TWENTY SIXTH ANNUAL NORTHEAST SURETY AND FIDELITY CLAIMS CONFERENCE

Transcription

1 TWENTY SIXTH ANNUAL NORTHEAST SURETY AND FIDELITY CLAIMS CONFERENCE SEPTEMBER 17th - 18th, 2015 APPLYING COLLATERAL ESTOPPEL TO LIMIT THE SCOPE OF NON-DISCHARGE ACTIONS IN BANKRUPTCY COURT PRESENTED BY: MATTHEW HOROWITZ, ESQUIRE Wolf, Horowitz, Etlinger & Case, LLC 99 Pratt Street, Suite 401 Hartford, Connecticut (860) Fax: (860) BRIAN BRAGG, ESQUIRE International Fidelity Insurance Co. Assistant Vice President, Corporate Counsel One Newark Center, 20th floor Newark, New Jersey 07102

2 APPLYING COLLATERAL ESTOPPEL TO LIMIT THE SCOPE OF NON- DISCHARGE ACTIONS IN BANKRUPTCY COURT Introduction For a surety pursuing salvage recovery against a principal or indemnitor, or a commercial crime carrier pursuing such recovery against a defalcating employee, the filing of a bankruptcy petition by the target of these actions ( Target ) is likely to be an unwelcome development. This is particularly the case if the petition is filed after judgment or settlement is obtained with respect to the Target but before the surety/carrier has been fully made whole. The principal in a fidelity claim has allegedly engaged in a theft. The principal or indemnitors in a surety salvage action may also have engaged in misconduct either by misrepresenting their finances to the surety in order to obtain bonding or by breaching a fiduciary duty to properly allocate bonded contract funds. If the Target has engaged in such wrongful conduct, one option for the surety/carrier upon the Target filing a bankruptcy petition may be to file a non-discharge complaint, claiming that the debt owed to the surety/carrier is not eligible for discharge under the Bankruptcy Code. A preliminary question that may arise upon the surety/carrier filing a non-discharge action is to what extent the elements of its nondischarge claim were litigated and decided in prior litigation ( Prior Action ) that established the Target s liability to the surety/carrier. To the extent that the facts underlying the non-discharge claim were previously litigated and decided, the doctrine of collateral estoppel requires the bankruptcy court to accept the findings reached in the Prior Action and precludes these issues from being re-litigated in the non-discharge action. This paper will address the circumstances that may bar re-litigation in a nondischarge action of issues resolved in favor of the surety/carrier in a Prior Action. This paper will also address pro-active steps that a surety/carrier may consider in pleading and litigating salvage actions in order to try to limit the scope of the issues that would need to be litigated in a non-discharge action in the event that the surety/carrier prevails against the Target only to have the Target later file a Chapter 7 petition in bankruptcy. Analysis I. Traditional Principles of Collateral Estoppel The doctrine of collateral estoppel bars parties from re-litigating fact issues previously litigated and decided among themselves and those with whom they are in privity. 1 If applicable, the doctrine requires a court in a subsequent proceeding to adopt the fact determinations previously made by the prior court. 2 1 See, e.g., Rzasa v. Bugnacki, 439 B.R. 12, 23 (Bkrtcy. D.Conn. 2010); In re Jordana, 232 B.R. 469, (B.A.P. 10 th Cir. 1999); Branton v. Hooks, 238 B.R. 880, (Bkrtcy. S.D.Ga. 1999) 2 See, e.g., In re Doctoroff, 133 3d 210, 214 (3 rd Cir. 1997); In re Bush, 62 F.3d 1319, 1322 (11 th Cir. 1995). 1

3 The particular collateral estoppel principles applied by a bankruptcy court in a non-discharge action may differ depending on whether the forum for the Prior Action was a state or federal court. 28 U.S.C requires federal courts to give full faith and credit to state court judgments. This includes applying state collateral estoppel principles to determine the operative effect of a prior state court judgment. 3 As such, bankruptcy courts typically apply state law to determine to what extent judgments in Prior Actions in state court are entitled to collateral estoppel effect in non-discharge actions. 4 This can result in differing applications of collateral estoppel in non-discharge cases depending on the law of the forum of the Prior Action. In contrast, if the forum of a Prior Action was a federal court, the bankruptcy court will apply the federal common law version of collateral estoppel. Under federal common law, in order for a party or its privy to be estopped from relitigating issues previously addressed in litigation: a. The issue in the prior and current actions must be identical; b. The issue in the current action must have been actually litigated to final judgment in the prior action; c. The determination of the issue in the prior action must have been a necessary part of the judgment entered in that litigation; d. The parties in the two actions must be identical or in privity with the initial litigants; and e. The burden of persuasion in the current action must not be significantly heavier than the burden of persuasion in the initial action. 5 Some states apply collateral estoppel rules that are identical to those applied in federal court. The rules in other states may differ somewhat from federal law. Collateral estoppel applies to non-discharge proceedings in bankruptcy and can result in a bankruptcy court in a non-discharge action deferring to the facts found by a state or federal court in a Prior Action. 6 3 In re Bugna, 33 F.3d 1054, 1057 (9 th Cir.1994); St. Laurent v. Ambrose, 991 F.2d 672, (11th Cir.1993); Rzasa v. Bugnacki, 439 B.R. 12, 23 (Bkrtcy. D.Conn. 2010); Pomeroy v. Pomeroy, 353 B.R. 371, 376 (Bkrtcy. D.Mass. 2006). See Kremer v. Chemical Construction Corp., 456 U.S. 461, (1982). 4 See, e.g., Pioneer Construction Inc. v. May, 518 B.R. 99, 116 (Bkrtcy. S.D.Ga. 2014); Shiver v. Shiver, 396 B.R. 110, (Bkrtcy. S.D.N.Y. 2008); Gilson v. Gilson, 250 B.R. 226, (E.D.Va. 2000); Itzler v. Itzler, 247 B.R. 546, (S.D.Fla.2000). 5 See, e.g., Wolstein v. Doctroff, 133 F.3d 210, 215 (3rd Cir. 1997); In re Bush, supra, 62 F.3d at 1322; In re Corey, 394 B.R. 519, 526 (B.A.P. 10 th Cir. 2008); Pomeroy v. Pomeroy, 353 B.R. 371, 376 (Bkrtcy. D.Mass. 2006). 2

