In re Stone

• Decision Date: 23 December 1988
• Docket Number: No. 88 B. 20195 (HS),88 Civ. 7329 (GLG).,88 B. 20195 (HS)
• Citation: 94 BR 298
• Parties: In re Norman STONE, Debtor. Richard STONE, Plaintiff/Appellee, v. Norman STONE, Defendant/Appellant.
• Court: U.S. District Court — Southern District of New York

94 B.R. 298 (1988)

In re Norman STONE, Debtor.

Richard STONE, Plaintiff/Appellee, v. Norman STONE, Defendant/Appellant.

Nos. 88 B. 20195 (HS), 88 Civ. 7329 (GLG).

United States District Court, S.D. New York.

December 23, 1988.

Aronwald & Pykett, White Plains, N.Y. (Daniel J. Pykett, of counsel), for plaintiff/appellee.

Barr and Faerber, Spring Valley, N.Y. (Harvey S. Barr, of counsel), for defendant/appellant.

MEMORANDUM DECISION

GOETTEL, District Judge.

This bankruptcy is the product of various partnerships operated by two brothers, Norman and Richard Stone, gone sour. The acrimonious dispute between the two has moved well beyond sibling rivalry into the realm of full-fledged internecine warfare. The abbreviated facts are as follows.

The two brothers (hereinafter referred to by their first names) were partners in a collection of business entities involved primarily in the manufacture and sale of floor tiles and kitchen cabinets. Beginning in 1976, Norman engaged in various and sundry schemes whereby partnership assets were diverted or concealed for his personal use. Slowly grasping this reality, Richard initiated legal proceedings in state court in 1978 that ultimately sought, inter alia, a dissolution and accounting of the brothers' partnership interests. Following trial, and finding that Norman had misappropriated partnership assets through a series of underhanded and devious practices, a dissolution and accounting were ordered. Stone v. Stone, Nos. 7141/79 & 11987/80 (Sup.Ct. June 24, 1983), aff'd as modified, 109 A.D. 2d 834, 486 N.Y.S.2d 358 (2d Dep't), appeal dismissed, 65 N.Y.2d 1053, 494 N.Y.S.2d 1061, 484 N.E.2d 1059 (1985). Following appeal, the matter was returned to the trial court for the accounting.

Norman, confronted by the reality that he would finally have to account to his brother for the misappropriated assets of what had apparently become a multi-million dollar business, filed for reorganization under Chapter 11 of the Bankruptcy Code on March 6, 1986 in the Central District of California. Barely one month later, the case was converted to Chapter 7.

Richard then petitioned for relief from the automatic stay to permit the court-ordered accounting, and further interposed an objection to the discharge of his as yet undetermined claim. The California bankruptcy court denied the motion for relief from the stay pending a trial on the dischargeability question. In July of 1987, however, before that trial could take place and almost seventeen months after Norman had filed his bankruptcy petition, Richard moved to transfer the proceeding to New York. That motion was granted.

Upon transfer to the bankruptcy court in this district, Richard moved for summary judgment on the dischargeability issue. He argued that Norman was collaterally estopped from relitigating certain factual issues decided by the state court that would, in effect, necessarily preclude discharge. In sum, claims deriving from the "fraud or defalcation" of the debtor while the debtor was acting in a "fiduciary capacity" are not dischargeable in bankruptcy. 11 U.S.C. § 523(a)(4) ("section 523(a)(4)"). Richard maintained that the state court dispositively determined that Norman had engaged in fraud and defalcation while serving as a partner and that, therefore, collateral estoppel prevented the relitigation of those issues now. The bankruptcy court, the Honorable Howard Schwartzberg presiding, agreed and granted the summary judgment motion. Stone v. Stone (In re Stone), 90 B.R. 71, 75 (Bankr. S.D.N.Y.1988). In addition, Judge Schwartzberg found that, because the debtor received a Chapter 7 discharge on November 3, 1987, and because Richard's claim had been deemed a non-dischargeable debt, neither the automatic stay nor a post-discharge injunction would operate to prevent the accounting, which could thus proceed apace. Id. at 81. Norman appeals that judgment on various grounds, which we consider seriatim.

1. Non-dischargeability and the use of collateral estoppel

Appellant's principal contention is that fraud and defalcation were not issues actually litigated in the state court proceeding, which was limited solely to determining if a dissolution and accounting of the brothers' partnership interests were warranted. Thus, it is posited, collateral estoppel improperly was invoked. We disagree.

