Opinion
NOT FOR PUBLICATION
Robert H. Lynn (Attorney for Plaintiff)
Ernest R. Vargas (Plaintiff)
Kathryn U. Tokarska Tokarska Law Center (Attorney for Defendant)
Sean M. Guinn (Defendant)
Sean M. Guinn(Defendant)
MEMORANDUM DECISION AND ORDER GRANTING PARTIAL NONDISCHARGEABILITY
CHRISTOPHER B. LATHAM, JUDGE United States Bankruptcy Court
This dispute arises from a failed business based on a written agreement between Plaintiff Emest Vargas and Debtor-Defendant Sean Guinn. Vargas contributed all of the investment capital, $30,000, while Guinn provided sweat equity. After the business failed, Vargas sued Guinn for breach of contract in state court and obtained a default judgment against him. Vargas now seeks to hold that debt nondischargeable under §§ 523(a)(2)(A) and (a)(4). For the following reasons, the court finds that that Vargas is entitled to partial judgment in the amount of $7,163.72, plus costs and interest, to be excluded from Guinn's discharge.
I. JURISDICTION AND VENUE
The court has jurisdiction over this adversary proceeding under 28 U.S.C. §§ 1334(b) and 157(b)(2)(I). Venue is proper under 28 U.S.C § 1409(a).
II. FACTUAL BACKGROUND AND FINDINGS
Guinn and Vargas are cousins. But before 2008, they had only minimal contact with one another. Guinn had recently graduated high school and lacked any formal business experience or education. Vargas was on the cusp of retirement. When Guinn came up with an idea for a business, a mutual relative proposed an initial meeting between the two cousins.
Vargas testified that Guinn presented him with a written agreement (the "Agreement") to form a limited liability company ("LLC") - Calaspherian Gaming - to sell trading cards and miniature figurines. The Agreement provided in its entirety:
Calaspherian Gaming Miniatures and Trading Cards
We, Ernest Vargas and Sean Guinn, agree to the terms as follows:
1. The company Calaspherian Gaming, a limited liability company, will be co-owned by Ernest Vargas and Sean Guinn.
2.The start-up money will total thirty thousand $30,000 dollars, which will be given by Ernest Vargas to the company.
3. When the net profits have been determined each month, they will be split into two parts.
a. Ernest Vargas will receive half of the profits each month.
b. Sean Guinn will receive half of the profits each month.
4. After a two year period Ernest Vargas and Sean Guinn will determine the goal of the company for future business.
a. If it is deteimined to sell the company, fifty 50% percent of the sale will go to Emest Vargas and fifty 50% percent of the sale will go to Sean Guinn.
b. If it is determined that growth of the company is necessary Emest Vargas and Sean Guinn will be responsible for all the costs associated with that.
5. All ideas for major changes to the company will be sent either via phone, or in writing to each of the owners.
a. If any time critical issues shall arise, Sean Guinn will have total authority to make decisions without Ernest Vargas.
PL's Ex. 1.
Vargas denied having any involvement with drafting the agreement's terms. He testified that Guinn unilaterally prepared the Agreement and presented it to him at their first meeting on March 12, 2008. But Guinn credibly recounted that Vargas had actually named the company, which appears at the top of the only version of the Agreement the parties committed to writing. This fact, coupled with Guinn's persuasive testimony, strongly suggests that the parties discussed terms of an eventual agreement sometime before the first meeting. Vargas's testimony on this point, by contrast, is not credible.
Vargas and Guinn executed the Agreement at that first meeting. The parties understood that Vargas would provide the $30,000 start up capital by check, while Guinn would operate the business. Although Guinn and Vargas included express profit sharing provisions, they neglected to discuss wages or allowances for Guinn's personal expenses if the business did not turn a profit. Vargas provided the check on March 12, 2008, and Guinn deposited the start up capital into his personal bank account the same day. His account previously contained just $42.15. He did not open a separate account for the business. Guinn stated simply that he "didn't think it mattered."
Trial Tr., 59:25, May 22, 2014, ECF No. 25.