4 As noted above, one critical prerequisite to applying collateral estoppel in a nondischarge action is proof that the fact issues resolved in the Prior Action are identical to those raised in the non-discharge action. As a first step to exploring how to maximize the operative effect of collateral estoppel principles to bar re-litigating the prima facie elements of a non-discharge action, the following section of this paper compares the elements for non-discharge actions with the causes of action that will most likely be asserted by a surety/carrier in a Prior Action to establish its rights to indemnity or subrogation against a Target. II. The elements to be proven to establish that a debt claimed by a surety/carrier is nondischargeable and the corresponding common law causes of action typically raised in a salvage suit. The two most common sources of authority for a surety/carrier to claim that a debt is non-dischargeable are 11 U.S.C. 523(a)(2) and 11 U.S.C. 523(a)(4). a. 523(a)(2) For purposes of a suit brought by a surety against its principal or indemnitors, a debt may be non-dischargeable if the principal or indemnitors materially misrepresented material facts that induced the surety to issue bonds. Under 11 U.S.C. 523(a)(2), a debt for the extension, renewal or refinancing of credit is non-dischargeable to the extent that: 1. Credit was secured under false pretenses or through a false representation or actual fraud; 2. Credit was secured through the use of a statement in writing that was materially false regarding the applicant s financial condition; 3. The Creditor reasonably relied on the false statement; and 4. The applicant made the false statement with intent to deceive. 7 A statement is materially false under Section 523 (a) (2) if it paints a substantially untruthful picture of a financial condition by misrepresenting information of the type which would normally affect the decision to grant credit. 8 Where a person knowingly or recklessly makes a false statement which the person knows or should know will induce another to issue credit, intent to deceive may be inferred. 9 6 See Grogan v. Garner, 498 U.S. 279, 284-5, n.11 (1991) U.S.C. 523(a)(2). 8 Bethpage Federal Credit Union v. Furio, 77 F.3d 622, 625 (2d Cir. 1996); Borg Warner Central Environmental System, Inc. v. Nance, 70 B.R. 318, 321 (Bkrtcy. N.D.Tex. 1987). 9 Bethpage Federal Credit Union v. Furio, 77 F.3d 622, 625 (2d Cir. 1996); Northern Trust Co. v. Garman, 643 F.2d 1252, (7 th Cir ), cert. denied, 450 U.S. 910 (1981). 3

5 The elements of the common law cause of action for fraudulent misrepresentation generally include the following: 1. The perpetrator made a false representation as a statement of fact; 2. The statement was untrue when made and known to be untrue when made by the party making it; 3. The perpetrator made the false statement to induce action on the part of the victim; 4. The victim relied on the false statement to his/her detriment; and 5. The victim s reliance on the false statement was reasonable. 10 The elements of the common law action for fraudulent misrepresentation closely track the prima facie case for non-discharge under 523(a)(2). Assuming that a trial court makes findings in a Prior Action establishing common law fraudulent misrepresentation in the securing of surety credit, these findings may establish the elements for non-discharge under 523(a)(2). b. 523(a)(4) Under 11 U.S.C. 523(a)(4), a debt is non-dischargeable where the debtor caused the loss through fraud or defalcation while acting in a fiduciary capacity, through embezzlement or through larceny. 11 Embezzlement is generally defined as the fraudulent appropriation of property by a person to whom such property has been entrusted, or into whose hands it has lawfully come. 12 Larceny, as defined in the common law, generally consists of the taking and carrying away of the personal property of another with intent to deprive the owner of his property permanently, and to convert the property to the use of someone other than the owner. 13 It is likely that where a commercial crime carrier brings a Prior Action in state or federal court against a defalcating employee it will need to prove up the common law elements of larceny or embezzlement and therefore it will have established the factual prerequisites for non-discharge under 523(a)(4). 523(a)(4) may also be applicable to a surety principal or indemnitor to the extent that the principal/indemnitor caused the surety a loss through fraud or defalcation while acting in a fiduciary authority. A "defalcation" for purposes of 523(a)(4) is the 10 Rzasa v. Bugnacki, 439 B.R. 12, 23 (Bkrtcy. D.Conn. 2010); Shiver v. Shiver, 396 B.R. 110, (Bkrtcy. S.D.N.Y. 2008) U.S.C. 523(a)(4). 12 United States v. Petti, 459 F.2d 294, (3 rd Cir. 1972). See Moore v. United States, 160 U.S. 268, 269 (1895). 13 United States v. Waronek, 582 F.2d 1158, 1161 (7 th Cir. 1978). See Bullock v. BancChampaign, N.A., 133 S.Ct. 1754, 1760 (2013) 4

