Court Opinion

ID: 8986402
Source: CourtListenerOpinion
Date Created: 2022-11-27 11:50:28.601969+00
Date Added: 2024-06-11T17:10:48.667209
License: Public Domain

BUTZNER, Senior Circuit Judge:
The narrow issue in this appeal is whether the district court properly denied discharge of a debtor by accepting as res judicata a prior default judgment awarding damages for fraud. We conclude that the default judgment provides an insufficient basis for the denial of discharge. We reverse and remand the case with directions to the bankruptcy court to conduct an adversary evidentiary proceeding on the issue of fraud in order to decide whether the debtor should be discharged.
I
M & M Transmissions, Inc. (M & M) contracted with AAA Distributors and Associates, Inc. (AAA) to purchase automobile repair equipment. Subsequently, M & M sued AAA and its agent, Charles G. Raynor, Sr., in a North Carolina court. Raynor engaged counsel to represent him and paid a retainer of $300. His counsel did not file a formal appearance or an answer.
The state court set the case for trial on October 2, 1986. During the preceding six months Raynor and his attorney did not have any contact. Just before trial the attorney attempted to phone Raynor twice but was unable to reach him. Since nobody answered Raynor’s phone, his attorney left no message. On the day of the trial Ray-nor’s attorney moved to withdraw. The trial court granted the motion. This left Raynor with no notice of the trial and no representation. The trial court entered a default judgment against AAA and Raynor jointly and severally in the sum of $226,000 for breach of contract and express and implied warranties, fraud, punitive damages, and unfair or deceptive trade practices. The trial court also awarded M & M a $15,000 attorney fee.
After receipt of a motion to claim exempt property, Raynor learned of the default judgment and his counsel’s withdrawal. Raynor moved for relief from judgment, but the trial court denied his motion. Finding no abuse of discretion on the part of the trial court, the North Carolina Court of Appeals affirmed the judgment in part but remanded with directions that M & M elect a remedy under either the unfair trade practices claim or the fraud claim. M & M elected the fraud remedy, and the trial court entered judgment for breach of contract, fraud, and punitive damages in the amount of $144,000.
II
Raynor voluntarily petitioned for bankruptcy. M & M filed a complaint initiating an adversary proceeding to determine whether Raynor should be discharged from the judgment debt. Raynor, represented by different counsel, filed an answer protesting that he had not had an opportunity to present his defense when the trial court entered judgment against him. M & M then filed a motion for summary judgment. Raynor filed an affidavit setting forth his version of the transaction, disputing the finding of fraud on which M & M’s judgment was based.
The bankruptcy court stated that the only evidence it had in support of the motion for summary judgment was the record in the state district court. This included the complaint, the trial court’s judgment, the trial court’s order denying relief from *1148judgment, and the court of appeals’ opinion holding that the trial court did not abuse its discretion by denying Raynor’s motion for relief from the judgment and remanding the case to require an election. M & M also presented a long list of Raynor’s prior judgments.
The bankruptcy court properly held that North Carolina law and bankruptcy law were similar with respect to the elements of fraud and the standard of proof. It then concluded:
This court, in its own independent judgment, concludes that the determination that the defendant was guilty of fraud, rendered by the District Court of New Hanover County, North Carolina, was proper. In the interest of justice and judicial economy, this court chooses not to look behind the state court findings, but instead applies the doctrine of res judicata in refraining from relitigat-ing those issues aptly disposed of in the lower court.
The bankruptcy court entered summary judgment for M & M in the amount of $226,000 and denied dischargeability.
Raynor appealed to the district court which, affirming the bankruptcy court, held that the default judgment was res judicata on the issue of fraud and that the debt was not dischargeable. It corrected the judgment entered by the bankruptcy court, reducing it to $144,000. This appeal followed.
Ill
Brown v. Felsen, 442 U.S. 127, 128, 99 S.Ct. 2205, 2207, 60 L.Ed.2d 767 (1979), reiterates that although discharge is intended to provide the debtor with “ ‘a new opportunity in life,’ ” this opportunity is limited “to the ‘honest but unfortunate debtor.’ ” (Citations omitted.) For this reason, the Act does not discharge an individual debtor from “any debt ... for money, property, [or] services ... to the extent obtained by false pretenses, a false representation, or actual fraud_” 11 U.S.C. § 523(a)(2)(A) (1988). Brown v. Felsen in some respects is the converse of the controversy between M & M and Raynor, but the principles it explains are relevant. In that case the parties settled a suit by consenting to a judgment based on a stipulation. Neither the stipulation nor the judgment disclosed the nature of the liability of the debtor, who subsequently filed a petition for bankruptcy. The creditor sought to prevent the debtor’s discharge on the ground of fraud. The debtor resisted, arguing that the judgment, which lacked any indicia of fraud, was res judicata. Reversing the court of appeals, the Court said:
Refusing to apply res judicata here would permit the bankruptcy court to make an accurate determination whether respondent in fact committed the deceit, fraud, and malicious conversion which petitioner alleges. These questions are now, for the first time, squarely in issue. They are the type of question Congress intended that the bankruptcy court would resolve.
