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    This case addresses whether a creditor established a prima facie case that a debt was nondischargeable in bankruptcy by introducing only a state court default judgment against the debtor for fraud. The court found that the default judgment did not have preclusive effect and that the bankruptcy court was required to independently determine if the elements for an exception to discharge under the bankruptcy statute were met. The court also noted that collateral estoppel did not apply because the issues were not actually litigated in state court due to the default judgment. Allowing such a default judgment to preclude relitigation of facts would undermine federal bankruptcy policy.

    Original Description:

    Filed: 1978-06-21 Precedential Status: Precedential Citations: 579 F.2d 289 Docket: 77-1566

    Original Title

    In the Matter of John Smith McMillan John S. McMillan John McMillan Bankrupt. (D. C. No. B-75-150 in Bankruptcy) in the Matter of Mary McMillan Bankrupt. (D. C. No. B-75-151 in Bankruptcy) Appeal of Freedom Finance Co., Inc, 579 F.2d 289, 3rd Cir. (1978)

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    This case addresses whether a creditor established a prima facie case that a debt was nondischargeable in bankruptcy by introducing only a state court default judgment against the debtor for fraud. The court found that the default judgment did not have preclusive effect and that the bankruptcy court was required to independently determine if the elements for an exception to discharge under the bankruptcy statute were met. The court also noted that collateral estoppel did not apply because the issues were not actually litigated in state court due to the default judgment. Allowing such a default judgment to preclude relitigation of facts would undermine federal bankruptcy policy.

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    United States Court of Appeals, Third Circuit

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    This case addresses whether a creditor established a prima facie case that a debt was nondischargeable in bankruptcy by introducing only a state court default judgment against the debtor for fraud. The court found that the default judgment did not have preclusive effect and that the bankruptcy court was required to independently determine if the elements for an exception to discharge under the bankruptcy statute were met. The court also noted that collateral estoppel did not apply because the issues were not actually litigated in state court due to the default judgment. Allowing such a default judgment to preclude relitigation of facts would undermine federal bankruptcy policy.

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    of 8

    579 F.

    2d 289

    In the Matter of John Smith McMILLAN, John S. McMillan,


    John McMillan,
    Bankrupt. (D. C. No. B-75-150 In Bankruptcy) In the Matter
    of Mary McMILLAN, Bankrupt. (D. C. No. B-75-151
    In Bankruptcy)
    Appeal of FREEDOM FINANCE CO., INC.
    No. 77-1566.

    United States Court of Appeals,


    Third Circuit.
    Submitted under Third Circuit Rule 12(6) Feb. 13, 1978.
    Decided June 21, 1978.

    John S. Giava, Newark, N. J., for appellant.


    Paul C. Gretchyn, Ocean-Monmouth Legal Services, Inc., Toms River, N.
    J., for appellee.
    Before GIBBONS and HUNTER, Circuit Judges and WEBER,* District
    Judge.
    OPINION
    WEBER, District Judge.
    This case raises the question of whether a bankrupt's creditor has made a
    prima facie case that his claim is nondischargeable under 11 U.S.C.
    35(a)(2) (Supp.1977)1 by introducing into evidence only the state court
    record and default judgment grounded in fraud.2
    Appellees John and Mary McMillan filed voluntary petitions in
    bankruptcy on January 27, 1975, and were duly adjudicated bankrupt and
    released from all dischargeable debts. On April 2, 1975, the appellant,
    Freedom Finance Company, filed in bankruptcy court a complaint which
    sought to have the McMillans' obligation to it declared nondischargeable.
    In support of this claim, appellant argues that a default judgment by the
    Ocean County, New Jersey district court that the bankrupts had been