Guinn planned to run the business in Bakersfield and to that end entered into a commercial lease there on April 1, 2008. He did not consult Vargas before signing the three-year lease for approximately 3, 000 square feet of commercial space. He did, however, include a fellow gamer, Jason Gillet, as co-signer on the lease. Once in Bakersfield, Guinn unilaterally abridged the business's name to "Cala Gaming", although he asserts he informed Vargas of this change. Guinn never registered the company as an LLC. But he did file a fictitious business name statement in Kern County listing Jason Gillet as his partner.
The company sold its merchandise in store and online via Guinn's PayPal account. Guinn maintained unorthodox accounting and bookkeeping practices. He used a point of sale ("POS") service, which he described as a computer system for cataloging inventory and tracking sales. But the POS system hardware vanished between the time Guinn shuttered the business and returned to vacate the premises. As such, the court does not have the POS data in the record. To make matters worse, Guinn neglected to retain receipts, purchase orders or invoices. Instead, he relied on his personal Comerica bank account and PayPal statements for record keeping. He entered this data into an accounting software program to generate ledgers for the PayPal and Comerica bank accounts, which he then compiled to produce a profit and loss statement.
The company did not flourish. During its short tenure, Cala Gaming generated just over $8,000 in revenue, while Guinn spent $17,950 on inventory and fees to sell his merchandise online. He also paid for fixed overhead and capital improvements to the store's interior to display merchandise and create the desired ambience for customers. Guinn's sparse accounting and the missing POS data complicate the court's task in tracing these funds. For instance on April 2, 2008, Guinn cashed a check for $4,000 to purchase merchandise at an auction in Los Angeles. But he could not produce a written record of the transaction. Nor could he explain the purpose and use of approximately $3,000 in checks and expenses referenced in his records. In fact, Guinn's general ledger denominates these line items as "unidentified." And he could not differentiate business fuel expenses from personal ones. Other than the general ledger created through the POS system and bank statements, only three receipts and invoices survived.
The court acknowledges that these heavy losses occurred despite Guinn's diligent efforts; he worked at least ten hours per day, six days a week. But having no other income, Guinn used the partnership fund to cover his living expenses. In total, he spent over $7,000 on his apartment rent, food, transportation and other personal needs. Guinn argued that some of these expenses benefitted the business, such as the gasoline for the trip to the auction in Los Angeles. Moreover, he would otherwise have had to hire an employee to run the store while he worked for a paid wage elsewhere. In response to Vargas's contention that he felt entitled to use the partnership funds, he retorted, "I needed to eat."
Trial. Tr., 129:11, ECF No. 25.
Between March and June 2008, Guinn depleted the partnership fund. Monthly revenues averaged $2,000, while the lease payment alone totaled $2,100. By mid-April, Guinn's personal account balance had fallen below $2,000. Meanwhile, he defaulted on the commercial lease. By June 2008, the start up capital was gone, and the business had failed. Guinn then notified Vargas of the financial struggle and his intention to return to San Diego. He shuttered the store later that month.
Guinn returned to San Diego shortly thereafter. After unsuccessfully attempting to reach Guinn, Vargas served him with legal process. This prompted Guinn to mail Vargas a letter promising to repay the $30,000 in $750 installments once he obtained employment. The letter also enclosed a $300 check. In the letter, Guinn characterized the $30,000 as a loan. He failed to make any further installment payments, although he eventually found work as an engineer.
On March 25, 2009, Vargas sued Guinn in San Diego County Superior Court for breach of contract. Vargas obtained a $34,101 default judgment on March 11, 2010, representing $29,500 in principal damages, $4,195.50 in prejudgment interest and $405.50 in costs. In addition, the commercial landlord won a $75,000 judgment against Guinn and Jason Gillet in May 2011. The landlord also enlisted the San Diego County Sheriff to garnish Guinn's wages to satisfy the judgment, which had grown to $90,471.99 by June 3, 2013.