6 misappropriation of funds held by a party in a fiduciary capacity. 14 Nondischarge under 523(a)(4) requires a culpable state of mind involving knowledge of or gross recklessness with respect to the improper nature of the fiduciary's illegal behavior. 15 "Recklessness can be established where the wrongdoer consciously disregards or is " willfully blind to a substantial and unjustifiable risk that his or her conduct will violate a fiduciary obligation (a)(4) actions may be applicable in a surety indemnity context where: (a) the principal breached its fiduciary duties secured by a probate bond; 17 (b) the principal or its indemnitors on a contract surety bond misappropriated bonded contract proceeds in violation of the terms of a trust funds statute; 18 (c) the principal or its indemnitors on a contract surety bond misappropriated bonded contract proceeds in violation of the trust provisions of an indemnity agreement; 19 or (d) the principal or its indemnitors on a contract surety bond misappropriated bonded contract proceeds in violation of the trust provisions of a bonded contract. 20 It is not as evident that there are tort causes of action that could be pleaded by a surety in a Prior Action that would, if proven, also establish all of the elements for nondischarge under 523(a)(4). In particular, neither the torts of conversion nor breach of fiduciary duty typically require proof of recklessness or intentional misconduct, as is 14 Tudor Oaks Ltd. Partnership v. Cochrane, 124 F.3d 978, 984 (8th Cir.1997); International Fidelity Insurance Co. v. Herndon, 277 B.R.765, 768 (Bkrtcy. E.D.Ark. 2002). 15 See Bullock v. BancChampaign, N.A., 133 S.Ct. 1754, (2013). 16 MacArthur Co. v. Cupit, 514 B.R. 42, (Bkrtcy. D.Colo. 2014). See Bullock v. BancChampaign, N.A., 133 S.Ct. at Heers v. Parsons, 529 B.R. 734 (B.A.P. 9 th Cir. 2015). 18 Compare MacArthur Co. v. Cupit, 514 B.R. 42 (Debt to surety is non-dischargeable to the extent that loss was caused by misappropriation of contract funds in violation of a trust fund statute) with Riden v. Tow, 196 B.R. 762 (Bkrtcy. W.D.Ky.1996) (Trust fund statute did not create trust relationship that would be required for debt to fall within discharge exception for defalcation while acting in fiduciary capacity). 19 Compare Poynter v. Great American Insurance Co., 535 F. Appx. 479 (6th Cir. 2013) (Debt to surety derives from a breach of fiduciary duty and is non-dischargeable under Section 523 (a)(4) to the extent that loss was caused by misappropriation of contract funds in violation of trust fund terms of indemnity agreement.) with Capitol Indemnity Corp. v. United States, 41 F.3d 320 (7th Cir. 1994), cert. denied, 515 U.S.1144 (1995)(Trust provision in indemnity agreement does not require a trust or impose a fiduciary obligation on the principal.). 20 See Marrs-Winn Co. v. Giberson Electric Co., 103 F.3d 584, 591 (7th Cir. 1996)(Trust provision of bonded contract imposes fiduciary obligations on the contractor). 5

