Opinion
BANKRUPTCY NO: 10-19165-MM7 ADVERSARY NO: 11-90361-MM
11-21-2011
In re: THEO HANSON AND KIMBERLY DAWN HANSON, Debtors, FRED WENDT, Plaintiff, v. THEO HANSON AND KIMBERLY DAWN HANSON, Defendants,
WRITTEN DECISION - NOT FOR PUBLICATION
MEMORANDUM DECISION RE DEBTORS'
MOTION TO DISMISS ADVERSARY
COMPLAINT
DATE: 12/15/11
TIME: 10:00 a.m.
DEPT: 1
JUDGE: Margaret M. Mann
Pro se debtors, Theo and Kimberly Hanson ("the Debtors"), brought a Motion to Dismiss ("Motion") pro se plaintiff Fred Wendt's ("Wendt") complaint filed against them ("Complaint"). Wendt alleged non-dischargeability claims for "actual fraud" and "fraud or defalcation while acting in a fiduciary capacity" under 11 U.S.C. §§ 523(a)(2) and (4). The Motion was brought under Federal Rule of Bankruptcy Procedure 7012 (which incorporates Fed. R. Civ. P. 12) based in part upon a California default judgment for breach of contract, and in part on the insufficiency of the allegations to state a claim for relief.
Having considered the parties' oral presentation at the hearing and all papers filed in regard to this Motion, the Court denies the Motion on collateral estoppel and res judicata grounds except to the extent of declining to allow the parties to re-litigate the amount of Wendt's debt. The Court also grants in part and denies in part the Motion's challenge to the sufficiency of the pleadings. For the benefit of these pro se parties, the Court explains its analysis in this Memorandum Decision.
I. FACTUAL BACKGROUND
In September 2005, the Debtors approached Wendt and requested his financial assistance with a business opportunity. Exactly what business opportunity was to be pursued is unclear, but it can be gleaned from the Complaint that Wendt would provide the capital investment, while the Debtors would provide the services and products to the customers as part of a marketing business.
At the Debtors' urging, Wendt entrusted substantial sums of money in this business opportunity by writing checks to HP Media, Inc., an alleged sham corporation used as a device to prevent others from dealing directly with the Debtors as individuals. Although the Debtors claimed they would immediately establish the business, this did not occur. Three months after Wendt entrusted his money in the business opportunity, the Debtors did open a checking account where HP Media Inc. began doing business under the name "Sixth Sense Studio." In the meantime, much of Wendt's money had already been spent.
After the Debtors failed to repay the loan, Wendt obtained a California default judgment in the amount of $210,000 plus interest, specifically on the two breach of contract claims asserted, even though fraud was also alleged in the state court complaint. The Debtors then filed bankruptcy, and Wendt then filed his Complaint.
II. ANALYSIS
A. Motion to Dismiss Legal Standard
The liberal pleading standards set out in Federal Rule of Civil Procedure 8(a)(2) (incorporated by reference into Bankruptcy Rule 7008) require only "a short and plain statement of the claim showing that the pleader is entitled to relief," in order to "give the defendant fair notice of what the ... claim is and the grounds upon which it rests." Bell Ail. Corp. v. Twombly, 550 U.S. 544, 555 (2007). These lax pleading standards are further relaxed for pleadings filed by pro se litigants. Erickson v. Pardus, 551 U.S. 89, 94 (2007); accord Hebbe v. Pliler, 627 F.3d 338, 342 (9th Cir. 2010).
While a complaint attacked by a Rule 12(b)(6) motion to dismiss does not need detailed factual allegations, a plaintiff's obligation to provide the "grounds" of his " entitle [ment] to relief requires more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do. See Papasan v. Allain, 478 U.S. 265, 286 (1986) (courts "are not bound to accept as true a legal conclusion couched as a factual allegation"). Even for pro se litigants, the court need not accept as true unreasonable inferences or conclusory legal allegations cast in the form of factual allegations. Western Min. Council v. Watt, 643 F.2d 618, 624 (9th Cir.), cert, denied, 454 U.S. 1031 (1981). A pro se litigant must nevertheless be given an opportunity to amend the complaint to state a claim, unless it is clear the deficiencies cannot be cured by amendment. McGuckin v. Smith, 974 F.2d 1050, 1057 (9th Cir. 1992), overruled on other grounds by WMX Technologies, Inc. v. Miller, 104 F.3d 1133 (9th Cir. 1997).
