CHAPTER 1 EXCEPTIONS TO DISCHARGE

• Jurisdiction: United States

CHAPTER 1: EXCEPTIONS TO DISCHARGE

When assisting clients with moving past debt through bankruptcy, debtor's attorneys may find themselves defending a discharge action. Defending the dischargeability action will depend on the type of debt and the creditor's basis for arguing it is nondischargeable, and unfortunately the analysis is not always clear.

The creditor may attempt to use collateral estoppel to prove a claim is nondischargeable, in which case it must show that there was final judgment on the merits, that the issues in the prior action and in the adversary proceeding are identical, and that the party being estopped is the same or in privity with the party from the prior action.

The dischargeability of taxes may be a common concern for debtors, but the analysis is a complicated by current ambiguity in the law. One important consideration in discharging taxes is what constitutes a tax "return." The Third, Fourth, Sixth, Seventh and Eleventh Circuits have applied the four-point Beard Test; the First, Fifth and Tenth Circuits use the "one-day-late rule;" and the outlier Eight Circuit relies on the form or content of the form, using the fourth prong of the Beard Test. Debtors are not the only ones acting without clear guidance. The taxing authority may rely on § 523(a)(1)(c) in attempting to collect non-dischargeable tax debt after a bankruptcy case, without needing to bring a dischargability adversary proceeding. However, as seen in the First Circuit Murphy case, if it turns out the debt is discharged and they acted to collect it, there may not be a good-faith defense to its willful violation of the discharge order.

Many dischargeability actions turn on questions of intent or scienter. However, do different sections of 523 require differing levels of culpability? And how can intent be proven at trial?

A. The Necessary Elements for Collateral Estoppel in Michigan Bankruptcy Adversary Proceedings

2018 Hon. Steven W. Rhodes Consumer Bankruptcy Conference

Written by:

Wendy Turner Lewis

Law Offices of Wendy Turner Lewis

Detroit, Michigan

What is Collateral Estoppel?

Collateral Estoppel prevents a party from relitigating issues of fact or law, which were necessarily decided by a previous final judgment.¹ In Bankruptcy cases, collateral estoppel applies in nondischargeablity proceedings; under the Bankruptcy Code, such as Adversary proceedings.²

If state courts would give "preclusive effect" (which is collateral estoppel) to the judgement, then the bankruptcy court must also give the judgement preclusive effect . The exception to this rule is if Congress has expressly or impliedly created an exception to 28 U.S.C.§1738, which should be applied to the facts before the federal court.

In determining the application of Collateral Estoppel in a bankruptcy proceeding, one must first consider the law of the State which the in which the judgment was rendered to determine preclusive effect.³

In order to invoke the doctrine of collateral estoppel, the party seeking estoppel must establish that:

1. There has been a final judgment on the merits in a prior action;

2. The issues are identical; and

3. The party to be estopped was a party or in privity with a party in the prior action.

With issue preclusion, it is important to note that the issue must have been "actually litigated and determined" in the prior litigation.

Under Michigan law, the following requirements must be met in order for collateral estoppel to apply:

1. There is identity of parties across the proceedings;

2. There was a valid, final judgment in the first proceeding;

3. The same issue was actually litigated and necessarily determined in the first proceeding; and

4. The party against whom the doctrine is asserted had a full and fair opportunity to litigate the issue in the earlier proceeding.⁴

When filing your complaint, one must plead pursuant to F.R.C.P. 8(a)(2), a "short and plain" statement of the claim showing that the pleader is entitled to relief. "Detailed factual allegations "are not required.⁵ The Twombly case sets forth the "flexible plausibility standard" obligating a pleader to amplify a claim with factual allegations where necessary to render it plausible.⁶ The rule set forth above does not call for sufficient factual matter, accepted as true, but only to "state a claim to relief that is plausible on its face". These cases set forth the standard for pleading the allegations necessary to set forth the plausibility of the Debtor being liable for damages in an adversary proceeding.

