State Court Judgments Not Preclusive in Dischargeability Proceedings

By: Kelly Porcelli

St. John’s Law Student

American Bankruptcy Institute Law Review Staff

In In re Mercer[1]the United States Bankruptcy Court for the Middle District of Alabama held that a pre-petition stipulation of nondischargeability entered into in connection with state court litigation did not bind the bankruptcy court in an action initiated by the creditor seeking a determination that its claim was nondischargeable.[2]  EFS, the creditor, obtained a judgment against Thomas A. Mercer, the debtor, in an Alabama state court.3  The judgment included a stipulation stating, “Mercer acknowledges that his actions constituted a knowing fraud, which would be and is non-dischargeable in the event Mercer were to file bankruptcy . . . .”4  Mercer subsequently filed for bankruptcy.5  EFS commenced an adversary proceeding seeking to except its debt from discharge pursuant to section 523(a)(2) of the Bankruptcy Code.6  EFS argued that the stipulation was sufficient evidence of fraud and that the stipulation was preclusive.7The bankruptcy court, however, held that the stipulation was not preclusive, reasoning that the resolution of the state court action was independent of the determination of the dischargeability of Mercer’s debt to EFS.8  The bankruptcy court further noted the purpose of the prior state court action was to establish the existence of a debt, whereas the purpose of the bankruptcy court action was to determine whether the debt was dischargeable.9  Ultimately, the bankruptcy court found that EFS failed to establish the elements of common law fraud, and therefore, the court denied the creditor’s motion for default judgment and dismissed its complaint with prejudice.10

 Section 523(a)(2)(A) excepts from discharge a debt “for money, property, services . . . to the extent obtained by false pretenses, a false representation, or actual fraud.”11 Many courts have held that pre-petition stipulations that a debt is non-dischargeable are void or unenforceable because allowing a debtor to waive his claim to discharge in bankruptcy is contrary to public policy.12  In In re Huang13 the court concluded it must be against public policy for a debtor to waive his claim to discharge in a subsequent bankruptcy proceeding because otherwise, “creditors would routinely require their debtors to waive.”14

Further, while it is established that a bankruptcy court may invoke the principle of issue preclusion in a nondischargeability adversary proceeding, the facts must have been “actually and necessarily litigated in a state court action’” in order for issue preclusion to apply.15  Additionally, in determining whether a prior state court judgment is preclusive, the court will look to the relevant state’s law on collateral estoppel.16  If the relevant state would have granted collateral estoppel, the bankruptcy court may give preclusive effect to that state court’s prior judgment.17  For example, in In re Sung Ho Cha,18 the court held a pre-petition judgment was preclusive as to damages but not as to whether the amount was dischargeable.19  Hence, collateral estoppel may properly be invoked by a bankruptcy court only as to “those elements of the claim that are identical to the elements required for discharge . . . .”20  Bankruptcy courts may only apply collateral estoppel if the state court “has made specific, subordinate, factual findings on the identical dischargeability issue in question . . . .”21

The Mercer court followed many of its sister courts when it opined that a creditor cannot rely solely on a pre-petition stipulations made in a state court to support a finding of dischargeability in a bankruptcy court. However, if a creditor obtains a judgment for fraud in state court, which has the same elements as a non-dischargeability claim, the creditor may be able to argue successfully that issue preclusion applies.22  Accordingly, to except a debt from discharge the creditor must “prove the elements of the underlying cause of action[,]”23and obtaining a judgment that includes those elements can potentially satisfy that burden.  Such a judgment would have “specific . . . factual findings on the identical dischargeability issue . . .” and a bankruptcy court could apply collateral estoppel in a subsequent bankruptcy proceeding.24

24 In re Dennis, 25 F.3d at 278.