    guilty of fraud in failing to disclose the full amount of their indebtedness


    when applying to Freedom Finance for a loan, as a matter of law,
    compelled a determination that the debt in question was nondischargeable.
    After this issue was briefed and argued by the parties, the bankruptcy
    judge ruled that he was
    "still bound to ascertain for . . . (himself) that the elements of an exception
    to dischargeability established by 17a(2), have been fully proven by the
    Plaintiff. This cannot be accomplished by mere reference to the wording
    of an earlier judgment. Rather this court must review the prior
    proceedings and determine whether Plaintiff has shown the elements of
    conduct required of the Bankrupt. . . . "
    under that section.3
    At the hearing on this claim, appellant failed to produce any proof other
    than the Ocean County judgment and record and, having found this
    insufficient, the bankruptcy judge dismissed the complaint and held the
    debt to be dischargeable. On appeal, the district court adopted the opinion
    of the bankruptcy judge and affirmed.
    Prior to 1970, a bankruptcy court granted the bankrupt a general discharge
    but did not rule on whether any specific obligation was nondischargeable
    on statutory grounds. Any judgment creditor could seek to enforce or
    execute on his claim in the appropriate forum, which would litigate the
    issue of dischargeability if the bankrupt raised his discharge as a bar. To
    do this, the court would examine the record of the judgment sought to be
    enforced to determine the nature of the judgment. In 1970, Section 17 c
    was amended to its present form. The effect of this change was to vest in
    the bankruptcy court exclusive jurisdiction to determine the
    dischargeability of debts allegedly falling within 17 a(2). See Herzog,
    Bankruptcy Act and Rules, 1975 Collier Pamphlet Edition at 61. The
    problem in this case, then, involves two analytically separate questions:
    (1) Apart from any special nature of a bankruptcy case, what is the
    collateral estoppel effect of the state court judgment in this case on the
    bankruptcy proceedings?
    (2) If the doctrine of collateral estoppel would apply so that the bankrupt
    could be barred from relitigating facts necessary to the judgment rendered
    by the state court, do the federal policies in bankruptcy cases supersede
    the policy of finality of judgments represented by the doctrine of collateral
    estoppel?

    One of the recent cases on collateral estoppel in this Circuit is Haize v.


    Hanover Insurance Co., 536 F.2d 576, 579 (3d Cir. 1976) wherein the
    doctrine was defined as follows:
    "Restatement of Judgments 68(1) (1942) states:
    'Where a question of fact essential to the judgment is actually litigated and
    determined by a valid and final judgment, the determination is conclusive
    between the parties in a subsequent action on a different cause of action . .
    .'.
    Thus, there are at least four requirements which must be met before
    collateral estoppel effect can be given to a prior action: (1) the issue
    sought to be precluded must be the same as that involved in the prior
    action; (2) That issue must have been actually litigated; (3) it must have
    been determined by a valid and final judgment; and (4) the determination
    must have been essential to the prior judgment." (footnotes omitted).4
    At this point, an examination of what actually happened in the state court
    proceedings is illuminating. Freedom Finance Co. commenced that action
    with a complaint which alleged that:
    "2. On or about September 21, 1973, defendants borrowed money from
    plaintiff and executed a promissory note therefor upon which note a
    balance of $1,082.37 is past due and owing, inclusive of accrued interest.
    3. That before making said loan defendants submitted their statement in
    writing showing all their outstanding obligations and listed 3 debts
    totalling $2480, on which plaintiff relied.
    4. That in truth and in fact defendants had 7 or more obligations totalling
    over $10,000.
    5. Had plaintiff known the truth it would not have made such a loan.
    6. That plaintiff has been damaged in the sum of $1,082.77 by defendants'
    misrepresentation." Appendix at 10.
    At the hearing, appellant's president testified substantially to this effect
    and added that, in a telephone conversation, John McMillan had admitted
    that he had known of the debts which had not been listed in the loan
    application at the time of its submission.
    From this, two conclusions must be drawn. First, Freedom Finance did not

    adequately plead in the state court complaint elements required by 17 a


    that either of the McMillans had made the false representations knowing
    at the time that they were false and with the intention and purpose of
    deceiving the creditor. Public Finance Corp. of Redlands v. Taylor, 514
    F.2d 1370 (9th Cir. 1975). Second, even if the proof at trial was sufficient
    to justify a finding by the trier of fact that John McMillan had had such
    knowledge and intent, no proof was offered that Mary McMillan had also
    committed "actual fraud involving moral turpitude," Wright v. Lubinko,
    515 F.2d 260, 263 (9th Cir. 1975).5
    In any case, we conclude that, because the bankrupts did not "actually
    litigate" the Ocean County case, not even facts which were necessary to
    that judgment can collaterally estop them from relitigating the same issues
    in the bankruptcy case. This holding is consistent both with general rules
    of collateral estoppel and with the federal policies in bankruptcy cases.
    See Vol. 1B Moore's Federal Practice P 0.419(3. 6), at p. 3121.
    The theory underlying the doctrine of collateral estoppel, as well as res
    judicata, is that, as between the parties and their privies, an issue need and
    should be judicially determined only once. Where the bankrupt or his
    trustee has actually litigated a suit prior to the determination of factually
    related issues in bankruptcy court, the collateral estoppel principle should
    and does apply in accordance with the requirements of Haize, supra.
    However, the preponderant view is that preferred by the Restatement,
    especially in comments d and e to Section 68 (1942): a default judgment
    has no collateral estoppel effect.6
    "To invoke the doctrine of collateral estoppel in default causes is not only
    an oppressive application of the doctrine, but it misconceives the nature of
    a default judgment.
    The defendant in a suit should not be compelled, at his peril, to embark on
    extensive litigation involving perhaps some minor matter 'in order to
    prevent the operation of a judgment which would be held conclusively to
    have established against him every material fact alleged and not denied in
    the declaration, so as to preclude him from showing the truth if another
    controversy should arise between the same parties.' There may be various
    reasons why the defendant does not wish to contest a suit . . . In any event
    a default judgment should be given the precise effect it merits. It should,
    of course, be conclusive in a subsequent suit on the same cause of action
    involving the same parties or their privies. But it should not, in a
    subsequent suit on another cause of action between the parties preclude
    the litigation of issues not litigated in the defaulted action, whether alleged