Other than taking judicial notice of appropriate matters, see Lee v. City of Los Angeles, 250 F.3d 668, 688 (9th Cir. 2001); Fed. R. Evid. 201, a court may not look beyond the complaint to a plaintiff's moving papers. Schneider v. California Dept. of Corr., 151 F.3d 1194, 1197, n.l (9th Cir. 1998) (emphasis in original).
Having taken judicial notice of the default judgment and the state court complaint, and having read the pro se pleadings here with the higher tolerance due them, the Court nevertheless finds that some of Wendt's claims are precluded by the default judgment and others are not viable based upon the facts alleged.
B. The Preclusive Effect of the Default Judgment
1. Res Judicata
Both parties point to the default judgment as dispositive of their respective claims without articulating the legal theory on which these assertions are based. Wendt asserts the state court complaint alleges fraud, so the matter has already been litigated in his favor. The Debtors claim the judgment was for breach of contract not fraud, so Wendt's claim is fully dischargeable. These claims implicate collateral estoppel and res judicata principles, which can be addressed on a sua sponte basis even when not formally raised by the parties. Columbia Steel Fabricators v. Ahlstrom Recovery, 44 F.3d 800, 802 (9th Cir. 1995) (sua sponte consideration of preclusion issues upheld).
Res judicata, also known as claim preclusion, prevents litigation of all grounds for, or defenses to recovery that were previously available to the parties, regardless of whether they were asserted or determined in the prior proceeding. Chicot Cnty. Drainage Dist. v. Baxter State Bank, 308 U.S. 371, 378 (1940). A successful defense of claim preclusion requires: (1) a final judgment on the merits in the prior action; (2) an identity of claims; and (3) the prior action must involve the same parties. Stewart v. U.S. Bancorp, 297 F.3d 953, 956 (9th Cir. 2002). Because the element of identity of claims is not present, fraud non-dischargeability claims actions are not precluded by prior state court judgments. Brown v. Felsen, 442 U.S. 127, 131 (1979) (claim preclusion did not apply because its application in dischargeability proceedings would inspire needless litigation by an otherwise unwilling party to try bankruptcy issues to protect against the mere possibility that a debtor may file bankruptcy in the future).
As was held in Brown, id, the claim preclusion arguments here fail the second requirement from Stewart, 297 F.3d at 956. The claims raised are not identical in both actions. The state court judgment was for breach of contract while the Complaint alleges non-dischargeability for fraud and defalcation while acting in a fiduciary capacity. Even if the state court judgment was for fraud, it is different from the non-dischargeability claims. Brown, 442 U.S. at 131. Applying the claim preclusion doctrine, the default judgment thus neither establishes nor bars Wendt's non-dischargeability claims.
2. Collateral Estoppel
That claim preclusion does not apply does not mean the default judgment is irrelevant to this proceeding. Collateral estoppel, otherwise known as issue preclusion, may bar the re-litigation of certain issues raised in the context of the claim to be considered. See Collins v. D.R. Horton, Inc., 505 F.3d 874, 880 (9th Cir. 2007). Unlike the case with claim preclusion, issue preclusion can be applicable in dischargeability cases. Grogan v. Garner, 498 U.S. 279, 284 (1991).
Because the default judgment is a California state court judgment, California law determines if collateral estoppel applies. As a matter of full faith and credit, 28 U.S.C. § 1738 requires courts apply the collateral estoppel principles of the state from which the judgment was entered. In re Honkanen, 446 B.R. 373, 382 (B.A.P. 9th Cir. 2011) (citing Grogan). Under California law, collateral estoppel requires that: (1) the issue to be precluded from re-litigation be identical to that decided in the prior proceeding; (2) the issue have been actually litigated; (3) the issue have been necessarily decided; (4) the decision on the issue be final and on the merits; and (5) the party be the same as, or in privity with, the party in the prior proceeding. In re Younie, 211 B.R. 367, 373 (9th Cir. B.A.P. 1997) (default judgment based upon fraud given collateral estoppel effect).