Guinn filed a Chapter 7 petition on July 16, 2013. Vargas brought the instant adversary proceeding on August 28, 2013. In this action, Vargas essentially argues that Guinn used the $30,000 fund for his personal expenses rather than to operate the business. He also contends that Guinn refused to communicate with him during the business's short life and failed to account for several unauthorized expenditures.
III. LEGAL ANALYSIS AND CONCLUSIONS
A. Preclusion Does Not Apply to the State Court Judgment
Vargas curiously urges against giving preclusive effect to his own default judgment he obtained in the state court breach of contract suit. The court ascribes two probable motives to this seemingly counterintuitive argument: (1) his perception that his pleading strategy in the state court action may subject this Complaint to claim preclusion; and (2) if the state court complaint or judgment characterized Guinn's obligation to Vargas as a loan, it would preclude relief under § 523(a)(4).
1. Claim Preclusion
Claim preclusion typically does not apply in bankruptcy nondischargeability proceedings. See Brown v. Felsen, 442 U.S. 127, 135-39 (1979), Banks v. Gill Distrib. Ctr., Inc., 263 F.3d 862, 868 (9th Cir. 2001). Rather than re-litigating the underlying debt, the bankruptcy court's task is to make "a determination as to the nature of that debt, an issue within the exclusive jurisdiction of the bankruptcy court." Banks, 263 F.3d at 868. A creditor may therefore assert nondischaregability for fraud or defalcation under § 523(a) even if the creditor failed to plead these theories in the underlying state court case and the statute of limitations has run. See id. at 868-69. For this reason, Vargas's state court breach of contract suit does not preclude him from now claiming that this debt is nondischargeable under §§ 523(a)(2) and (6).
2. Issue Preclusion
By contrast, collateral estoppel, or issue preclusion, applies in nondischargeability proceedings brought under § 523(a). Grogan v. Garner, 498 U.S. 279, 284 n. 11 (1991). Indeed, "28 U.S.C. § 1738 requires [the court], as a matter of full faith and credit, to apply the pertinent state's collateral estoppel principles." Cal-Micro, Inc. v. Cantiell (In re Canti-ell), 329 F.3d 1119, 1123 (9th Cir. 2003). And California law supplies the relevant preclusion doctrine, as Vargas obtained his judgment from a California state court. See In re Siller, 427 B.R. 872, 884 (Bankr. E.D. Cal. 2010); see also Khaligh v. Khaligh (In re Khaligh), 338 B.R. 817, 823 (B.A.P. 9th Cir. 2006).
California courts will apply issue preclusion if five threshold requirements are met:
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.
Pemstein v. Pemstein (In re Perns tern), 492 B.R. 274, 281 (B.A.P. 9th Cir. 2013) (citation omitted). Even if these factors are present, the court must still look to the "public policies underlying the doctrine before concluding that collateral estoppel should be applied in a particular setting." Lucido v. Sup. Ct., 51 Cal.3d 335, 342-43 (1990). In the nondischargeability context, "Reasonable doubts about what was decided in the prior action should be resolved against the party seeking to assert preclusion." Honkanen v. Hopper (In re Honkanen), 446 B.R. 373, 382 (B.A.P. 9th Cir. 2011).
Here, the parties to both proceedings are the same. And the default judgment qualifies as a final order on the merits because Guinn clearly had notice of the state court action. See Baldwin v. Kilpati-ick (In re Baldwin), 249 F.3d 912, 918-19 (9th Cir. 2001). But the court cannot conclude that the issues addressed in the state court action are identical to those presented here. Notably, Vargas filed his earlier lawsuit using a California Judicial Council form, which did not include any specific allegations beyond the existence of a contract, a corresponding breach and damages. Although the judgment indicates the court relied on a declaration, neither party produced it in this case. And the record contains no further information regarding that action. Thus, the court cannot ascertain whether the Superior Court considered the $30,000 to be loan proceeds or investment capital. Further the judgment does not contain a finding with respect to fraud or Guinn's intent in breaching the contract. Since the court has significant doubts about exactly what the Superior Court decided, it will not give the state court judgment preclusive effect in this case.
