NJ Bankruptcy Court Says State Court Default Judgment For Fraud Not Binding
Assume the following scenario: A client consults with a NJ bankruptcy lawyer about filing a bankruptcy case. During the course of their initial meeting, the client discloses that one of his largest creditors recently filed a lawsuit in the Superior Court of New Jersey (“NJ Court”) accusing him of engaging in fraud, and that he failed to respond to the lawsuit which resulted in the Court entering a judgment by default (or default judgment) against him for $200,000 predicated on fraud.. “How does this default judgment affect my bankruptcy case?,” the client asks the lawyer.
The lawyer explains that while bankruptcy will discharge or wipe out most unsecured debts that the Bankruptcy Code provides a remedy for creditors to challenge the discharge of a particular debt grounded in fraud. To secure an exception to discharge, the Bankruptcy Code requires the creditor to file a separate lawsuit (called an adversary proceeding) in the Bankruptcy Court challenging the discharge of the creditor’s debt. An adversary proceeding to except a debt from discharge on the grounds of fraud must be filed within a very limited time frame set by the Bankruptcy Code, and if the creditor fails to meet this deadline then his fraud claim is considered discharged.
Since the NJ Court already has determined the client to have engaged in fraud, will that finding be binding upon the client in a subsequently filed bankruptcy case? In other words does the NJ Court’s default judgment predicated on fraud conclusively establish that the client committed fraud so that the creditor will automatically be able to except the $200,000 debt from being discharged in a subsequently filed bankruptcy case? As discussed herein, the answer is “no” according to several published decisions issued by the United States Bankruptcy Court for the District of New Jersey.
A judgment is the final part of a court case. A valid judgment resolves all the contested issues and terminates the lawsuit, since it is regarded as the court's official pronouncement of the law on the action that was pending before it. It states who wins the case and what remedies the winner is awarded. Remedies may include money damages, injunctive relief, or both. A judgment also signifies the end of the court's jurisdiction in the case, except for post-judgment collection proceedings in aid of execution on the judgment.
A default judgment results from a defendant's failure to appear in court or from one party's failure to take appropriate procedural steps. A default judgment is entered upon the failure of the party to appear or to plead at an appropriate time in response to a complaint filed with the Court. Before a default judgment is entered, the defendant must be properly served notice of the pending action. The failure to appear or answer is considered an admission of the truth of the opposing party's pleading, which forms the basis for a default judgment.
In cases filed in the Law Division of the NJ Court, there is a 35-day period for a defendant to file an answer once served with the Complaint. There could be several reasons why a defendant may not respond to a lawsuit, including excusable neglect – i.e., defendant simply forgets to respond within the 35-day time period,or the family member living in the defendant’s household who gets served with the Complaint forgets to give it to the defendant, the process server never actually serves the defendant but submits a false affidavit of service, the defendant is unable to afford the services of a lawyer, the defendant was in the military service, etc.
The NJ Court Rules provide the defendant with an opportunity to petition the State Court to have the default judgment vacated.R. 4:50-1 offers several different bases to vacate a default judgment, including excusable neglect. A motion to vacate a default judgment must be brought within in a reasonable time, and usually not more than 1 year after entry of the judgment.
The decision whether to vacate a default judgment, brought under R. 4:50-1, also rests in the discretion of the court. Marder v. Realty Constr. Co., 84 N.J.Super. 313, 318 (App. Div. 1964). Since the main scope of this article addresses whether a default judgment is binding in a subsequently filed bankruptcy case, I will not be addressing the myriad of factors that courts consider when considering a defendant’s application to vacate a default judgment under R. 4:50-1.
Is a Default Judgment Binding on the Bankruptcy Court?
The Bankruptcy Code ("Code") is designed to relieve debtors from the weight of oppressive indebtedness and to provide them with a "fresh start." In re Cohn, 54 F.3d 1108, 1113 (3rd Cir.1995). This "fresh start" is available only to the "honest but unfortunate debtor." Grogan v. Garner, 498 U.S. 279, 287, 111 S.Ct. 654, 659, 112 L.Ed.2d 755 (1991); In re Fegeley,118 F.3d 979, 983 (3rd Cir.1997); In re DeBaggis, 247 B.R. 383, 388 (Bankr.D.N.J.1999).
However, not all debts owed by an individual debtor are discharged in bankruptcy. Certain debts, listed in 11 U.S.C. §523 are excepted from discharge, including actual fraud. The plaintiff has the burden of establishing all elements of a section 523 exception to discharge by a preponderance of the evidence. Grogan, 498 U.S. at 287-88, 111 S.Ct. at 659-60. Exceptions to discharge are to be construed strictly against creditors and liberally in favor of debtors.