These elements are each analyzed for the two separate components of this suit: whether the Debtors owe a debt to Wendt, and if so, whether the debt is non-dischargeable.
a) Do the Debtors Owe Wendt a Debt?
On the debt issue, the California default judgment satisfies all five elements required for collateral estoppel.
(1) Identical Issues
The '"identical issue requirement' concerns whether 'identical factual allegations' are at stake in the two proceedings..." Murphy v. Murphy, 164 Cal. App. 4th 376, 400 (2008) (citing Lucido v. Superior Court, 51 Cal. 3d 335, 342 (1990)). The factual issues for breach of contract and fraud are identical in the instant and prior state court proceedings. In both proceedings, Wendt sought to recover money he invested with the Debtors. Even if non-dischargeability was not litigated in state court, the factual allegations supporting both claims are identical. The first element of the collateral estoppel test is thus satisfied.
(2) Actually Litigated
Younie held that a California "default judgment satisfies the 'actually litigated' requirement for the application of collateral estoppel" even though the debtors were never involved in the state court proceeding and the state court did not make full findings on the elements of fraud. Younie, 211 B.R. at 374-375. A default judgment is as conclusive on the allegations in the non-dischargeability complaint as would be a trial on the issues. See In re Moore, 186 B.R. 962, 972 (Bankr. N.D. Cal. 1995) (citing Burtnett v. King, 33 Cal. 2d 805, 810 (1949)). All that needs to be demonstrated is that the judgment is regular and valid, and that the judgment was based on a cause of action in the non-dischargeability complaint. Id; Younie, 211 B.R. at 375. The state court here entered a regular, valid judgment and demonstrated distinctly that its judgment was entered only on the breach of contract claim. The "actually litigated" element for whether the Debtors owe Wendt a debt has been met here.
(3) Necessarily Decided
The issue of whether the Debtors owe Wendt a debt was necessarily decided in the California default judgment for breach of contract. The contract was a loan from Wendt to the Debtors that was to be repaid. Therefore, the California default judgment for breach of contract necessarily decided that the Debtors owe Wendt a debt for breach. The third collateral estoppel element is satisfied.
(4) Final and On the Merits
The California default judgment is final and on the merits. The Debtors included in their Motion the California default judgment entered by the Clerk. (Exh. B. to the Debtors' Motion to Dismiss). The Court can take judicial notice of this judgment. Lee v. City of Los Angeles, 250 F.3d at 688. There is nothing in the record that suggests the matter is on appeal.
(5) Same Party or in Privity
The parties in both the state court action and this current adversary case are identical. The fifth element of collateral estoppel is satisfied. Therefore, this issue of whether the Debtors owe Wendt a debt cannot be re-litigated in this Court.
b. Is Wendt's California Default Judgment Non-dischargeable for Fraud?
On the separate issue of fraud, four of the five elements of collateral estoppel discussed above are met. The judgment was final, the parties were the same, the claims were actually litigated, and the issues relating to Wendt's investment in the Debtors' business venture were the same. However, fraud was not necessarily decided. While fraud was alleged generally, only breach of contract claims were formally pled. The judgment expressly by its terms states judgment was entered only on the breach of contract claims.
The collateral estoppel effect of a California default judgment only precludes the party from challenging the material factual issues that were both raised in the state court pleadings and necessary to uphold the judgment. In the previous action, the state court expressly entered its default judgment only for breach of contract, without finding that the Debtors committed fraud. In re Harmon, 250 F. 3d 1240, 1248-49 (9th Cir. 2001) (judgment for constructive fraud not tantamount to a determinative of actual fraud so collateral estoppel cannot be applied). Fraud was thus not necessarily decided. Id. Therefore, collateral estoppel principles leave the issue of non-dischargeability for fraud or defalcation while acting in a fiduciary capacity to be decided in this Court.