B. First Claim for Relief Under § 523(a)(2)(A)
Vargas claims that Guinn fraudulently induced him to provide the $30,000 for the business. Section 523(a)(2)(A) renders a debt nondischargeable if it has been "obtained by ... false pretenses, a false representation, or actual fraud . . ." This exception to discharge requires that the fraud at issue be an "actual fraud, and not constructive fraud or fraud implied in law." Tsurukawa v. Nikon Precision, Inc. (In re Tsurukawa), 287 B.R. 515, 520 (B.A.P. 9th Cir. 2002). To prevail, the plaintiff must show the elements of common law fraud: "I) misrepresentation of a material fact; 2) knowledge of the falsity of the representation; 3) intent to induce reliance; 4) justifiable reliance; and 5) damages." Id. at 524; see also Ghomeshi v. Sabban (In re Sabban), 600 F.3d 1219, 1222 (9th Cir. 2010).
Vargas alleges that the Guinn misrepresented that he would use the start up capital solely for business purposes. Vargas contends that this promise was knowingly false because Guinn immediately commingled the business capital with his personal funds and used it for personal needs. He also points to the fact that Guinn burned through the $30,000 in just over four months. Alternatively, Vargas asserts that Guinn, shortly after accepting Vargas's check, realized the business would fail and seized the first opportunity to use the fiinds for his personal benefit.
The court finds that Vargas has failed to sustain his burden of proof that Guinn either made a misrepresentation or had knowledge of its falsity when it was made. Further, Vargas has not proven that Guinn made the promise with intent deceive or induce reliance. Vargas notably omitted any allegation, and presented no proof, that Guinn knew or should have known that the business would fail. Moreover, the evidence at trial clearly established that Guinn lacked intent to use the entire start up fund for personal expenses when he signed the Agreement. Indeed, he worked long hours diligently running the store. Guinn testified that his personal expenses had necessarily to be covered so that he could devote his working week to operating the store. The court credits his testimony and accepts that Guinn directed his efforts with the desire for the business to succeed.
Further, Vargas has failed to prove that he justifiably relied upon Guinn's representations. When the parties signed the agreement, they both expected Guinn to work full-time at the store. Unfortunately, they neglected to discuss wages or compensation for his labor if the business was not profitable. But the evidence established that Vargas must have strongly suspected Guinn lacked another source of funds for personal expenses. Thus, he could not have justifiably believed that Guinn would be able to sustain himself and run the business without using the partnership funds.
At trial, Vargas also asserted that Guinn never intended to fulfill the June 2008 promise to repay Vargas. According to Vargas, Guinn made this promise after the business failed and while lacking sufficient means to make payments. He adverted to Guinn's failure to make payments despite obtaining employment. Even so, Vargas failed to show that Guinn made a material misrepresentation at the time he sent the letter or that Vargas justifiably relied on it. In fact, the evidence established the opposite. Vargas never responded to the letter and instead continued to pursue legal process against Guinn. For all of these reasons, Vargas has failed to sustain his burden of proof under § 523(a)(2).
C. Second Claim Under § 523(a)(4)
Vargas also submits that the debt is nondischargeable under § 523(a)(4). A debt is nondischargeable under § 523(a)(4) if: " 1) an express trust existed, 2) the debt was caused by fraud or defalcation, and 3) the debtor acted as a fiduciary to the creditor at the time the debt was created." Otto v. Niles (In re Mies), 106 F.3d 1456, 1459 (9th Cir. 1997); Maxwell v. Maxwell (In re Maxwell), 509 B.R. 286, 289 (Bankr. E.D. Cal. 2014). The creditor bears the burden to prove by a preponderance of evidence that the debtor "was acting in a fiduciary capacity and that, while doing so, he committed defalcation." Pemstein v. Pemstein (In re Pemstein), 492 B.R. 274, 280 (B.A.P. 9th Cir. 2013) (citing In re Niles, 106 F.3d at 1462). At that point, the burden shifts to the debtor to render an accounting. Id
"The fiduciary relationship must be one arising from an express or technical trust that was imposed before and without reference to the wrongdoing that caused the debt." Ragsdale v. Haller, 780 F.2d 794, 795 (9th Cir. 1986). In California, a "partner has a duty to hold as trustee any 'property, profit, or benefit derived' from partnership business or use of partnership property." In re Pemstein, 492 B.R. at 281-82 (quoting Cal. Corp. Code § 16404(b)(1)). As such, "California partners are fiduciaries within the meaning of § 523(a)(4)." Haller, 780 F.2d at 796; In re Pemstein, 492 B.R at 282.