    or not. A plaintiff 'cannot justly complain that the defendant has not seen
    fit to set up defenses and raise issues for the purpose of enabling him to
    settle facts for future possible controversies.' " Vol. 1B Moore's Federal
    Practice P 0.444(2) at 4006-07 (footnotes omitted).
    This is in accordance with the approach preferred by the treatise writers
    dealing with this question in the bankruptcy context, who advocate a rule
    allowing the bankruptcy court to relitigate factual issues determined by
    the state court in every 17 a(2) case. See Volume 1A Collier on
    Bankruptcy, (14th Ed.), P 17.16, pp. 1650-1650.3; Cowan's Bankruptcy
    Law and Practice, Supplement, 433 at p. 102 (1973). Clearly, adoption
    of the result urged upon us by the appellant giving full collateral estoppel
    effect to all facts necessarily determined by a prior default judgment
    would in bankruptcy court determinations under 17 a(2)
    " . . . necessarily defeat a major federal policy of granting exceptions to
    discharge only in certain circumstances specified by the bankruptcy Act . .
    .
    The court also wishes to point out that creditors should not be encouraged
    to go into state courts prior to bankruptcy seeking default judgments based
    upon fraud. Such a circumstance would create an injustice greater than
    that which the 1970 amendments were intended to cure."

    Opinion of the Bankruptcy Judge, Appendix at 45-46. For these reasons the
    order of the court below will be affirmed.

    GIBBONS, Circuit Judge, concurring.

    I agree that the order of the district court must be affirmed. In all cases covered
    by 28 U.S.C. 1738, federal courts must give state court judgments the same
    full faith and credit they have in the state of origin. In this case, the collateral
    estoppel effect of the Ocean County District Court judgment is determined by
    the law of New Jersey. In Texas Co. v. Di Gaetano, 71 N.J.Super. 413, 432, 177
    A.2d 273, 283 (1962), the Superior Court of New Jersey, Appellate Division,
    stated the effect to be given a prior default judgment:

    4 is to be noted that judgment here was entered by default, and while such a
    it
    judgment is conclusive as an adjudication between the parties of whatever is
    essential to support the judgment, it is conclusive only as to such matters or issuable
    facts as were properly averred in the complaint. Girard Trust Co. v. McGeorge, 128
    N.J.Eq. 91, 101, 15 A.2d 206 (Ch. 1940). A judgment by default does not estop a

    defendant as to matters which he might have affirmatively pleaded. Phillips v.


    Phillips, 118 N.J.Eq. 189, 192, 178 A. 265 (Ch. 1935), reversed on other grounds,
    119 N.J.Eq. 462, 183 A. 220 (E. & A. 1936), and affirmed in part, 119 N.J.Eq. 497,
    183 A. 222 (E. & A. 1936).
    5

    As the majority correctly observes, Freedom Finance did not adequately plead
    in the state court complaint all the elements required to avoid discharge by
    section 17a of the Bankruptcy Act, 11 U.S.C. 35. Under New Jersey law the
    McMillans are, therefore, entitled to a fresh determination of dischargeability
    by the bankruptcy court.

    But I find no reason to rest our decision on New Jersey law. Even if state law
    on the preclusive effect of the judgment were to the contrary (which it is not), I
    would vote to affirm the order of the district court in this case. Section 1738 is
    not without exceptions. Federal habeas corpus is one illustration of the
    proposition. See Townsend v. Sain, 372 U.S. 293, 83 S.Ct. 745, 9 L.Ed.2d 770
    (1963); Fay v. Noia, 372 U.S. 391, 83 S.Ct. 822, 9 L.Ed.2d 837 (1963). In my
    opinion, this is another.