Since Wendt's allegations of non-dischargeability under 11 U.S.C. §§ 523(a)(2) for fraud and (4) for defalcation survive to be litigated in part in this Court, whether these claims are properly alleged must be addressed.
C. Dischargeability under 11 U.S.C. § 523(a)(2)
Wendt's fraud allegations, liberally construed, are that his debt is not dischargeable under 11 U.S.C. § 523(a)(2) since it was incurred through fraud and a false representation of the Debtors' financial condition. To prove fraud under 11 U.S.C. § 523(a)(2)(A), Wendt must prove that: (1) the Debtors made a representation; (2) the Debtors knew the representation was false at the time it was made; (3) the Debtors made the representation with the intention and purpose of deceiving the creditor; (4) Wendt relied on the representation; and (5) Wendt sustained damages as a proximate result. In re Kirsh, 973 F.2d 1454, 1457 (9th Cir. 1992) (quoting In re Britton, 950 F.2d 602, 604 (9th Cir. 1991)). Under a separate sub-section of the statute, 11 U.S.C. § 523(a)(2)(B), Wendt's allegations also can be liberally construed as claiming that the Debtors fraudulently presented a false picture of their overall financial health. In re Joelson, 427 F.3d 700, 714 (10th Cir. 2005); In re Medley, 214 B.R. 607, 612 (B.A.P. 9th Cir. 1997) (statements of specific financial facts actionable, while general hopes of a sale of assets or vague opinions are not).
Applying these legal standards, the Court concludes Wendt adequately alleges facts for a non-dischargeability claim due to fraud concerning two of the eight misrepresentations.
1. The Debtors Made Representations
Wendt alleges the Debtors made false representations, citing multiple instances throughout the Complaint:
1. Representation that the Debtors had a solid contract with Red Bull (Wendt's Exh. B)
2. Representation that Wendt's investment was safe and secure (Compl. at 4)
3. Representation that agreements with Red Bull were so solid that the Debtors guaranteed repayment of all money advanced to them by Wendt (Compl. at 4)
4. Representation that the only thing that could go wrong was if Debtor Theo Hanson died (Compl. at 4)
5. Representation that the Debtors had already invested a sum of $ 16,000 into the business venture (Compl. at 4)
6. Representation that the Debtors had assets which would be used to invest in the business enterprise in the amount of $40,000 (Compl. at 4)
7. Sum of $200,000 used for non-business expenses for HP Media, Inc. and Sixth Sense Studios (Compl. at 6)
8. Check No. 1086 for $20,000 from Sixth Sense Studios given to Wendt as partial payment, which was returned for insufficient funds (Compl. at 6).
The Debtors misguidedly focus much of their Motion on the eighth representation; the insufficiency of funds check. Knowingly writing a check with insufficient funds is not a '"false statement" within the meaning of the federal criminal law. Williams v. United States, 458 U.S. 279, 284 (1989). This type of representation is thus not a basis to state a claim and the Motion is granted to this extent.
Fraud also cannot be based upon mere opinion or predictions of future events. Caldwell v. Hanes (In re Hanes), 214 B.R. 786, 810 (Bankr. E.D. Va. 1997); Lisk v. Criswell (In re Criswell), 52 B.R. 184, 196 (Bankr. E.D. Va. 1985); Wilder v. Waller (In re Waller), 210 B.R. 370, 378 (Bankr. D. Colo. 1997); see also In re Jogert, Inc., 950 F.2d 1498, 1507 (9th Cir. 1991) (applying California law). The first four examples of fraudulent misrepresentations are predictions and opinions, not misrepresentations. The Motion is granted to eliminate these allegations as part of the fraud cause of action.
Two of the remaining fraud claims, representations five and six, are actionable misstatements of fact: that the Debtors had already invested a sum of $16,000 into the business venture and that the Debtors had assets which would be used to invest in the business enterprise in the amount of $40,000. These representations also fit within the 11 U.S.C. § 523(a)(2)(B) test for non-dischargeability as claims that the Debtors fraudulently presented a false picture of their overall financial health. In re Barrack, 201 B.R. 985, 987-88 (Bankr. S.D. Cal. 1996).
