In re: Martin Pemstein and Diana Pemstein
An Order consistent with this Memorandum will be entered.
Christopher L. Blank, Newport Beach, CA, for Appellant Harold Pemstein; Alan Wayne Forsley, Los Angeles, CA, of Fredman Knupfer Lieberman LLP for Appellees Martin Pemstein and Diana Pemstein.
Before: TAYLOR, PAPPAS, and MARKELL, Bankruptcy Judges.
INTRODUCTION
This appeal presents the question whether defalcation under
On remand, the bankruptcy court also should be mindful of the Supreme Court‘s recent decision in Bullock v. BankChampaign, N.A., ___ U.S. ___, 133 S.Ct. 1754, 185 L.Ed.2d 922 (2013).5 In Bullock, the Supreme Court resolved the split among the circuits regarding the mental state that must accompany defalcation under
FACTS
Harold and Martin are brothers and were partners in a California general partnership, as well as directors of and shareholders in a small, closely-held family corporation. The partnership owned industrial real property that it leased to the corporation and from which the corporation ran the family business. Harold filed lawsuits against Martin in state court based on disputes that arose between them regarding the corporation and the partnership (the “State Court Action“).
During the course of the litigation, the state court filed a Statement of Decision and Judgment in the State Court Action on June 30, 2005 (the “2005 Decision“). The 2005 Decision primarily ordered dissolution of the corporation and the partnership. On January 5, 2010,6 Harold obtained a money judgment in the State Court Action against Martin in the amount of $696,218.03 (the “2010 Judgment“).7 The state court did not issue a statement of decision in connection with the 2010 Judgment, as neither party requested it.8 The 2010 Judgment states as follows:
The Court finds for the Plaintiff Harold Pemstein against Martin Pemstein finding that Martin Pemstein breached his duty of care to Harold Pemstein in the collection of rent on behalf of HMS Properties. The Court finds that the breach caused Harold Pemstein dam-
ages of $295,871.00 in principal and $400,347.03 in interest.
The State Court Complaint, in particular the fifth cause of action for breach of fiduciary duty against Martin as partner of the partnership, cited statutory authority that would support findings that Martin had breached the duty of loyalty to Harold in the management and winding up of the partnership.9 It also alleged facts that would support findings that Martin had breached both the duty of loyalty and the duty of care owed to Harold, although it did not include a citation to the statute defining the duty of care.10 The 2010 Judgment was based on the finding that Martin hаd breached his duty of care to Harold. Under California law, this finding necessarily means that the state court found that Martin had engaged in “grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law” while acting as a trustee over partnership assets.
Harold, but apparently not Martin,11 appealed from the 2010 Judgment.12 The Court of Appeal resolved Harold‘s appeal by affirming the 2010 Judgment in an unpublished opinion on May 16, 2011 (“DCA Opinion“).13
Martin аnd his wife Diana Pemstein filed their joint petition under chapter 11 on April 28, 2010, and Harold filed his complaint objecting to discharge and dischargeability thereafter (“Adversary Complaint“). Pemstein v. Pemstein (In re Pemstein), 476 B.R. 254, 256 (Bankr. C.D. Cal. 2012). The Adversary Complaint incorporated the 2010 Judgment. Pursuant to the first cause of action, Harold sought an exception to discharge under
23. A partner‘s duty of loyalty to the partnership and the other partners includes all of the following:
(A) To account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the pаrtnership business or derived from a use by the partner of partnership property or information, including the appropriation of a partnership opportunity.
(B) To refrain from dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest adverse to the partnership.
(C) To refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership.