    In 1970 Congress amended the Bankruptcy Act in order to eliminate certain


    abuses by finance companies. Under the unamended Act the bankruptcy court
    had determined whether to grant a discharge, but state courts had been able later
    to determine whether any given claim had survived discharge because it was
    founded on a materially false statement intended to deceive. The 1970
    amendments were designed to make the bankruptcy court the sole forum for
    the determination of the dischargeability of a certain type of debt:

    8 type of debt held by a finance company against a nonbusiness bankrupt which,


    (a)
    through tactics often found abusive of the bankruptcy discharge, survives the
    discharge in a subsequent suit which the bankrupt failed to defend, for one reason or
    another.
    9

    1A Collier on Bankruptcy P 17.15, at 1628.2 n.45c (14th ed. 1973). See also
    H.R.Rep. No. 91-1502, 91st Cong. 2d Sess. (1970), reprinted in (1970)
    U.S.Code Cong. & Ad.News, p. 4156.

    10

    The issue in this case is whether a finance company holding the same type of
    debt can evade the congressional intent by securing a state court judgment
    against a delinquent borrower in anticipation of his bankruptcy. I think that the
    answer should be no, and that we should admit an exception to the federal duty
    to recognize state court judgments imposed by 1738. When Congress

    expressly identifies an abuse, when it has the constitutional power to correct it,
    and when as here it exercises that power, then the courts should give the
    congressional act its full effect. While I agree with the majority's analysis as far
    as it goes, I would prefer to rest the affirmance on this more fundamental
    reason.

    Honorable Gerald J. Weber, United States District Judge for the Western
    District of Pennsylvania, sitting by designation

    35. Dischargeability of debts Debts not affected by discharge


    (a) A discharge in bankruptcy shall release a bankrupt from all of his provable
    debts, whether allowable in full or in part, except such as . . .
    (2) are liabilities for obtaining money or property by false pretenses or false
    representations, or for obtaining money or property on credit or obtaining an
    extension or renewal of credit in reliance upon a materially false statement in
    writing respecting his financial condition made or published or caused to be
    made or published in any manner whatsoever with intent to deceive or for
    willful and malicious conversion of the property of another.
    11 U.S.C. 35(c) sets forth the procedure for the determination of
    dischargeability.

    The text of the state court judgment was as follows:


    "It is, on this 11th day of December, 1974:
    ORDERED that judgment be and is hereby entered against the defendants in
    the sum of $1,082.77 plus costs of $14.40 and attorney's fees of $36.65.
    It is furthered Ordered, that said judgment is grounded in fraud and
    misrepresentation on the part of the defendants."

    Opinion by Amel Stark, Bankruptcy Judge, reproduced at p. 39 of the


    Appendix

    In its Tentative Draft no. 1 (1973), the ALI has proposed the following revised
    version of Section 68
    "Issue Preclusion General Rule
    When an issue of fact or law is actually litigated and determined by a valid and

    final judgment, and the determination is essential to the judgment, the


    determination is conclusive in a subsequent action between the parties, whether
    on the same or a different claim."
    5

    The bankruptcy judge, after reviewing the state court transcript and pleadings,
    concluded that Freedom Finance had failed satisfactorily to demonstrate that:
    "(1) Defendant made such representations knowing they were false;
    (2) Defendant made such representations with the intention and purpose of
    deceiving the Plaintiff;
    (3) Plaintiff actually relied upon such misrepresentations; and
    (4) Plaintiff suffered damage as the proximate result of such representations
    having been made." Appendix at p. 43.
    He further noted that Freedom Finance Co.'s 1973 loan to the McMillans was
    the sixth to them in a period of five years and intimated that this fact cast doubt
    on the appellant's ability to prove that it had relied on the misrepresentations in
    the 1973 application in making that loan.
    As to points 1, 3 and 4, however, it seems to us that the testimony offered at the
    state court hearing would have been sufficient to support findings against the
    McMillans on these points.

    We have read and considered those cases cited to us by appellant on this point
    and find in them nothing to the contrary. While a default judgment does have a
    res judicata effect which bars either party from again litigating the Same cause
    of action, as held by the court, in for example, Riehle v. Margolies, 279 U.S.
    218, 49 S.Ct. 310, 73 L.Ed. 669 (1929), the appellant has here, as in other
    sections of its brief, confused res judicata and collateral estoppel

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