In most instances, a default judgment issued by a court of competent jurisdiction is final as to all issues raised in the lawsuit. In fact, the legal doctrine of collateral estoppel (or issue preclusion) prevents the parties to a lawsuit from getting a “second bite at the apple” by subsequently relitigating the same issues previously raised and litigated between them.
Under New Jersey law, the doctrine of collateral estoppel, which prohibits the relitigation of issues that have been resolved in a prior lawsuit, applies in bankruptcy discharge proceedings. See Grogan v. Garner, 498 U.S. 279, 284-85 n.11 (1991); In re Docteroff,133 F.3d 210, 214 (3rd Cir. 1997).
"A federal court must give to a state-court judgment the same preclusive effect as would be given that judgment under the law of the State in which the judgment was entered." Walker v. Horn,385 F.3d 321 (3rd Cir. 2004) (internal citations and quotations omitted). See also 28 U.S.C. § 1738 (requiring federal courts to give state court judgments the same full faith and credit they have in the state of origin.). There are limitations on the application of collateral estoppel, however, because NJ law treats a default judgment to be a final or conclusive adjudication between the parties only as to such matters or issuable facts as were properly alleged in the complaint. Girard Trust Co. v. McGeorge, 128 N.J.Eq. 91, 101 (Ch. 1940).
Under New Jersey law, a party asserting collateral estoppel must satisfy five elements: 1) the issue to be precluded is identical to the issue decided in the prior proceeding; 2) the issue was actually litigated in the prior proceeding; 3) the court in the prior proceeding issued a final judgment on the merits; 4) the determination of the issue was essential to the prior judgment; and 5) the party against whom the doctrine is asserted was a party to or in privity with a party to the earlier proceeding. In re Estate of Dawson, 136 N.J. 1, 20 (1994).
Whether these requirements have been met should be decided "by the bankruptcy judge after a careful review of the record of the prior case, a hearing at which the parties have the opportunity to offer evidence, and the making of findings of fact and conclusions of law." In Re Ross, 602 F.2d 604, 607 (3rd Cir. 1979).
In several published decisions, the United States Bankruptcy Court for the District of New Jersey has held that a state court default judgment based on fraud is not conclusive in a subsequently filed adversary proceeding brought under the fraud exception to discharge provision set forth in Bankruptcy Code Section 523(a)(2)(A). Mattson v. Hawkins (In re Hawkins),. 231 B.R. 222 (D.N.J. 1999); and Grumbine v. Azeglio (In re Azeglio), 422 B.R. 490 (Bankr. D.N.J. 2010).
Make no mistake, the Bankruptcy Court will apply the doctrine of collateral estoppel when a matter is “actually litigated” in state court. However, because the fraud exception to a bankruptcy discharge is an independent federal law that requires evaluation of a different set of criteria, the Bankruptcy Court does not view a state court default judgment as satisfying the “actual litigation” factor for collateral estoppel to apply because the state court could not have considered the discharge issue pre-bankruptcy.
In the Grumbine case, the defendant actually participated in the case but failed to appear on the scheduled trial date. Another co-defendant also failed to appear on the trial date. Following a proof hearing (or evidentiary hearing), the state court judge entered a default judgment against both defendants for the sum of $772,419 plus attorneys’ fees, finding that they violated the New Jersey Consumer Fraud Act regarding their failure to disclose the existence of an underground storage tank in connection with the sale of a residential property.
When one of the defendants (Nicholas Azeglio) filed for bankruptcy, the plaintiffs in the state court case filed an adversary proceeding objecting to the discharge of their debt and argued that the state court default judgment was binding on the issue of fraud. U.S. Bankruptcy Judge Judith H. Wizmur rejected the plaintiffs’ argument, finding that collateral estoppel did not apply because the issue of fraud was not litigated in the state court:
Here, although the debtor participated actively in pretrial proceedings, he did not participate at all at the trial, and had no opportunity to present a defense to the trier of fact. Although the court accepted proofs from the plaintiff in the action, the proceeding was akin to the entry of a default judgment against the debtor. The debtor did not have his day in court. No preclusive effect may attach to the judgment.
While every case is decided on its own set of facts, when it comes to the serious matter of weighing a debtor’s right to a fresh start versus a creditor’s right to challenge discharge of his/her debt on the grounds of the fraud exception to discharge, the New Jersey Bankruptcy Court will not apply collateral estoppel to give conclusive effect to a state court default judgment predicated on fraud.
Comments