442 U.S. at 138, 99 S.Ct. at 2212.
Brown v. Felsen does not preclude reliance on an underlying judgment in all cases concerning the question of discharge. This circuit’s leading case, Combs v. Richardson, 838 F.2d 112 (4th Cir.1988), involved the question of discharge under § 523(a)(6) for assault. The reasoning of the court clearly states the rule of this circuit:
We hold that the judgment debtor here may be precluded from relitigating an issue that was actually litigated and decided in an earlier proceeding and that was necessary to the decision. However, the determination that an issue was actually litigated and necessary to the judgment must be made with particular care. Here an examination of the jury instructions and verdict in the earlier tort action clearly demonstrates that the willful and malicious nature of [the debtor’s] actions was actually and necessarily litigated.
838 F.2d at 113 (citation omitted).
We have consistently applied the principles explained in Combs. In Long v. West, 794 F.2d 928 (4th Cir.1986), the issue was whether a lump-sum payment was alimony or a property settlement. Examination of the instructions, the verdict, and the di*1149vorce decree showed that the parties litigated the issue, that the court instructed on the difference between alimony and a property settlement, and that the jury returned a verdict establishing that the payment was alimony. Consequently, we held that the bankrupt could not be discharged from the debt under § 523(a)(5).
In Whitson v. Middleton, 898 F.2d 950 (4th Cir.1990), the issue was whether § 523(a)(9) precluded discharge of a debtor from a state court default judgment arising out of a motor vehicle accident because the debtor’s intoxication caused the accident. The debtor argued that since the judgment creditors’ complaint in state court alleged only negligence, he was entitled to a discharge. The bankruptcy court properly rejected this argument and heard evidence proving that the debtor had been intoxicated. Its denial of a discharge was affirmed on appeal.
In re Myers, 52 B.R. 901 (Bankr.E.D.Va.1985), dealt with a controversy similar to the dispute between M & M and Raynor. The Commonwealth of Virginia obtained a default judgment in state court against Mr. and Mrs. Myers to recover the proceeds of hunting and fishing licenses that they sold as agents of the Commonwealth. After the Myers filed a petition in bankruptcy, the Commonwealth sought to preclude their discharge under § 523(a)(4), which bars discharge of a bankrupt from debts incurred by “fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny.” With respect to the issue of collateral estoppel, the bankruptcy court said:
The [Commonwealth] asserted that this Court should be bound by the issues determined in the state court proceeding, and that the debtor in this case is barred by the doctrine of collateral estoppel from denying there was a breach of fiduciary duty. However, the doctrine of collateral estoppel only precludes relit-igation of issues actually and necessarily decided, and it is well established that a state court default judgment does not have collateral estoppel effect because it is not the result of actual litigation.
52 B.R. at 903-04 n. 1 (citations omitted). After hearing evidence, the bankruptcy court decided that the Myers’ obligation was a simple debt, not defalcation or embezzlement, and granted discharge.
The common denominator of these four discharge cases is their recognition that an indispensable requirement of res judicata (more precisely, issue preclusion or collateral estoppel) is actual litigation of the issue. See Restatement (Second) Judgments § 27 (1982). They illustrate the law of the circuit: To preclude a debtor from litigating an issue dispositive of discharge, the record of the case giving rise to the judgment debt must show that the issue was actually litigated and determined by a final valid judgment in an earlier proceeding and that it was necessary to the decision. Combs v. Richardson, 838 F.2d at 113; see also Restatement (Second) Judgments § 27. Moreover, the bankruptcy court must determine whether the issue was actually litigated “with particular care.” Combs v. Richardson, 838 F.2d at 113.
IV
The record of the state court proceedings discloses that the issue of fraud was not actually litigated. Raynor was not aware of the proceeding. The court’s findings of fact and conclusions of law supporting its judgment were prepared by M & M’s counsel. The record contains no transcript of the evidence or depositions.
Raynor was present when the court heard his motion to be relieved of the judgment. The court found that Raynor was at fault because he failed to keep in touch with his counsel. It also found that he presented no meritorious defense to fraud. In the exercise of its discretion the court denied Raynor’s motion for relief of the judgment. The issue of fraud was not actually litigated at the hearing on the motion. The record discloses no cross-examination of M & M’s witnesses, and the court placed the burden of showing a defense to fraud on Raynor. This allocation of the burden of proof is contrary to the rule in bankruptcy that the party who challenges discharge — in this instance M & M — must prove the dispositive statutory *1150factor for nondischarge. See Long v. West, 794 F.2d at 930.
In the state appellate court, the issue of fraud was not actually litigated. That court held that the trial court had not abused its discretion in denying relief from the default judgment. The error that the appellate court corrected in the judgment dealt with election of remedies and not with the question of the existence of fraud.
V
Because the issue of fraud was not actually litigated, M & M cannot invoke the default judgment to bar Raynor’s discharge by relying on res judicata or issue preclusion. See In re Myers, 52 B.R. at 903-04 n. 1; Restatement (Second) Judgments § 27 comment e (default judgment cannot support issue preclusion).
The judgment of the district court is reversed, and this case is remanded with directions that the bankruptcy court conduct an evidentiary hearing on the issue of fraud to determine whether Raynor should be discharged.
REVERSED AND REMANDED.