24. A partner‘s duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.
The bankruptcy court conducted a trial on November 30, 2011.14 It requested or allowed three rounds of post-trial briefs on specifically identified legal questions regarding defalcation under
JURISDICTION
The bankruptcy court had jurisdiction pursuant to
ISSUES
Did the bankruptcy court err in determining that Harold‘s
STANDARD OF REVIEW
In reviewing a bankruptcy court‘s dischargeability determination, we review its findings of fact for clear error and its conclusions of law de novo. Oney v. Weinberg (In re Weinberg), 410 B.R. 19, 28 (9th Cir. BAP 2009). The availability of issue preclusion is a question of law, which we review de novo. Wolfe v. Jacobson (In re Jacobson), 676 F.3d 1193, 1198 (9th Cir. 2012). If issue preclusion is available, the decision to apply it is reviewed for abuse of discretion. Lopez v. Emergency Serv. Restoration, Inc. (In re Lopez), 367 B.R. 99, 103 (9th Cir. BAP 2007). A bankruptcy court abuses its discretion if it bases a decision on an incorrect legal rule, or if its application of the law was illogicаl, implausible, or without support in inferences that may be drawn from the facts in the record. United States v. Hinkson, 585 F.3d 1247, 1261-62 & n. 21 (9th Cir. 2009) (en banc).
DISCUSSION
A creditor objecting to the dischargeability of its claim bears the burden of proving, by a preponderance of the evidence, that the particular debt falls within one of the exceptions to discharge enumerated in
Harоld cites as error the bankruptcy court‘s placement of the burden of proof on him at trial.17 Harold‘s argument on this point consists entirely of quotations from case authority with no discussion. As confirmed during oral argument, Harold argues that the burden of proof should have shifted to Martin at some point to show that he had properly accounted. See Otto v. Niles (In re Niles), 106 F.3d 1456, 1462 (9th Cir. 1997) (burden is placed on the fiduciary to render an accounting, “once the principal has shown that funds have been entrusted to the fiduciary and not paid over or otherwise accounted for“). The burden never shifted here because the bankruptcy court too narrowly defined defalcation.
Harold also bears the burden of proof for application of issue preclusion. Honkanen v. Hopper (In re Honkanen), 446 B.R. 373, 382 (9th Cir. BAP 2011). To meet this burden, Harold was required to pinpoint “the exact issues litigated in the prior action and introduce[] a record revealing the controlling facts.” Id. As a pro se litigant at trial, Harold provided the 2005 Decision, the 2010 Judgment, and his direct testimony by declaration. Martin offered the State Court Complaint and the DCA Opinion, as well as his direct testimony by declaration. Harold testified that the dispute between Martin and him in the state court concerned how much rent was due him from Martin for the period of time Martin was in sole possession of partnership properties. In effect, the bankruptcy court found that Harold did not meet this burden. The bankruptcy court, however, did not perform a complete issue preclusion analysis, given its view of defalcation.
Federal courts must give “full faith and credit” to judgments of state courts.
California courts will apply issue preclusion only if certain threshold requirements are met, and then only if application of preclusion furthers the public policies underlying the doctrine. There are five threshold requirements:
First, the issue sought to be precluded from relitigation must be identical to that decided in a former proceeding. Second, this issue must have been actually litigated in the former proceeding. Third, it must have been necessarily decided in the former proceeding. Fourth, the decision in the former proceeding must be final and on the merits. Finally, the party against whom preclusion is sought must be the same as, or in privity with, the party to the former proceeding.
Id. (internal citations omitted).
Here, the bankruptcy court decided it could not apply issue preclusion in connection with the defalcation claim because it determined that the issue decided in the State Court Action was not identical to the question of whether Martin committed defаlcation while acting in a fiduciary capacity. Pemstein, 476 B.R. at 258. In making this determination, the bankruptcy court utilized an inappropriately narrow definition of defalcation.
Section 523(a)(4) defalcation by a fiduciary.
As relevant here,
Under California law, “all partners [are] trustees over the assets of the partnership.” Ragsdale, 780 F.2d at 796; and see
The critical question here is whether the 2010 Judgment was based on Martin‘s defalcation. The bankruptcy court based its negative answer to this question on the omission from the 2010 Judgment of any statement that “Martin had failed to account for rents he received.” Id. (emphasis in original). Our analysis of existing court decisions, supported by the Supreme Court‘s discussion in the recent Bullock decision, leads us to conclude that actual receipt of funds subject to a trust is not necessary to establish defalcation.