The seventh representation, that the sum of $200,000 invested by Wendt was not used as promised, but instead for non-business expenses for HP Media, Inc. and Sixth Sense Studios, is not actually a representation of fact, but instead a claim for misuse of the money Wendt invested. While this claim may be recoverable under the defalcation or a false promise theory, it is not a statement of fact. A debtor's failure to perform some promised action is not enough to prove false pretense, false representation, or actual fraud. Matter of Bercier, 934 F.2d 689, 691-92 (5th Cir. 1991). Wendt must prove either defalcation or the Debtors' intent to misuse these funds before the investment was made for this cause of action to be viable. In re Woodman, 451 B.R. 31, 38 (Bankr. D. Idaho 2011); see Matter of Bercier, 934 F.2d 689, 692 (5th Cir. 1991); see also Palmacci v. Umpierrez, 121 F.3d 781, 788 (1st Cir. 1997).
2. The Debtors Knew Representation Was False
As to the remaining allegations, Wendt, as a pro se party, has adequately alleged that the Debtors knew these representations were false at the time they were made. From their nature, the Court can infer that the Debtors would have known that the representations were false. Because these facts were fully within their personal knowledge, the Debtors would have known if they had already paid $16,000 of their own money into the company at the time they made the representation, and whether they had $40,000 to invest. As Wendt is proceeding without representation, the Court holds his pleadings to less stringent standards, and therefore can infer that Wendt is claiming the Debtors knew the representation was false at the time it was made even if he did not specifically allege this fact. Hebbe, 627 F.3d at 342.
3. The Debtors Had Intent and Purpose of Deceiving Creditor
Wendt adequately alleged that the Debtors made the false representations that the Debtors had already invested $16,000 of their own money, and had $40,000 of their own to invest to induce Wendt into investing in the company. The nature of these actions likewise implies an intent and purpose to deceive Wendt into investing in the business opportunity. See In re Kennedy, 108 F3d 1015, 1018 (9th Cir. 1997) (intent to defraud is a question of fact that can be inferred from surrounding circumstances).
4. Creditor Relied on Representations
Wendt adequately alleged he relied on the Debtors' false representations and would not have entered into the agreements with the Debtors or incurred the unpaid debt that the Debtors are seeking to discharge.
5. Creditor Sustained Damages
Not only is the debt established by issue preclusion, Wendt also adequately alleged that he advanced substantial sums of money, and his damages in the amount of $210,000 plus interest need not be further litigated. In re Kirsh, 973 F.2d at 1457.
D. Dischargeability under 11 U.S.C. § 523(a)(4)
Under 11 U.S.C.§ 523(a)(4), Wendt must allege the Debtors engaged in defalcation through misappropriation of funds while acting in a fiduciary capacity. The Debtors contend that Wendt does not allege sufficient facts to show that there was a fiduciary relationship, which requires proof that the Debtors were (1) acting in a fiduciary capacity, and (2) in that capacity, committed fraud or defalcation. In re Teichman, 774 F.2d 1395, 1398 (9th Cir. 1985). The broad, general definition of a fiduciary relationship—one involving confidence, trust and good faith—is inapplicable in the dischargeability context. E.g., Ragsdale v. Haller, 780 F.2d 794, 796 (9th Cir. 1986).
For the purposes of Bankruptcy Code section 523(a)(4), "fiduciary capacity" only includes express or technical trust relationships, and implied or constructive trusts are excluded from the definition. In re Stanifer, 236 B.R. 709, 714 (B.A.P. 9th Cir. 1999). The general characteristics of an express trust are: (1) sufficient words to create a trust; (2) a definite subject; and (3) a certain and ascertained object or res. In re Thornton, 544 F.2d 1005, 1007 (9th Cir. 1976); Reagh v. Kelley, 10 Cal.App.3d 1082, 1089 (1970); In re Stanifer, 236 B.R. at 714. Federal law determines a fiduciary relationship while state law controls if an express or technical trust has been established. In re Stanifer, 236 B.R. at 714. For example, in Ragsdale v. Haller, the court, applying state law, found an express trust because California law has made all partners trustees over the assets of the partnership, and partners were fiduciaries within the meaning of 11 U.S.C. §523(a)(4) when exercising control over partnership property. 780 F.2d at 796.