When a motion to dismiss is being considered, it should be noted that a motion to dismiss does not need detailed factual allegations, a moving party's obligation to provide "the grounds of his entitlement to relief requires more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do.⁷ In relying upon the legal theory of collateral estoppel, factual allegations must be enough to raise a right to relief above the speculative level, on the assumption that all of the allegations in the complaint are true in fact.⁸

In re Wahrman outlines in great detail, the standard upon which a motion to dismiss, pursuant to F.R.C.P. 12(b)(6) is overcome with the Twombly "plausibility" requirement. In the case McCallum v. Pixley,⁹ the court discusses whether or not the exact cause of action was litigated regarding a default judgment in the State court action. Substantial participation by a defendant in a state court case is not necessary in order for collateral estoppel to apply. The court determined in the above referenced cases that failure of the defendant to participate in the litigation process did not preclude collateral estoppel standing for and in the bankruptcy case.

Under Michigan law, a "true default" judgment meets Michigan's "actually litigated" requirement and must therefore be given preclusive effect under the doctrine of collateral estoppel. Substantial participation by a defendant in a State court case is not necessary in order for collateral estoppel to apply. The court determined that failure of the defendant to participate in the litigation process did not preclude collateral estoppel standing for the bankruptcy case.

The Michigan Supreme court has stated that a default judgment is just as conclusive as adjudication and as binding upon the parties of whatever is essential to support the judgement as one which has been rendered following answer and contest.¹⁰ The Sixth Circuit's Bankruptcy Appellate Panel concurred, stating that the Barnes Court shows that "the Michigan Supreme Court does not distinguish among judgments, whether entered by default or otherwise, in applying the preclusive effect of the collateral estoppel doctrine".

In the case of Townsel v. Recon Mgmt. Group,LLC,¹¹ the court sets forth in Michigan, the process for determining how an issue is "actually litigated". In this case, the same elements were established by the moving party in their adversary proceeding, by incorporating by reference, the elements of embezzlement from the debtor's state court conviction. The court concluded that the definition of embezzlement was the same as set forth in the bankruptcy court, specifically, 11U.S.C. §523(a)(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny.¹²

In this case, different from McCallum v. Pixley, the court noted that the count of fraud was only noted in the default judgement and was not plead in the complaint.

By way of comparison, several cases in this district have set forth reasons why collateral estoppel will not be able to be applied in an adversary proceeding.¹³ In this case, the issue of the application of collateral estoppel is voided, because the same elements were not plead in both cases; including both the state and the bankruptcy court adversary proceeding.

The Michigan Supreme Court has stated that "a default judgment is just as conclusive an adjudication and as binding upon the parties of whatever is essential to support the judgment as one which has been rendered following answer and contest".¹⁴

In conclusion, it is very clear that in order to rely upon the doctrine of collateral estoppel in a bankruptcy proceeding, creditors must set forth the same elements in both state court actions and the judgments that follow must fall in line with the elements set forth as necessary in bankruptcy court adversary proceedings.

B. In re Colsen and the Circuit Court Split Defining a Tax "Return"

ABI Journal

January 2018

Written by:

Justin C. Valencia

Nebraska Department of Revenue

Lincoln, Neb.

There is currently a split among the courts of appeals interpreting the definition of a "return" for purposes of dischargeability of taxes under § 523(a). In determining whether a late-filed tax form qualifies as a "return," the Third, Fourth, Sixth, Seventh, Ninth and Eleventh Circuits have adopted and applied the four-part Beard test, which occurred before the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCPA). The First, Fifth and Tenth Circuits have applied the post-BAPCPA "one-day-late rule" based on the § 523(a)(*) "hanging paragraph." In re Colsen¹⁵ is a rarely discussed anomaly from the Eighth Circuit that focuses on the form or content of the form under the fourth prong of the Beard test.

Looking at the face of the form, this presents a problem for local and state taxing authorities in the Eighth Circuit that do not accept late-filed post-assessment tax returns and an extra-ordinary definition that the U.S. Supreme Court must resolve. Colsen, a wildly out-of-step decision, and the current circuit court split regarding the definition of a "return" presents a fascinating yet unresolved Holmesian mystery.

The Split

The Beard test¹⁶ was a tax court decision prior to BAPCPA that itself drew from prior U.S. Supreme Court's opinions.¹⁷ According to the tax court in Beard, a form is a return if it (1) contains sufficient information to permit a tax to...