The second element requires the court to assess whether a defalcation occurred. "Defalcation itself has two elements: a breach of a fiduciary duty and wrongful intent." In re Maxwell, 509 B.R. at 289. Breach of fiduciary duty entails "misappropriation of trust funds or money held in any fiduciary capacity [or the] failure to properly account for such funds." In re Niles, 106 F.3d at 1460 (quoting Lewis, 97 F.3d at 1186). Personal unauthorized use of corporate funds clearly qualifies under this rubric. See Nahman y. Jacks (In re Jacks), 266 B.R. 728, 737 (B.A.P. 9th Cir. 2001). Further, breach of fiduciary duty includes "wrongfully taking trust property, engaging in self-dealing with trust property for [the fiduciary's] own profit, and failing to provide a full accounting." Tomasi v. Savannah N. Denoce Trust (In re Tomasi), No. CC-12-1401-KTTAD, 2013 Bankr. LEXIS 4596 at 33 (B.A.P. 9th Cir. Aug. 15, 2013); In re Pemstein 492 B.R. at 282-83.
Additionally, defalcation requires a culpable state of mind "involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior." Bullock v. Bankchampaign, N.A., ___ U.S. ___, 133 S.Ct. 1754, 1757 (2013). Specifically, the Bullock Court stated, "Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary 'consciously disregards' (or is willfully blind to) 'a substantial and unjustifiable risk' that his conduct will turn out to violate a fiduciary duty." Id. at 1759 (quoting ALI, Model Penal Code § 2.02(2)(c), p. 226 (1985)). Further, the risk "must be of such a nature and degree that, considering the nature and purpose of the actor's conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor's situation." Id.
Here, Guinn does not seriously dispute the first and third elements. In fact, he admits that he and Vargas were partners at all relevant times. These two elements are therefore satisfied. The parties' primary disagreement lies with whether Guinn's dissipation of the partnership fund constituted defalcation. Vargas's essential argument is that Guinn used the business funds for his own personal gain and failed to account to Vargas for them. He submits that Guinn's recourse to the funds for food purchases, gasoline, car insurance and housing costs clearly demonstrates Guinn's intent to violate his fiduciary duties.
The evidence at trial established that the business agreement, despite being hopelessly vague, did not contemplate Guinn's use of the funds during business's the initial phase. Nor did the parties discuss Guinn's right to use partnership funds for personal expenses if the business did not turn a profit. Thus, Guinn knew or should have known that his use of partnership assets for his sole benefit would violate his fiduciary obligations to Vargas.
The court finds Guinn's testimony credible and accepts his rendition of the facts. Guinn admits to having spent $7,163.72 on personal expenses not related to the business. This figure includes the amount Guinn spent from his Comerica and PayPal accounts on food, gas, his personal car insurance and his personal rent. Specifically, the court arrived at this number by tallying expenditures from Guinn's ledgers in the following categories:
• Personal/Miscellaneous: $2,793.73
• Wallet: $492.63
• Clothing: $16.09
• Food/Groceries: $1,106.45
• Gasoline/Travel: $1,166.82
• Personal Insurance: $488.00
Additionally, the court must add $1,100 for Guinn's March 2008 personal rent that he erroneously delineated as "Cost of Goods Sold" on the Comerica account ledger.
Although Guinn argued that he incurred some of the fuel expenses for business purposes, he could not differentiate between personal and business use. The court finds that Debtor failed to properly segregate personal from business fuel costs in conscious disregard of the risk that it would violate his fiduciary duties. The court therefore excludes the entire $7,163.72 spent on personal expenses from Debtor's discharge under § 523(a)(4).
