Dear constituency list members of the Insolvency Law Committee, the following is a case summary written by Kathleen A. Cashman-Kramer analyzing a recent case from the Bankruptcy Appellate Panel of the Ninth Circuit.
On March 7, 2023, the Bankruptcy Appellate Panel of the Ninth Circuit (the “BAP”) issued its memorandum decision in the case of In re Mack, 2023 WL 2397345 (B.A.P. 9th Cir. Mar. 7, 2023), affirming the bankruptcy court’s dismissal of a complaint under 11 U.S.C. §523(a)(4) for failure to state a claim under Federal Rules of Civil Procedure (FRCP) 12(b)(6).
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This case involved a complaint by creditor El Dorado Liquidation Associates, LLC (“El Dorado”) for determination that the debt owed to it pursuant to an assignment of a state court judgment in favor of Carter and Julie Unruh (the “Unruhs”) by the debtors Darin and Deborah Mack (“Debtors”) was nondischargeable on grounds of embezzlement under § 523(a)(4). The bankruptcy court dismissed the complaint for failure to state a claim upon which relief may be granted under FRCP Rule 12(b)(6) and El Dorado appealed to the BAP.
The Debtors owned Absolute Archery LLC (“Archery”). In 2013 and 2014, Archery borrowed a total of $140,000 from the Unruhs pursuant to a series of promissory notes (the “Notes), which obligations were secured by a lien on Archery’s inventory. The Debtors personally guaranteed the obligations. The Notes provided that Archery would be in default if any disposition of inventory resulted in a total inventory value of less than $150,000.
Archery provided to the Unruhs monthly financial statements that indicated it was maintaining the agreed amount of inventory. Archery’s December 2015 financial statements – the last one provided to the Unruhs – indicated that Archery had $205,687 of inventory on hand. In or around March 2016, Archery ceased its business operations. Debtors offered Archery’s inventory as partial payment on the notes and proposed a plan for repayment of the remainder of the debt owed to the Unruhs. The parties disagreed as to the cost value of the inventory, but the Unruhs accepted the turnover of collateral. Later, they determined that the inventory had a cost value of only $60,932.44 – approximately $35,000 less than the Debtors estimated.
The Unruhs then demanded payment in full of the notes’ balances and asserted fraud due, in part, to the $35,000 discrepancy in the cost value of the surrendered inventory. The Unruhs filed a complaint in state court against Debtors and Archery, asserting claims for breach of contract, fraud, money had and received, conversion, unfair business practices, and negligent misrepresentation. The state court entered a default judgment against Debtors and Archery for $150,616.30. The default judgment included no findings and made no attempt to specify which causes of action formed the basis for the award of damages, attorneys’ fees and interest.
After the Debtors filed their chapter 7 case in August 2018, the Unruhs filed an adversary complaint to except the default judgment from discharge under §§523(a)(2)(A) and (B). The bankruptcy court entered summary judgment in favor of the Unruhs. Debtors appealed that ruling, and the BAP reversed and remanded. The BAP found that the state court record was insufficient to warrant issue preclusion because the “actually litigated” and “necessarily decided” elements were not met, and the bankruptcy court had not analyzed the public policy prong of the issue preclusion analysis. See In re Mack, 2020 WL 4371887, at * 8.
On remand, the Unruhs amended their complaint to name El Dorado as plaintiff pursuant to the Unruhs’ assignment of the state court judgment and alleged claims under §§523(a)(2)(A), (a)(2)(B), and (a)(4), alleging that the Debtors executed the Notes and personal guarantees with the intent to deceive the Unruhs by representing that they would maintain a minimum inventory of $150,000 and that the Debtors embezzled approximately $88,439 in mortgaged inventory.
The bankruptcy court granted the Debtors’ motion dismiss the §523(a)(4) embezzlement claim without leave to amend, agreeing that the Unruhs and El Dorado lacked standing to assert such a claim because the allegedly embezzled property was owned by Archery and not the Debtors. The Debtors moved for summary judgment on the §523(a)(2) claims, which the bankruptcy court granted. El Dorado timely appealed only the dismissal of the §523(a)(4) claim.