7 required for non-discharge under 523(a)(4). 21 However, there may be civil causes of action particular to a jurisdiction that can be alleged by a surety in a Prior Action which would require proof of intent in order to secure an enhanced civil remedy for the wrongful taking of another s property. 22 III. Litigation strategies to maximize the applicability of collateral estoppel in a non-discharge action. a. Pleading and Taking a Case to Judgment To the extent that a surety/fidelity carrier at the outset of salvage litigation seeks to anticipate and prepare for the risk of a non-discharge action, it is important to assure that all of the elements that would need to be pleaded and proved in a non-discharge action are pleaded in the Prior Action. Regardless of this kind of planning, a fidelity carrier would almost certainly need to plead the factual equivalent of the prima facie case for non-discharge in bringing a subrogation action against the defalcating employee. A surety, however, has other options in seeking recovery against its principal and indemnitors. Generally, the most efficient cause of action available to a surety in a Prior Action is a claim for breach of contract under the operative indemnity agreement. 23 The Surety needs to prove the amount of a loss and possibly also establish that it did not act in bad faith in incurring the loss. 24 A claim that the principal and/or indemnitors fraudulently misrepresented facts in order to obtain the bonds or that the principal and/or indemnitors misappropriated bonded contract funds with an illicit intent may be more complicated, time consuming, and costly to prove and may not be likely to yield a greater recovery in the Prior Action. One reason to plead claims for fraudulent misrepresentation or breach of fiduciary duty in surety indemnity actions is to preserve the right to litigate these claims to judgment if that appears prudent to do at the time of trial. Whether or not to actually try these claims as part of a surety indemnity action involves a balance of factors to be considered, including the additional time and expense to be incurred in litigating these claims and the likelihood that the defendants might file for bankruptcy if a judgment is entered against them in the Prior Action. Securing judgment on these claims in the Prior Action may deter a subsequent 21 See Litzinger v. Estate of Victor Litzinger, 340 B.R. 897, (B.A.P. 8 th Cir. 2006) ( The actor's good faith, motive, knowledge, care or negligence are not generally involved in actions for conversion. ); Renz v. Beeman, 589 F.2d 735, 749 (2d Cir. 1978) (Breach of fiduciary duty does not require proof of intent) 22 See Kovaco v. Rockbestos Surprenant Cable Corp., 979 F.Supp.2d 252, 263 (D.Conn. 2013) (Recovery of treble damages for statutory theft under Conn. Gen. Stats. Sec requires proof of intent to steal). See also Restatement (Second) of Torts 876(b) (1977) ( For harm resulting to a third person from the tortious conduct of another, one is subject to liability [as an aider and abettor] if he knows that the other's conduct constitutes a breach of duty and gives substantial assistance or encouragement to the other so to conduct himself. ). 23 See generally THE SURETY S INDEMNITY AGREEMENT: LAW AND PRACTICE (Marilyn Klinger, George Bachrach, & Tracey Haley, eds., 2 nd ed. 2008). 24 Id. 6

8 bankruptcy filing and/or enhance the surety s negotiation position in post judgment settlement discussions. b. Settlements and Stipulated Judgments If the Initial Action is resolved through a generic settlement agreement which requires payments over time and the Target subsequently files for bankruptcy prior to paying all sums owed, no facts will have been litigated and decided in the Prior Action. Therefore, collateral estoppel principles will generally not be applicable under these circumstances in a subsequently filed non-discharge action. The Restatement (Second) of Judgments however anticipates in its commentary circumstances under which a settlement of the Prior Action may have collateral estoppel effect if the Target subsequently files a bankruptcy petition: In the case of a judgment entered without contest by confession, consent, or default, none of the issues is actually litigated. Therefore the rule of (issue preclusion) does not apply with respect to any issue in a subsequent action. The judgment may be conclusive, however, with respect to one or more issues, if the parties have entered an agreement manifesting such intention. 25 This Restatement provision was applied by the appellate court in Halpern v. First Georgia Bank. 26 The bank brought an action in state court against a borrower alleging breach of contract for failing to pay the obligation owed and intent on the part of the borrower to defraud the bank. The parties resolved the prior action through a consent judgment which mandated payment over time and incorporated detailed stipulated findings regarding the borrower s fraud. At a time when the debt remained outstanding in whole or part, the borrower filed a bankruptcy petition and the bank filed a nondischarge action. The bankruptcy court granted the bank s motion for summary judgment in the non-discharge action based on the application of collateral estoppel principles. On appeal, the panel applied the criteria set out in the Restatement and affirmed the judgment below. 27 The panel found that the parties intended that the consent judgment operate as a final adjudication of the factual issues addressed therein. The court based this conclusion in part on the detailed fact findings regarding the bank s fraud allegations that were entered by the court as part of the judgment. The court also relied on more general terms in the consent judgment such as the following: These findings of fact and conclusions of law will collaterally estop borrower from denying any of the 25 Restatement (Second) of Judgments, 68, comment e. See Halpern v. First Georgia Bank, 810 F.2d 1061 (11 th Cir. 1987); Balbirer v. Austin, 790 F.2d 1524 (11 th Cir. 1986); Kaspar Wire Works Inc. v. LECO Engineering and Machine Co., 575 F.2d 530 (5 th Cir. 1978); Pioneer Construction Inc. v. May, 518 B.R. 99, (Bkrtcy. S.D.Ga. 2014); Coates v. Kelley, 957 F.Supp (E.D.Ark. 1997); Austin v. Austin, 93 B.R. 723, (Bkrtcy. D.Colo. 1988) F.2d 1061 (11 th Cir. 1987) F.2d at