Vargas has not sustained his burden, however, with respect to the unidentified expenses. He did establish that he entrusted Guinn with $30,000 for the business and that Guinn failed to adequately account for the expenses marked as unidentified. Guinn's accounting method was unorthodox, at best. And the court does not have the benefit of examining the POS system data because Guinn left the system in the store when he closed the business.
But Vargas did not demonstrate that Guinn acted with wrongful intent or gross recklessness. Rather, the trial testimony revealed that Guinn worked industriously with the company's best interests in mind. For instance, Guinn adequately explained that the $4,000 check he cashed went directly to purchasing inventory for the business. The court cannot find that Guinn's failure to meticulously catalogue each business expenditure, while possibly negligent, rises to the level of culpability required for § 523(a)(4) liability. Finally, the court concludes that Guinn has adequately accounted for the remaining partnership funds. Though Cala Gaming failed under Guinn's stewardship, the great majority of the financial transactions Guinn entered into had a direct business purpose and thus did not violate his fiduciary duties.
IV. AMOUNT EXCLUDED FROM DISCHARGE
Having determined that Guinn committed a defalcation, the court must calculate the proper amount to exclude from Debtor's discharge. The nondischargeable debt includes the principal amount and any ancillary liability, including interest and costs. See In re Niles, 106 F.3d at 1463; see also Cohen v. de la Cruz, 523 U.S. 213, 223 (1998) (holding that all liability arising from nondischargeable debt, including treble damages and award of attorney's fees and costs, should be excluded from the debtor's discharge.).
It is ordinarily inappropriate for a bankruptcy court to enter a money judgment in conjunction with a nondischargeability order if a corresponding state court judgment exists. See Gertsch v. Johnson & Johnson, Fin. Corp. (In re Gertsch), 237 B.R. 160, 171-72 (B.A.P. 9th Cir. 1999). This enhances the risk of giving "the plaintiff a windfall, by rolling post-judgment interest into the principal of the new federal money judgment, on which post-judgment interest runs, transmuting the state court post-judgment simple interest into compound interest." Id. at 172. Thus, the BAP concluded, "Where the debt at issue has been reduced to judgment, the bankruptcy court's judgment in a nondischargeability action should merely declare the prior judgment nondischargeable (or not) in whole or in part." Id. Although the court has authority to enter a money judgment, it should not "except under unusual circumstances." Sasson v. Sokoloff(In re Sasson), 424 F.3d 864, 874 (9th Cir. 2005) (quoting Local Loan Co. v. Hunt, 292 U.S. 234, 241 (1934)). Here, the court is not giving preclusive effect to the state court judgment. Moreover, the court only finds part of the sum prayed for nondischargeable. A separate judgment is therefore appropriate.
The court determines that $7,163.72 of the total amount spent by Guinn is nondischargeable under § 523(a)(4). Because the predicate liability arose under California state law, California law governs an award of prejudgment interest. See In re Niles, 106 F.3d at 1463. "Under California law, prejudgment interest is a matter of right where there is a vested right to recover 'damages certain' as of a particular day." Id. (quoting Cal. Civ. Code § 3287(a)). The court will accordingly apply California's legal rate of 10% to the offensive transfers from the dates they occurred until judgment in this case. Because this action arises under a federal statute, however, postjudgment interest will accrue at the federal rate. See 28 U.S.C. § 1961.
V. CONCLUSION
For the foregoing reasons, the court finds that Guinn is entitled to judgment on Vargas's § 523(a)(2) claim. But the court further concludes that Guinn committed a defalcation within the meaning of § 523(a)(4). The court therefore finds Vargas's debt partially nondischargeable in the principal amount of $7,163.72, plus simple interest calculated at the California prejudgment rate of 10% from the dates of the transfers to the date of this judgment. Postjudgment, interest shall accrue at the federal rate. Finally, Vargas is awarded his costs of suit. The court will issue a separate judgment.
IT IS SO ORDERED.