Bankruptcy: Marital Obligation Discharged in Bankruptcy

     The United States Bankruptcy Court in Richmond, in the case of Nelson v. Nelson, ruled that a wife’s obligation to husband was discharged. The Court found that although a Virginia Circuit Court held that the wife had to pay a husband $5,6535 for a car debt under a “hold harmless” clause in their divorce agreement, the Bankruptcy Court ruled that the State Circuit Court order was void. 

     The parties’ separation agreement, incorporated into their final divorce decree, provided that an auto was the wife’s exclusive property, that she would be responsible for debt, taxes, insurance and licensing fees on the vehicle, and that she would “indemnify and hold the Husband harmless for the same.” The wife, who received a Chapter 7 discharge in bankruptcy, contends the obligation was discharged. The husband brought a show cause proceeding in a Virginia Circuit Court seeking an order that wife remained liable for the debt secured by the auto and that she was in contempt for violating the separation agreement. The State Circuit Court entered an order stating that the wife was liable to the husband for the debt secured by the auto, or $5,635 with interest. Although the State Circuit Court found that the debtor still had an obligation to indemnify the husband, it lacked the jurisdiction to determine whether this debt had been discharged because the Bankruptcy Court has exclusive jurisdiction in discharging a pre-petition debt included in Bankruptcy Code §523 (c). In any event, the Circuit Court order was silent as to its findings on the dischargeability of the debt. The parties therefore could not argue that the Circuit Court order prevented the relitigation of the dischargeability issue based on the principle of collateral estoppel; nor could the parties argue that this matter was barred by res judicata.

     The Bankruptcy Court ruled that the debtor’s obligation to discharge the husband for the indebtedness secured by the auto was discharged by operation of Bankruptcy Code §523 (c)(1). Accordingly, Bankruptcy Code § 524(a)(1) voided the judgment the husband obtained in State Circuit Court and the discharge injunction in Bankruptcy Code §524(a)(2) further enjoined the husband from taking any action to collect this debt as a personal liability of the debtor.

Bankruptcy: Collateral Estoppel - Default Judgment in State Court

     Two cases illustrate how courts will handle default judgments being argued as collateral estoppel in bankruptcy court. 

     The United States District Court at Norfolk, Virginia, in the case of L&R Assoc. v. Curtis, reviewed the question as to whether a creditor's default judgment in state court collaterally estopped a debtor from relitigating in Bankruptcy Court whether his debt was nondischargeable because of the debtor's alleged fraud. 

     In Curtis the Bankruptcy Court found that the creditor advanced funds to the debtor for the purchase of automobiles at auction. The debtor was to be compensated in the form of half of the profits from the subsequent sale of the automobiles. The creditor apparently charged in state court that the debtor had fraudulently converted some of the purchase money to his own personal use. 

     The Bankruptcy Court found in Curtis that the issue of fraud, as alleged by the creditor, was not the subject of actual litigation in the state court action which resulted in the entry of the default judgment. The Bankruptcy Court held that because it had no evidence before it that the state court had decided this issue of fraud with "particular care", the doctrine of collateral estoppel did not apply to the judgment. Subsequently, the Bankruptcy Court dismissed the complaint upon a full trial on the merits. The United States District Court, upon appeal, agreed with the result of the Bankruptcy Court's decision, but stated that the emphasis for reaching the decision should have been on whether the state court had actually litigated the issue of fraud. The District Court recognized that counsel for the creditor represented to the Bankruptcy Court that it had presented witnesses and evidence before the state court. The judgment order indicated that the plaintiff/creditor and witnesses for the plaintiff appeared before the state trial court. Yet the creditor presented no other information to the Bankruptcy Court to indicate that the issue actually had been litigated and was necessary to the decision. 

     The Bankruptcy Court gave the creditor in Curtis more than one opportunity at the hearing on its motion for summary judgment and at trial to present evidence concerning prior litigation. The creditor presented no transcript of the proceeding before the state court or anything else to suggest that the state court entered more than a standard default judgment. 

     The District Court agreed with the Bankruptcy Court in Curtis that more had to be submitted than the state court default judgment by testimony at trial to establish that the issue was actually litigated and that the determination of the issue was necessary to the judgment of the state court. The District Court found that the Bankruptcy Court determined "with particular care" that the state court's default judgment should not collaterally estop debtor from relitigating the issue of fraud as it relates to the dischargeability of this debt.

     In Neese the creditor, a video store, had obtained a default judgment in state court against a husband and wife, who had contracted to use store material and services in a nightclub. The wife filed a bankruptcy petition. The Creditor filed a proof of claim in order to collect from the debtor's bankruptcy estate.

     The District Court in Neese found that the Bankruptcy Court evaluated the validity of the State Court judgment for reasons other than fraud. Accordingly, the District Court found that this was an error. The District Court ruled that under Bankruptcy Code §502, a creditor's proof of claim is deemed allowed unless a party in interest objects to that claim. The validity of a creditor's claim that is based on a State Court judgment may be attacked in Bankruptcy Court by an objection to a proof of claim only upon the grounds that there was a lack of jurisdiction over the parties or subject matter of the suit (which was not alleged in this case) or that the judgment was the product of fraud (which was initially raised but not pursued). The trial conducted in the Bankruptcy Court, however, focused upon whether judgment was proper against the debtor individually.

     In regard to the facts in Neese, the District Court found that the debtor had properly been served with the State Court suit, that she failed to respond to that claim, and that she failed to contest the claim on appeal even after judgment was entered. Nothing in the record indicated that the judgment was obtained fraudulently, and it was clear that the default judgment was fully enforceable in State Court.

     Accordingly, the District Court ruled that the Bankruptcy Court did not have the authority to look beyond the validity of the State Court judgment. The doctrine of res judicata applied. The creditor's claim should have been allowed.