In In re Snyder (2d Cir. Sept. 12, 2019), the U.S. Court of Appeals for the Second Circuit addressed an issue of first impression and joined the Third, Ninth, Tenth and Eleventh circuit courts in recognizing an exception to the rule that a default judgment has no preclusive effect in nondischargeability proceedings: where a default judgment arises from a party's own sanctionable conduct, that party will be deemed to have had a full and fair opportunity to litigate the issues, and the judgment may be afforded preclusive effect in such proceedings.

Background

Before filing a voluntary Chapter 11 petition for bankruptcy protection in 2015, Stuart and Doreen Snyder entered into an oral agreement in 2005 with Stuart's sister and brother-in-law, Nancy and Joseph Murphy, that provided for the Snyders and the Murphys to become "silent partners" in connection with a construction project to build three luxury residential homes in New Jersey, and for the Snyders to repay the Murphys' initial investment of $100,000 in full, plus a return of 20%. In 2006, the Snyders and the Murphys similarly entered into a second oral agreement that provided for the Snyders and the Murphys to be partners in connection with a construction project to build a luxury residential home in Connecticut, and for the Snyders to repay the Murphys' investment of $275,000 in full, plus a return of 20%. Unfortunately, and unbeknownst to the Murphys, the money that they invested for the Connecticut project was used by the Snyders for other purposes.

In 2010, after the Snyders had failed to repay the Murphys in connection with either project, the Murphys filed a complaint against the Snyders and various related corporate entities in the U.S. District Court for the Eastern District of New York. The complaint included claims for breach of contract, conversion, unjust enrichment, fraudulent inducement and breach of fiduciary duty. During the course of the ensuing litigation, the Snyders continually disregarded their discovery obligations together with any number of court orders.

After the Snyders failed to respond to the Murphys' first set of interrogatories and document requests, the court granted the Murphys' first motion to compel and awarded the Murphys attorneys' fees and costs.  Subsequently, upon receiving the Snyders' "woefully deficient" discovery responses, the Murphys filed a second motion to compel, which the court granted with an additional sanctions award and a warning to the Snyders that their "obstreperous conduct" could result in the entry of default judgment. Upon the Snyders' further failure to comply, the court entered an order striking the Snyders' answer to the complaint, awarding sanctions and entering default judgment.

Successor counsel to the Snyders and corporate defendants subsequently appeared and filed a motion to vacate and, while that matter was pending, the Snyders moved on to their third law firm. The trial court then granted the motion to vacate on the condition that the previously awarded sanctions be paid in full. However, less than a month after the default judgment was vacated, the Snyders' counsel filed a motion to withdraw on the grounds that the firm had been unable to communicate with its clients and had been left with substantial unpaid legal fees. The court granted that motion.

The court next issued a scheduling order directing the parties to serve interrogatories and document requests by June 28, 2013. While the Murphys complied with the order, the Snyders and corporate defendants ignored it. The Snyders further failed to respond to a "good faith letter" sent by counsel to the Murphys requesting that the Snyders comply with the scheduling order, and then they failed to appear for their scheduled depositions and a status conference. Because of the Snyders' ongoing noncompliance with court rules, the clerk of court issued a certificate of default, and the Murphys thereafter filed a motion for the entry of a default judgment. The district court entered default judgment against each of the Snyders and the corporate defendants on the claim for breach of contract, and awarded damages in the aggregate amount of $634,778.49, consisting of $120,000 in compensatory damages arising from the breach of contract for the New Jersey project, $330,000 in compensatory damages arising from the breach of contract for the Connecticut project, and pre- and post-judgment interest.

After the Snyders commenced a voluntary Chapter 11 case in the U.S. Bankruptcy Court for the District of Connecticut, which was later converted to a case under Chapter 7 of the Bankruptcy Code, the Murphys filed an adversary complaint seeking to have the judgment debt declared nondischargeable under Sections 523(a)(2)(A) (debts obtained by false pretenses, a false representation or actual fraud), 523(a)(4) (debts obtained through fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny) and 523(a)(6) (debts obtained through willful and malicious injury by the debtor) of the Bankruptcy Code. The Murphys moved for summary judgment on all counts of their adversary complaint, invoking the doctrine of collateral estoppel and seeking to bar the Snyders from re-litigating the judgment.