9 facts or law established herein. 28 A finding that the parties to a consent judgment intended that facts stipulated to therein have binding effect is itself heavily fact dependent. It is possible under certain circumstances that a court may accord collateral estoppel effect to facts recited in a consent judgment notwithstanding the absence of language specifically invoking the applicability of collateral estoppel principles. 29 Targets may be reluctant to stipulate to their wrongful conduct. However, a surety/carrier should be at least as reluctant to stipulate to a settlement involving payment over time where the Target has an unimpeded opportunity to evade the settlement through a subsequent bankruptcy filing. Where a stipulated judgment incorporates findings of fact, it is critical that these facts track the prima facie elements of a non-discharge action. In order to secure an agreement that incorporates such stipulations, the facts set out in a stipulated judgment can be recited as neutrally as possible. For instance, as to a fidelity principal: 1. Defendant stipulates that he took property owned by the insured valued at $ 10,000 with the intent to retain the Insured s property. 2. Defendant stipulates that s/he knew that the Insured owned the property at the time that the property was taken and Defendant further stipulates that s/he knew that s/he did not have a right to the property. As to a surety s principal/indemnitor who provided false information to the underwriters: 1. Defendant represented to the underwriters in writing that s/he owned a property in New York. 2. This statement was false when made because Defendant had sold the property to a third party one day prior to making the statement to the underwriters. 3. Defendant knew the statement was false when made. 4. Defendant made the statement in order to induce the surety to issue a bond. 28 Id. See Austin v. Austin, supra, 93 B.R. at 729 (Bankruptcy Court accords collateral estoppel effect to a consent judgment to estop a non-discharge action where the consent judgment sets out specific fact findings and the debtor had numerous opportunities to litigate the operative facts before agreeing to the entry of judgment). 29 See Austin v. Austin, supra, 93 B.R. at

10 5. The Surety reasonably relied on the statement and would not have issued the bond if the true facts were known to it. 6. Defendant made the statement because it knew that the surety would not have issued the bonds if it was made aware of the Defendant s true financial condition. As to a surety s principal/indemnitor who diverts bonded contract funds: 1. Individual Indemnitor was president of Principal. 2. Indemnitor and Principal executed an Indemnity Agreement in favor of surety under which they agreed that contract funds from projects bonded by the surety were to be held in trust to be dedicated to paying subcontractors, suppliers and workers on the particular bonded project. 3. Indemnitor understood that s/he was obligated to the surety to insure that contract funds held in trust were not diverted from their specified purpose. 4. On December 1, acting as Principal s president, Individual Indemnitor took $X in contract funds from the bonded project upon their receipt by the Principal and conveyed these funds to a lender to partially re-pay a high interest loan issued by the lender to Indemnitor personally. 5. Indemnitor knew at the time of this transaction that this payment benefited him personally but did not benefit the Principal. 6. Indemnitor knew at the time of this transaction that the Principal lacked funds necessary to pay its obligations owed on the bonded project and that the diverted funds were needed by Principal to pay these bills. 7. Indemnitor knew that the diversion of these funds would cause injury to Principal and s/he intended to cause this injury to Principal in order to further his own personal interests. 8. Indemnitor knew at the time of this transaction that these funds were held in trust by Principal and could only properly be used, in the first instance, solely to pay the Principal s obligations. 9. Indemnitor knew as of the time of this transaction that he was obligated as president of Principal to apply these funds for the benefit of Principal and that he violated his duties to Principal by diverting these funds for his own personal use. Whether or not such stipulations are likely to be a serious topic of negotiations may depend, in part, on whether or not the Target is exposed to criminal charges. If not, such stipulations may be a serious topic for settlement discussions, regardless of the Target s initial reluctance, depending on the extent to which the surety/fidelity carrier is 9

11 prepared to offer consideration for such stipulations as part of a stipulated judgment agreement. If a court does not accord collateral estoppel effect to stipulated fact findings, in whole or part, these stipulations would be admissible in the non-discharge action as statements by an opposing party and could be used either to support a motion for summary judgment or to be introduced at trial. 30 c. Default Judgments The Prior Action may be concluded through the entry of a default judgment, after which the Target files a bankruptcy petition. Default judgments do not generally have collateral estoppel effect because the court does not hear evidence and enter findings of fact. 31 However, in cases applying the federal common law of collateral estoppel (where the default in the Prior Action was entered in federal court), the case law has carved out an exception to the general rule that default judgments do not have collateral estoppel effect. Under this exception, a bankruptcy judge has the discretion to accord collateral estoppel effect to a default judgment in a Prior Action if the debtor in bankruptcy substantially participated in the Prior Action or had a fair opportunity to participate in the Prior Action. 32 Applying this exception, the courts balance the following factors in deciding whether to accord collateral estoppel effect to a default judgment notwithstanding the lack of fact findings by the court in the Prior Action: 1. The courts in a non-discharge action almost never accord collateral estoppel effect to a default in a prior action where the Target simply chooses not to appear or participate. 33 A Target may make this decision because s/he cannot afford to retain counsel and does not want to proceed pro se, s/he is judgment proof, s/he chooses not to allocate time or financial resources to a defense of the Prior Action in light of the amount of the exposure, or s/he plans to conserve resources in order to contest the matter in a different forum such as a bankruptcy court. There is nothing about these circumstances that would render a debtor unworthy of a discharge and, therefore, without more, it remains the case that a routine 30 See Federal Rules of Evidence Rule 801(c) (2). 31 Pomeroy v. Pomeroy, 353 B.R. 371, 376 (Bkrtcy. D.Mass. 2006); Luedtke v. Hodges, 271 B.R. 347, 351 (Bkrtcy. N.D.Ia. 2000). But see Lasky v. Itzler, 247 B.R. 546 (Bkrtcy. S.D.Fla. 2000) (Court accords collateral estoppel effect to a default judgment in a Prior Action where the target never appeared or contested in any respect). 32 See Cornwall v. Loesch, 109 Fed. Appx. 682 (5th Cir. 2004); Herbstein v. Bruetman, 32 Fed. Appx. 158 (7th Cir. 2002); Wolstein v. Doctroff, 133 F.3d 210, 215 (3rd Cir. 1997); Bush v. Balfour Beatty Bahamas, 62 F.3d 1319, 1324 (11th Cir. 1995); FDIC v. Daily, 47 F.3d 365, 367 (9th Cir. 1995); McCart v. Jordana, 232 B.R. 469, 472 (10th Cir. BAP 1999), affd, 216 F.3d 1087 (10th Cir. 2000); Pomeroy v.pomeroy, 353 B.R. 371, 377 (Bkrtcy. D.Mass. 2006). 33 Bush, 63 F.3d at 1325; In re Gottheimer, 703 F.2d 1136, 1140 (9th Cir. 1983); Pomeroy v. Pomeroy, 353 B.R. 371, 376 (Bkrtcy. D.Mass. 2006). 10