The bankruptcy court relied on a definition of defalcation articulated by the Ninth Circuit, quoting Black‘s Law Dictionary, in In re Lewis: “Defalcation is defined as the ‘misappropriation of trust funds or money held in any fiduciary capacity; [t]he failure to properly account for such funds.‘” 97 F.3d at 1186 (citation omitted). From this definition, the bankruptcy court focused largely on the words “misappropriation” and “funds.”
In effect, the bankruptcy court‘s focus negates any difference between defalcation and embezzlement under
And, the bankruptcy court missed the broader meaning of defalcation actually applied in Lewis, where the Ninth Circuit held that the debtors’ failure to “provide a complete accounting of the funds [plaintiff] invested in the partnership, or of the partnerships [sic] assets generally, and сommingl[ing] [of] his investment with their other funds” fit within the legal definition of defalcation. Id. at 1187 (emphasis added). Defalcation, therefore, is broader than the misappropriation of funds or mere bookkeeping malfeasance. Defalcation includes the failure by a fiduciary to account for money or property that has been entrusted to him. Woodworking Enter., Inc. v. Baird (In re Baird), 114 B.R. 198, 204 (9th Cir. BAP 1990); and see In re Hemmeter, 242 F.3d at 1191 (the Ninth Circuit has “as yet not fully defined the contours of defalcation under
Whether the 2010 Judgment was based on Martin‘s receipt of rents and a failure to account for those rents or was based on rents from partnership property that he should have received but failed to collect, the state court determined that Martin caused his partner, Harold, damages of
The 2010 Judgment specifically states the finding that Martin “breached his duty of care to Harold Pemstein in the collection of rent on behalf of HMS Properties.” We may infer that in making this finding, the state court necessarily decided against Martin on the fifth cause of action in the operative complaint, the only claim in the State Court Complaint against Martin for breach of fiduciary duty as Harold‘s partner. The wrongful conduct alleged there includes failing to account to the partnership and to “hold as trustee the properties, profits, and benefits” derived therefrom (State Court Complaint at 12-13, para. f); dealing with partnership properties in a manner adverse to Harold (Id. at 13, para. g); and “refusing to set market rents” for partnership properties rented to the family corporation, from which Harold had been excluded (Id. at 13. para. k).
This inference is supported by our review of the DCA Opinion. In the DCA Opinion, the Court of Appeal recited the history of the litigation between these parties, and in summary stated that after the 2005 Decision, “[t]he only issue remaining was the equitable accounting for rents Harold claimed Martin owed him.” DCA Opinion at 3. It then quoted the state court‘s minute order dated December 14, 2009, wherein the state court prefaced its oral ruling after the multi-dаy trial on the State Court Complaint by stating that the only issue then remaining was “Harold‘s equitable claims for RENT between himself and Martin regarding Martin[‘s] stewardship of HMS on behalf of the partnership....” Id. at 3-4. Thus, as the 2010 Judgment was the result of Martin‘s failure to account for partnership property entrusted to him, the bankruptcy court utilized an incorrect legal rule when it denied the 2010 Judgment issue preclusive effect, based on the assumption that defalcation resulted only when the fiduciary fails to account for cash actually received.
Section 523(a)(4)‘s scienter requirement.
In its decision, the bankruptcy court opined that the 2010 Judgment may have been based on a finding of “negligence,” which the bankruptcy court thought insufficient to establish defalcation. In re Pemstein, 476 B.R. at 259. We find no support in the record for a finding of simple negligence. The State Court Complaint contained no negligence cause of action. And, at the time the bankruptcy court rendered its decision, at least in the Ninth Circuit, “the term ‘defal-
We acknowledge, however, that the Bullock decision abrogates the Ninth Circuit‘s previous standard that omitted a scienter element for
In the 2010 Judgment, the term “duty of care” apрlies to one of the two statutory fiduciary duties of partners to one another and the partnership as enunciated in the California Corporations Code. See
CONCLUSION
Based on the foregoing, we conclude that the bankruptcy court erred when it ruled that Harold‘s