The bankruptcy court granted the Murphys' summary judgment motion with respect to counts two and three (the fiduciary defalcation, embezzlement and willful and malicious injury claims) affording preclusive effect to the findings set forth in the magistrate's report and recommendation, under the doctrine of collateral estoppel, but denied the motion with respect to count one, the fraud claim. On appeal, the district court affirmed the bankruptcy court's judgment on counts two and three.

The Doctrine of Collateral Estoppel

The doctrine of collateral estoppel precludes the retrial of issues that were actually litigated and decided in a prior action. See Grogan v. Garner, 498 U.S. 279 (1991). In order for collateral estoppel to apply, the party seeking to invoke the doctrine must establish that:

• The identical issue was raised in a previous proceeding;
• The issue was actually litigated and decided in the previous proceeding;
• The party against whom the doctrine is to apply had a full and fair opportunity to litigate the issue; and
• The resolution of the issue was necessary to support a valid and final judgment on the merits.

It is the second requirement, that the issue have been "actually litigated" in the previous proceeding, which typically bars application of the collateral estoppel doctrine to a default judgment.

The Snyders appealed the district court's judgment to the Second Circuit, which joined the Third, Ninth, Tenth and Eleventh circuits in recognizing "an exception to the 'actually litigated' requirement when the party sought to be precluded actually participated in the prior litigation and had a full and fair opportunity to litigate, but the issue was resolved by default as a sanction on account of that party's own obstructive behavior," see In re Corey, 394 B.R. 519, 527-28 (10th Cir. B.A.P. 2009), aff'd, 583 F.3d 1249 (10th Cir. 2009) (holding that a default judgment entered against the debtor in a federal fraud action had preclusive effect in a subsequent nondischargeability action because it resulted from the debtor's own sanctionable conduct); see also, e.g., In re Docteroff, 133 F.3d 210 (3d Cir. 1997); In re Bush, 62 F.3d 1319 (11th Cir. 1995) and In re Daily, 47 F.3d 365 (9th Cir. 1995).

The court of appeals found that "affording a default judgment entered as a sanction preclusive effect furthers the goal of imposing the sanction in the first instance because it deprives the sanctioned party an opportunity to relitigate an issue that could and should have been decided in the first litigation," and held that the Snyders were bound by the preclusive effect of the judgment.

The court affirmed the determinations of nondischargeability as to the debt allocated by the judgment to the Connecticut project based on "ample evidence in the record" that the Murphys had made personal expenditures with funds earmarked for the Connecticut project. It vacated and remanded with respect to the determination of nondischargeability with respect to the New Jersey project on the basis that the lower courts had "failed to consider whether the debt could be fairly parsed so as to consider the debt associated with the New Jersey project separately from the debt associated with the Connecticut project," noting that proper judicial inquiry required such an analysis.

Conclusion

The appellate court's decision, which is grounded in the furtherance of policy considerations, creates less certainty for potential debtors considering bankruptcy for the purpose of discharging a debt obtained through default judgment. In advising clients, debtors' counsel should carefully review the details of any prior cases or proceedings in order to determine whether a default judgment was the result of the debtor's own obstreperous conduct, which might well be afforded preclusive effect in a nondischargeability proceeding.

As of the date of publication, no notice of appeal or petition for certiorari has been filed.

Rudolph J. Di Massa Jr., is a partner at Duane Morris. He is a member of the business reorganization and financial restructuring practice group and concentrates his practice in the areas of commercial litigation and creditors' rights.

Keri L. Wintle, an associate at Duane Morris, practices in the area of business reorganization and financial restructuring with a focus on bankruptcy and creditors' rights. Wintle represents trustees, corporate debtors, creditors and creditor committees in Chapter 7 and 11 cases.