. However, the Garner court rested its holding that the relevant facts had been actually litigated in the state court action not on the defendant's failures but on the fact that the state court had held a trial in the defendant's absence and received testimony and evidence. Garner, 56 F.3d at 678, 680. The Garner court noted the Texas rule that a plaintiff must carry his burden of proof in a post-answer default situation. Id. In this case, the state court was authorized to enter a default judgment as a sanction, without taking evidence, because of Pancake's discovery abuses. No summary judgment evidence indicates that the state court held, in Pancake's absence, a trial similar to the one in Garner.
For the "actually litigated" prong to be met, the cases, especially Garner, but also Camp and Limbaugh, evince a requirement that some evidence underlying the state court judgment serve as the basis for the application of collateral estoppel in a subsequent nondischargeability proceeding. The opportunity to contest the allegations in the underlying state court proceeding, while .vital to a later application of collateral estoppel, is not the sole requirement. Otherwise, any valid default judgment obtained after proper service of process would serve as the basis for collateral estoppel. This is not the rule, however, and the courts have noted that a defendant may suffer default for many valid reasons other than the merits of the claims against him. Garner, 56 F.3d at 680.
The holdings of Allen-West and Long do not compel a different result. The holding of Allen-West, that a pre-answer default judgment cannot be collaterally attacked, does not determine the "actually litigated" issue. Allen-West involved a pre-answer default judgment where the defendant was deemed to have admitted the allegations contained in the plaintiffs petition. Allen-West, 228 S.W. at 344. Usually a pre-answer default judgment is insufficient for collateral estoppel. 18 Chaeles A. Wright, Arthur R. Miller, & Edward H. Cooper, Federal Practice and Procedure § 4442 (1981). Moreover, in contrast to the Allerir-West defendant, Pancake filed an answer in the state court action and, thus, put the allegations in Reliance Insurance's petition at issue. Stoner v. Thompson, 578 S.W.2d 679, 683 (Tex.1979) (stating that a plaintiff in a post-answer default situation must meet his burden of proof). Again, no summary judgment evidence shows Reliance Insurance met this burden. The holding in Long is likewise inapplicable. The Long court applied res judicata to an issue which was a lesser included proposition to the issues involved in a claim determined by a judgment entered in a previous action after litigation on the merits. Long, 151 S.W.2d at 880-81.
In summary, the summary judgment record does not reflect that the "actually litigated" prong for the application of collateral estoppel was satisfied in the state court pro ceeding. Turner, 144 B.R. at 51-53; In re Stowell, 113 B.R. 322, 329-30 (Bankr.W.D.Tex.1990). Thus, the order of the bankruptcy court is reversed, and the case is remanded for further proceedings.
It is worth noting once again that the relevant issue in this ease is whether the debt evidenced by the state court judgment arose out of Pancake's alleged fraud against Sunbelt while he was one of its fiduciaries. This issue is narrower than those posed by the underlying state court action. Cf. Shuler, 722 F.2d at 1256-57. On remand, the application of collateral estoppel may prove appropriate upon a showing, possibly in a renewed summary judgment motion, that Reliance Insurance met its post-answer burden under Stoner on its fraud claims in the state court action.
It is therefore ORDERED that the judgment of the bankruptcy court entered November 22, 1995, is reversed. This action is remanded for further proceedings consistent with this order.
. Appellant's Brief, at 10 (Apr. 5, 1996).