12 default judgment in the Prior Action will not have collateral estoppel effect in a non-discharge action. 2. In contrast, the courts carefully consider whether to grant collateral estoppel effect to a default judgment where the Target actively participated in the Prior Action either while represented or as pro se before default entered. The courts will weigh the extent to which the Target pleaded, whether the Target filed cross claims or counterclaims, to what extent the Target participated in discovery, and whether the Target filed or responded to dispositive motions. The greater the Target's participation in the Prior Action, both of a quantitative and qualitative nature, the more likely that a bankruptcy court may find that a default judgment should be accorded collateral estoppel effect The courts will consider whether a default was entered as a sanction, either as to improper discovery practice or other improper conduct before the court. Even if a default did not enter as a sanction, the courts will consider to what extent the Target did or did not evidence respect for the court's rules and procedures in the Prior Action or whether the Target obstructed the court process--- i.e., whether the Target failed to show up at hearings or court conferences without giving prior notice, whether the Target complied with scheduling deadlines, whether the Target ceased to accept mail from the court or opposing parties (possibly failing to provide notice of a new address), whether the Target failed to comply with court orders regarding discovery compliance, etc. 35 The breadth of this balancing test is evidenced by the bankruptcy court decision in Camacho v. Camacho. 36 In the Prior Action, the defendant had appeared through counsel and answered the complaint. At some point in the litigation process, he became unable to pay his counsel and unable to incur the expense associated with travel to the courthouse. He did not appear for trial and a default entered against him on all counts, including a count sounding in fraud. The defendant filed for bankruptcy and the creditor filed a non-discharge complaint and claimed that the defendant/debtor was collaterally estopped from contesting non-discharge based on the default judgment 34 For cases in which the court applied collateral estoppel to a default entered in a Prior Action at least in part because the target had actively participated in the Prior Action before default entered, see Wolstein v. Doctroff, 133 F.3d at 215; Bush v. Balfour Beatty Bahamas, 62 F.3d 1319, 1324 (11th Cir. 1995); FDIC v. Daily, 47 F.3d 365, 367 (9th Cir. 1995); McCart v. Jordana, 232 B.R. 469, 472 (10th Cir. BAP 1999), affd, 216 F.3d 1087 (10th Cir. 2000); Nortman v. Smith, 362 B.R. 438, (Bkrtcy. D.Ariz. 2007); Pomeroy v. Pomeroy; 353 B.R. 371, 377 (Bkrtcy. D.Mass. 2006). 35 For cases in which a bankruptcy court applied collateral estoppel to a default judgment entered in a Prior Action based in whole or part on a finding that the debtor had abused the litigation process in the Prior Action, see Cornwall v. Loesch, 109 Fed. Appx. 682 (5th Cir. 2004); Herbstein v. Bruetman, 32 Fed. Appx. 158 (7th Cir. 2002); Wolstein v. Doctroff, 133 F.3d 210, 215 (3rd Cir. 1997); Bush v. Balfour Beatty Bahamas, 62 F.3d 1319, 1324 (11th Cir. 1995); FDIC v. Daily, 47 F.3d 365, 367 (9th Cir. 1995); McCart v. Jordana, 232 B.R. 469, 472 (10th Cir. BAP 1999), affd, 216 F.3d 1087 (10th Cir. 2000); Pomeroy v. Pomeroy; 353 B.R. 371, 377 (Bkrtcy. D.Mass. 2006). 36 Camacho v. Camacho, 411 B.R. 496 (Bkrtcy. S.D.Ga. 2009). 11

