The following is a case update written by the Hon Meredith Jury (United States Bankruptcy Judge C.D. Cal., Ret.), analyzing a recent decision of interest:

The Ninth Circuit Bankruptcy Appellate Panel recently ruled that issue preclusion was properly applied against a debtor in a nondischargeability action under §523(a)(6) based on a state court judgment notwithstanding that (1) the bankruptcy court failed to address the public policy element of issue preclusion and (2) the debtor was deprived of his opportunity to complete his appeal of the state court judgment when the chapter 7 trustee sold those appellate rights to the successor of the state court plaintiff. Delannoy v. Woodlawn Colonial, L.P. (In re Delannoy), 2020 WL 3406066 (9th Cir. BAP 6/19/20).

To view the opinion, click here.

FACTS

Debtor Chad Paul Delannoy lost his job as captain of a luxury yacht when his employer discovered he was stealing money and property. State court litigation followed, resulting in a civil judgment (Judgment) against him based on conversion, with an award of punitive damages because he “had acted with fraud, malice, and an intent to cause economic injury.” Delannoy appealed the Judgment, while the state court plaintiff assigned it to Woodlawn. While his appeal was pending, Delannoy made what turned out to be the critical error of filing a chapter 7 petition. As the BAP so aptly described, the chapter 7 trustee “promptly seized the helm in his appeal [and] Delannoy was no longer the master of his appellate fate.”

After a noticed compromise and sale motion, with competitive overbidding that included Delannoy, the trustee sold the estate’s appellate rights to Woodlawn, which had commenced an adversary against Delannoy, asserting the Judgment was nondischargeable under §§ 523(a)(2), (4), and (6). As soon as Woodlawn was substituted into the pending appeal as appellant, it voluntarily dismissed the appeal, rendering the state court judgment final. It then filed a summary judgment motion in the adversary, asserting that the Judgment was nondischargeable by application of issue preclusion. The bankruptcy court granted the motion, finding the Judgment nondischargeable under § 523(a)(6) based on tortious conversion. It subsequently, at Woodlawn’s request, dismissed the alternative claims and certified the summary judgment as ripe for appeal under Fed. R. Civ Pro. 54(b).

The BAP affirmed, holding that the application of issue preclusion was sound, notwithstanding Delannoy’s loss of his rights to pursue the appeal and that the bankruptcy court had failed to make findings on what is accepted as “the sixth element” for the application of issue preclusion under California law, public policy concerns.

REASONING

Delannoy argued that none of the six criteria for issue preclusion existed. The bankruptcy court and the BAP were required to apply the elements of issue preclusion under California law because the judgment was rendered on a state law claim in a California court. Those elements are: (1) the issue is identical to that in the first suit; (2) the issue was actually litigated; (3) the issue was necessarily decided; (4) the decision is final and on the merits, and (5) the party to be bound is the same as, or in privity with, the party to the first suit. Lucido v. Super. Ct., 51 Cal. 3d 335, 341 (1990). Even if those criteria are met, application of preclusion law also must be consistent with public policy. Id. at 343. The BAP addressed each criterion in turn, determining the Judgment satisfied all. The unique aspect of this published opinion, however, is how the BAP handled Delannoy’s assertion that allowing the state court appellee/bankruptcy court plaintiff to buy and then dismiss the appeal destroyed the necessary finality and privity criteria and also made application of preclusion a violation of public policy, an element which the bankruptcy court had failed to address at all.

The BAP concurred that the bankruptcy judge did not make a public policy inquiry, but rather than remand for the bankruptcy court to address that issue, it determined that the record was sufficiently developed for it to do so in the first instance. Although Delannoy asserted broad public policy concerns, the BAP focused only on those stated in Lucido, “preservation of the integrity of the judicial system, promotion of judicial economy, and protection of litigants from harassment by vexatious litigation.” It found the integrity of the judicial system was not impugned in an instance where the debtor voluntarily relinquished his right to control the appeal by filing a chapter 7 and then those rights are sold through a judicially supervised sale. The process was neither improper nor unfair. Application of issue preclusion directly promoted judicial economy and the BAP saw no vexatious behavior.

The BAP next analyzed California authorities to respond to Delannoy’s assertion that the Judgment had evaded appellate review because of the sale to Woodlawn. These authorities provide that appellate rights can be waived or forfeited. Although facially it could appear that Delannoy did not waive or forfeit them since he initiated a timely appeal, but he was solely responsible for his loss of those rights through the bankruptcy sale because he filed his chapter 7 before the appeal was completed. The BAP considered this to be the functional equivalent of relinquishment of his appellate rights and therefore the sale followed by dismissal did not defeat the “final on the merits” element. Similarly, the BAP found this voluntary relinquishment of his defensive rights by his filing of Chapter 7, which he had held throughout the trial and commencement of the appeal, was tantamount to an assignment of those rights (to the trustee), which would assure privity, not defeat it.

AUTHOR’S COMMENTS

The lesson here is simple for a defendant in a state court action which results in a judgment with potential nondischargeable findings: do not file a chapter 7 before your appeal of the adverse judgment has been completed or you will lose the opportunity to control that appeal. The outcome here was totally predictable if competent and experienced bankruptcy counsel had thought it through. There was no question that the right to appeal was an asset, control of which would be in jeopardy with a chapter 7 filing. It is well known that trustees often sell litigation claims to the party opposing nonbankruptcy court litigation. Now, usually that party is a defendant in litigation initiated by the debtor, but the criteria for sale of an estate asset are the same as they would be for a sale to a stranger to the litigation. So long as the court recognizes the transfer as a sale, not just a compromise, all due process elements are met. And they were expressly met here when the debtor actively participated in the bidding. The debtor put himself in this spot, and it was the voluntary nature of his actions that reverberated throughout the BAP’s reasoning.

One more thing jumps out at me and that is on the public policy concerns. Not only do I find no public policy violations because of the voluntary relinquishment of control by the debtor, but it is the opposite result which would challenge the integrity of the judicial system. Should a state court defendant who has lost after litigating on the merits, resulting in a judgment which will most likely be nondischargeable in bankruptcy (say, a fraud judgment where the elements are found or, as here, conversion with intent to injure findings) be able to escape the preclusive effect by interrupting a likely losing appeal by filing a bankruptcy and then claim no privity or finality when his opponent buys his rights in a noticed sale? I think the answer to that query is evident.

These materials were authored by the Hon Meredith Jury (United States Bankruptcy Judge C.D. Cal., Ret.), a member of the ad hoc group, with editorial contributions by Adam A. Lewis, Senior Counsel, Morrison & Foerster LLC, a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.