The Supreme Court has noted that "if, in the course of adjudicating a state-law question, a state court should determine factual issues using standards identical to those of § 17 of the Bankruptcy Act, the precursor to section 523 of the current Bankruptcy Code, then collateral estoppel, in the absence of countervailing statutory policy, would bar relitigation of those issues in the bankruptcy court." Brown v. Felsen, 442 U.S. 127, 139 n. 10, 99 S.Ct. 2205, 2213 n. 10, 60 L.Ed.2d 767 (1979) (dictum). Notwithstanding the Felsen dictum, some courts have placed limitations on the use of collateral estoppel in the context of section 523(a)(4). We, however, agree with and adopt the precedent cited by the bankruptcy court in its decision and find that, consistent with the Felsen dictum, collateral estoppel is applicable in the context of a section 523(a)(4) determination. Stone, 90 B.R. at 74-75. Thus, invocation of collateral estoppel in such circumstances will be appropriate when issues before the bankruptcy court are the same as issues actually and necessarily litigated in a prior proceeding that have been determined by a final judgment. MA & M Inc. v. Supple (In re Supple), 14 B.R. 898, 903-04 & n. 7 (Bankr.D.Conn.1981) (and cases collected therein).

Here, had the bankruptcy court's holding rested solely on the question of fraud, appellant's argument on appeal might derive firmer support. One need not engage in fraud to be found in breach of a fiduciary duty, and it might be argued that any findings of fraud by the state court were neither necessary to nor a part of the court's determination that appellant had breached his fiduciary duties as a partner. We need not reach that issue, however, for either fraud or defalcation by a fiduciary will prevent discharge, and we can say without hesitation that the state court found there to be defalcation in this case — whether or not that actual term was used.

At minimum, "defalcation," as that term is used in section 523(a)(4), embraces misappropriation by a fiduciary. Central Hanover Bank & Trust v. Herbst, 93 F.2d 510, 511-12 (2d Cir.1937) (L. Hand, J.). Indeed, it has been suggested that the term probably includes behavior beyond misappropriation, encompassing a fiduciary's failure to properly account for entrusted funds. Id.; Besroi Constr. Corp. v. Kawczynski (In re Kawczynski), 442 F.Supp. 413, 418 (W.D.N.Y.1977); Kaufman v. Lederfine, 49 F.Supp. 144, 145 (S.D.N.Y.1943). Determining whether there had been a misappropriation of partnership assets (i.e., whether appellant had breached his fiduciary duties) was necessarily part and parcel of the state court's finding that dissolution and an accounting were warranted. The various underhanded practices and acts of misappropriation found by the state court and which served as the bases for its ruling are meticulously set forth in Judge Schwartzberg's decision, and need not be repeated here. See Stone, 90 B.R. at 75-79, 80. Thus, whether or not there was outright fraud in this case (and, make no mistake, it appears quite clearly that there was), appellant unquestionably was found by the state court to have engaged in the defalcation of partnership assets, and that finding was necessary to the state court's ruling. Further, that appellant had a sufficient incentive to litigate these matters at that time, if not obvious to the reader, is underscored by counsel's own admission that, "unable to pay the extreme costs of the accounting, Norman had no choice but to file a petition for bankruptcy." Appellant's Brief at 4. Under these circumstances, the bankruptcy court correctly decided that the defalcation issue conclusively had been determined by the state court, and that appellant would be collaterally estopped from relitigating the matter in these proceedings. Cf. Klemens v. Wallace (In re Wallace), 840 F.2d 762, 765 (10th Cir.1988) (notwithstanding fact that complaint in state action did not expressly allege "embezzlement," the state judge found there to be embezzlement, the issues raised in the state and bankruptcy proceedings were essentially the same, the state and federal standards for embezzlement were identical, and the bankruptcy court thus properly invoked collateral estoppel in determining that "embezzlement" under section 523(a)(4) had occurred).

Appellant is particularly troubled by the bankruptcy court's conclusions that it was "required to adhere to the state court's findings of fact," and that those facts were "accepted as binding." Stone, 90 B.R. at 75. We do not share appellant's concern, for such is the end of collateral estoppel. See 1B J. Moore, J. Lucas, & T. Currier, Moore's Federal Practice ¶ 0.4412, at 729 (2d ed. 1988) ("The purpose of collateral estoppel by judgment is to preclude the repeated controversy of matters judicially determined. . . .") (emphasis added). Of course, as we have made clear, it remains solely within the purview of the bankruptcy court to determine if the requirements of section 523(a)(4) have been met, and if the standards for the litigated state claim match the federal standards for the exceptions provided under that section. Wallace, 840 F.2d at 764-65. Judge Schwartzberg, relying on those facts that had been conclusively and finally determined by the state court, made such an independent judgment. Stone, 90 B.R. at 79-80.

Appellant's reliance on Carey Lumber Co. v. Bell, 615 F.2d 370 (5th Cir.1980) (per curiam) and its relations for a contrary conclusion is misplaced. See Supple, 14 B.R. at 903-04 n. 7 (distinguishing these cases as limiting the full application of collateral estoppel in the...