13 entered in the prior action. The bankruptcy court agreed, finding that the debtor's participation in the Prior Action was sufficient to find that he had had a fair opportunity to litigate the question of fraud and that the fraud finding had been actually litigated and decided. 37 This balancing test affords each judge substantial discretion to afford or not afford collateral estoppel effect to a default judgment in a prior proceeding based on the bankruptcy court's perception as to whether or not the debtor has acted fairly in his contacts with the courts and therefore is deserving of a discharge or whether the debtor has misused the court system and is therefore not worthy of discharge. The balancing process is so without structure and predictability that some courts have refused to apply this exception to traditional collateral estoppel principles and have continued to hold in all or most all cases that a default judgment is not entitled to collateral estoppel effect. 38 As noted above, where a default judgment is entered by a state court in the Prior Action, the bankruptcy court in a non-discharge action applies that state's collateral estoppel principles. Some state courts have adopted in whole or part the balancing test used under the federal common law and have permitted default judgments to have collateral estoppel effect if the Target had a full and fair opportunity to litigate the issues in the Prior Action. 39 In order for a surety to take advantage of the emerging trend to expand the scope of collateral estoppel, whether under state or federal law, it is essential that the surety plead the common law causes of action and underlying facts in the Prior Action that correspond to the prima facie case for the applicable non-discharge claim. It is also necessary that the default order entered in the Prior Action specifically enter judgment in connection with the counts that would provide the findings necessary to establish non-discharge. 40 d. Unopposed Summary Judgments The courts have also addressed the applicability of collateral estoppel principles in non-discharge actions where the defendant in the Prior Action initially filed an 37 Camacho v. Camacho, 411 B.R Compare Sterling Factors, Inc. v. Schaner, 236 B.R. 495 (N.D.Ga. 1999) (court refuses to accord collateral estoppel effect to a default judgment entered in a Prior Action, finding that the defendant did not have a fair opportunity to litigate key issues in the Prior Action). 38 See Federal Insurance Co. v. Gilson, 250 B.R. 226, (Bankr. E.D.Va. 2000). 39 See Rzasa v. Bugnacki, 439 B.R. 12, (Bkrtcy D. Conn. 2010); Camacho v. Camacho, 411 B.R. 496, (Bkrtcy. S.D.Ga. 2009); Shiver v. Shiver, 396 B.R. 110, (Bkrtcy. S.D.N.Y. 2008); Luedtke v. Hodges, 271 B.R. 347, (Bkrtcy. N.D.Ia. 2000); Parker v. Parker, 241 B.R. 366, (Bkrtcy. M.D. Pa. 1999); Branton v. Hooks, 238 B.R. 880, (Bkrtcy. S.D.Ga. 1999); Brown v. Evans, No. C/A W, 1999 WL at *5-*8 (Bkrtcy D.S.C.1999). But see Elleston v. Riggle, 389 B.R. 167, (Bkrtcy. D.Colo. 2007) (holding under Colorado Law that a default judgment in a Prior Action should not be accorded collateral estoppel effect unless the debtor had engaged in serious obstructive conduct in the Prior Action). 40 See Branton v. Hooks, 238 B.R. 880, (Bkrtcy. S.D.Ga. 1999). 12

14 appearance and actively litigated, the plaintiff in the Prior Action filed a motion for summary judgment, the defendant did not file a response to the summary judgment motion, and the court entered summary judgment in the absence of opposition ( Unopposed Summary Judgment ). According collateral estoppel effect in a nondischarge action to an Unopposed Summary Judgment entered in a Prior Action is in some respects fairer than according collateral estoppel effect to a default judgment entered in a Prior Action since the court in entering a summary judgment would have reviewed admissible evidence provided by the movant and likely would have issued findings of fact based on that review. 41 On the other hand, it can be argued that reliance on an Unopposed Summary Judgment is comparable to reliance on a default judgment for collateral estoppel purposes since judgment enters in both contexts in the absence of the facts being litigated through an adversary process. 42 For purposes of the application of collateral estoppel in non-discharge actions, the courts treat Unopposed Summary Judgments similarly to their treatment of default judgments, tending to apply collateral estoppel effect to Unopposed Summary Judgments to the extent that the defendant in the Prior Action actively participated in the litigation and had a fair opportunity to litigate the underlying issues. 43 These principles were addressed in the context of a surety indemnity suit in In re Vigilotti. 44 The Surety brought an action in federal district court against its principal and indemnitors alleging, inter alia, causes of action under the operative indemnity agreement for losses incurred as a result of having issued bonds to the principal and a claim for fraud in the inducement based on the allegation that the indemnitors had knowingly misrepresented their assets during the underwriting process and that bonds would not have issued but for these misrepresentations. The indemnitors initially appeared through counsel, answered the complaint, and filed a multi-million dollar counterclaim against the surety. Immediately prior to the deadline for the defendants responding to the surety s written discovery requests, about six months after the suit was filed, defense counsel filed a motion to withdraw which was granted by the court. The surety filed and served a motion to compel discovery responses, but the service copies of the motion sent to the defendants were returned unopened. The court 41 See Katahin Associates, Inc. v. Wien, 155 B.R. 479, (N.D.Ill.1993); Brill v. Dvorak, 118 B.R. 619, (Bkrtcy. N.D.Ill.1990). 42 Id. 43 Compare United States v. Gottheiner, 703 F.2d 1136, (9 th Cir. 1983) (Court in non-discharge case applies collateral estoppel effect to Unopposed Summary Judgment entered in Prior Action because the debtor had a fair opportunity to contest the entry of judgment in the Prior Action); Staggs v. Forrester, 177 B.R. 92, (N.D.Ill.1995) (same); Katahin Associates, Inc. v. Wien, 155 B.R. 479, (N.D.Ill.1993) (same) with Brill v. Dvorak, 118 B.R. 619, (Bkrtcy. N.D.Ill.1990) (Court in nondischarge case refuses to apply collateral estoppel effect to Unopposed Summary Judgment entered in Prior Action because the issues decided through the Unopposed Summary Judgment were not actually litigated); Polechronis v. Cape Cod Needleworks, Inc., 186 B.R. 1 (D.Mass. 1995) (On appeal from bankruptcy court, district court reverses bankruptcy court s application of collateral estoppel to Unopposed Summary Judgment entered in Prior Action and remands to bankruptcy court with instructions for the court to determine whether the debtor had a good faith excuse for permitting judgment to enter in the Prior Action without opposition) B.R. 191 (Bkrtcy. D.Conn. 2014). 13