1. The Debtors Were Acting in a Fiduciary Capacity
While Wendt does not allege he was a partner with the Debtors, his allegations would support that the parties had entered into a joint venture. Whether a joint venture relationship exists is a question of fact, depending on the intention of the parties. April Enterprises, Inc. v. KTTV, 147 Cal. App. 3d 805, 820 (1983). The essential element of a joint venture is an undertaking by two or more persons to carry out a single business enterprise jointly for profit. Nelson v. Abraham, 29 Cal. 2d 745, 749 (1947). A joint venture agreement may be informal or oral. Fitzgerald v. Provines, 102 Cal. App. 2d 529, 538 (1951). "The rights and liabilities of joint venturers, as between themselves, are governed by the same rules which apply to partnerships" since partners or joint venturers have a fiduciary duty to act with the highest good faith towards each other regarding affairs of the partnership or joint venture. Boyd v. Bevilacqua, 247 Cal. App. 2d 272, 288 (1966); see also BT-Iv. Equitable Life Assurance Society, 75 Cal. App. 4th 1406, 1410-1411 (1999); Laux v. Freed, 53 Cal. 2d 512, 522 (1960).
The facts alleged by Wendt are very close to those in Pellegrini v. Weiss, 165 Cal. App. 4th 515, 525 (2008), where the court found a fiduciary duty existed through the formation of a joint venture where two people came together for the common purpose of developing real estate for profit. One party was charged with identifying the property to be developed, and had expertise in how to develop property, and the other was to provide the capital for the investment, as well as co-direct the development and sale of the property. Id. Wendt's Complaint similarly alleges the Debtors were charged with providing the services and products to the customers as part of the marketing efforts, and Wendt would provide the capital investment. The Complaint adequately alleges a joint venture.
2. Fraud or Defalcation
Wendt alleges the Debtors engaged in multiple instances of fraud or defalcation:
1. Commingling and misappropriating funds placed in their custody for the furtherance of the business venture into which they induced Wendt to invest
2. Numerous checks issued and ATM withdrawals made from the business account to pay for the Debtors' personal items
3. Misappropriation of $4,500 as repayment of a loan to Rick Frederick, who was not involved with the business enterprise
4. Checks issues for $2,000 to Phyllis and Wensel, the parents of Debtor Kimberly Dawn Hanson, as repayment of a loan
5. Misappropriation of $10,800 from the company checkbook given to Debtor's son, Adam Mills, not in connection with the business enterprise
6. Check issued from Sixth Sense Studio business account to Alliance Title and Escrow for an unknown purpose
These allegations are classic examples of defalcation. Ragsdale, 780 F.2d at 797. Representation 7 of the Complaint, that the sum of $200,000 invested by Wendt was not used as promised, but instead for non-business expenses for HP Media, Inc. and Sixth Sense Studios, also presents a classic case of defalcation. Id. These allegations are sufficient, and the Motion for failure to state a claim for defalcation by a fiduciary is denied.
III. CONCLUSION
The Motion is denied to the extent it seeks to bar or establish the non-dischargeability claims on res judicata grounds. The Motion is also denied to the extent it seeks to re-litigate the amount of the debt owing to Wendt, as this issue is established as a matter of law on collateral estoppel grounds.
The Motion is granted to the extent it challenges the sufficiency of the Complaint regarding the allegations of a bad check and opinions relating to the future success of the business, and denied on all other sufficiency grounds. The Court notes that exceptions to discharge are construed liberally in favor of the debtor and the party seeking to establish an exception to discharge bears the burden of proof. In re Barr. 194 B.R. 1009, 1016 (Bankr. M.D. 111. 1996). While Wendt can proceed with his claims in this Court, whether Wendt can prove his fraud and defalcation claims will need to be resolved at trial.
IT IS SO ORDERED.
MARGARET M. MANN, JUDGE
United States Bankruptcy Court