RESULT AND REASONING.
The BAP affirmed the bankruptcy court’s dismissal of the §523(a)(4) claim. El Dorado argued that the bankruptcy court erred by ignoring the state court default judgment and by disregarding “binding California law” imposing criminal liability upon a party that sells mortgaged property without permission.
The BAP disagreed, finding that the bankruptcy court did not err in disregarding the state court default judgment in its dismissal of the §523(a)(4) embezzlement claim. The BAP referred specifically to its reversal of the initial finding by the bankruptcy court (2020 WL 4371887) and also discussed the “actually litigated” and “necessarily decided” prongs of the issue preclusion analysis, and its finding that those prongs were not met by the bankruptcy court (also finding that its 2020 decision “is now law of the case, and the matters we previously decided dispose of El Dorado’s arguments that the state court default judgment established elements of its §523(a)(4) claim.”) Id. At *2.
After reviewing the allegations of the amended complaint, the BAP discussed the requirements to plead a viable embezzlement claim. In particular, citing numerous Ninth Circuit and other cases, it stated that a plaintiff asserting an embezzlement claim under §523(a)(4) must establish that the property at issue belonged to the plaintiff. It then noted that the inventory did not belong to either the Unruhs or El Dorado and instead was owned by Archery, such that the security interest held by the Unruhs was insufficient to support an embezzlement claim under §523(a)(4) [citation omitted]. Id. At *3. Finally, the BAP concluded that regardless of whether the Debtors were correct – that El Dorado did not have standing to assert an embezzlement claim under §523(a)(4) – or otherwise, the bankruptcy court did not err in dismissing the embezzlement claim with prejudice.
Finally, El Dorado had argued that California law provides that it is the crime of larceny to sell mortgaged goods without the permission of the mortgagee (citing California Penal Code Section 538.3). The BAP found this statue and argument irrelevant and reminded El Dorado that the bankruptcy court had previously rejected El Dorado’s attempt to plead a cause of action for conversion under §523(a)(6) and that El Dorado did not appeal that denial.
It is clear that this case was decided on the facts, rather than on any nuances in, or recent changes to, applicable law. The BAP’s discussion of the law with respect to issue preclusion essentially reiterated what the law has been in connection with default judgments in this circuit. A notable take-away from this decision for practitioners is: when seeking a default judgment in a state court action in which some form of fraud (or conversion) has been pled, ensure that the judgment contains findings that satisfy the issue preclusion elements, especially the “actually litigated,” “necessarily decided,” and public policy prongs.
These materials were authored by Kathleen A. Cashman-Kramer, Of Counsel at Sullivan Hill Rez & Engel (Cashman-Kramer@Sullivanhill.com), with editorial contributions from ILC member Maggie E. Schroedter (maggie@theRSfirm.com) (email).
 The “amended complaint alleged, “Plaintiff is informed and believes that … the defendants embezzled approximately $88,439 in mortgaged inventory…. They have never accounted for this missing inventory.” It further alleged that because the inventory value exceeded $950 and was sold without the Unruhs’ permission, the alleged embezzlement was a felony under California Penal Code § 538. Finally, the complaint alleged that Debtors’ promise to maintain $150,000 of inventory was false when made but even if it were true, they did not follow through on that promise.” Id. At *3.
 This section provides: “Every person, who, after mortgaging any of the property permitted to be mortgaged by the provisions of Sections 9102 and 9109 of the Commercial Code, excepting locomotives, engines, rolling stock of a railroad, steamboat machinery in actual use, and vessels, during the existence of the mortgage, with intent to defraud the mortgagee, his or her representative or assigns, takes, drives, carries away, or otherwise removes or permits the taking, driving, or carrying away, or other removal of the mortgaged property, or any part thereof, from the county where it was situated when mortgaged, without the written consent of the mortgagee, or who sells, transfers, slaughters, destroys, or in any manner further encumbers the mortgaged property, or any part thereof, or causes it to be sold, transferred, slaughtered, destroyed, or further encumbered, is guilty of theft, and is punishable accordingly…”.