15 scheduled a phone conference to discuss the pending discovery motion and ascertain the defendants intentions regarding the litigation, but the defendants did not participate in the conference or advise the court that they would not attend. The surety filed a motion for summary judgment on both its claims for indemnity and fraud. The service copies of the motion were again returned unopened and the defendants never filed an opposition. The trial court entered summary judgment and made detailed findings both as to fraud and indemnity. The Targets filed a bankruptcy petition and the surety filed a non-discharge action under 523(a)(2). In the course of discovery in bankruptcy court, the surety ascertained that the targets in fact resided at the addresses to which pleadings had been sent and returned unopened in the course of the Prior Action. The surety filed a motion for summary judgment in the non-discharge action asserting that the defendants were collaterally estopped by the granting of the Unopposed Summary Judgment to deny the elements for non-discharge under 523(a)(2). The court applied collateral estoppel effect to the Unopposed Summary Judgment from the Prior Action and granted judgment for the surety in the non-discharge action, holding that the indemnitors had had a fair opportunity in the Prior Action to litigate further and contest summary judgment had they chosen to do so. Much as with default judgments, the case law appears to be trending toward granting Unopposed Summary Judgments collateral estoppel effect in subsequent nondischarge actions. Conclusion Where a surety or fidelity carrier s Target for salvage purposes has engaged in conduct that could warrant non-discharge under the bankruptcy code, it makes sense to anticipate and plan for a possible bankruptcy filing as of the time that a subrogation action is initially filed against the Target. The surety should seek to maximize the possibility that if the surety/fidelity carrier secures a judgment and the Target file for bankruptcy, the surety may be able to file a non-discharge petition and have that petition resolved by way of summary judgment based on the application of collateral estoppel principles. To this end, the surety/carrier should consider pleading causes of action in the Prior Action whose prima facie elements correspond to the prima facie case for non-discharge. In the event that the Prior Action settles and the settlement involves payment over time, the surety should consider memorializing the settlement through a stipulated judgment incorporating detailed fact findings regarding these causes of action. Assuming that the Target files a bankruptcy petition after entering into a settlement of the Prior Action and the surety/carrier files a petition for non-discharge, the surety/carrier may be able to secure judgment in the non-discharge action based on collateral estoppel principles even if the Prior Action is resolved through a default judgment or an Unopposed Summary Judgment. 14

16 Matthew M. Horowitz Wolf, Horowitz, & Etlinger, L.L.C. 99 Pratt Street, Suite 401 Hartford, Connecticut Phone: (860) Facsimile: (860) Matt Horowitz is a partner in the Hartford, Connecticut Law Firm of Wolf, Horowitz, & Etlinger, LLC. Mr. Horowitz graduated from Tufts University in 1973 and New York University School of Law in He is a member of the Connecticut, Massachusetts, District of Columbia and Texas Bars. Over the last 37 years, he has engaged in a varied litigation practice. For approximately 25 years, his practice has focused primarily on fidelity and surety claims and litigation in Connecticut and Massachusetts. He has co-chaired the surety presentation at the ABA Fidelity and Surety Mid-Year Meeting and presented papers at the ABA Fidelity and Surety Mid-Year Meeting, the Northeast Surety and Fidelity Conference, the National Bond Claims Association Conference, and the Surety Claims Institute. He is a coeditor of the TIPS Law of Performance Bonds Manual and the TIPS CGL/Builder s Risk Monograph and he is a contributor to numerous TIPS publications, including the Miscellaneous Bond Monograph, the Law of Commercial Surety & Miscellaneous Bonds, and The Law of Payment Bond Manual BRIAN BRAGG, Esquire International Fidelity Insurance Co. Assistant Vice President, Corporate Counsel One Newark Center, 20th floor Newark, New Jersey Brian Bragg is Assistant Vice President/Corporate Counsel for International Fidelity Insurance Company. Prior to joining the Company in 2001, Mr. Bragg worked in private practice for approximately 10 years. He received his undergraduate degree from Wayne State University (B.A., English, magna cum laude, 1988) and his law degree from the University of Michigan Law School (J.D., 1991).