Arbitration Judgment Applies to Determination of Nondischargeability

Posted by NCBRC - November 13, 2014

The doctrine of collateral estoppel mandated that findings in a state court arbitration judgment applied to the determination of nondischargeability of a debt in chapter 7 bankruptcy. Margolis v. Hensley (In re Hensley), No. 12-42785, Adv. Pro. 12-4180 (Bankr. E.D. Tex. Oct. 1, 2014). In Hensley, a home construction project went from contentious to litigious when the buyer (Margolis) sued the builder (Hensley) for breach of fiduciary duty, among other things, in state court. The case was referred to arbitration in accordance with the terms of the construction contract. Before arbitration took place, however, the builder/defendant filed chapter 7 bankruptcy. The bankruptcy court granted relief from stay to permit the arbitration to go forward. The plaintiff prevailed in arbitration upon a finding that the defendant had violated certain sections of the Texas Construction Trust Fund Act (CTFA). Without entering findings of facts or conclusions of law, the state court confirmed the arbitration award in the amount of $98,737.9 for the fraud claim, as well as attorney’s fees and costs.

In the bankruptcy court, the homeowners filed a claim against Hensley and, in an adversary proceeding, sought to have the portion of the state judgment attributable to fraud found non-dischargeable under section 523(a)(4). The issue came before the court on the plaintiff’s motion for summary judgment.

The court began with whether the state court judgment was entitled to collateral estoppel. Applying Texas law, the court found that collateral estoppel, or issue preclusion, prevents relitigation when: “(1) the facts sought to be litigated in the second case were fully and fairly litigated in the first; (2) those facts were essential to the prior judgment; and (3) the parties were cast as adversaries in the first case. Bonniwell v. Beech Aircraft Corp., 663 S.W.2d 816, 818 (Tex. 1984).” In the context of nondischargeability of a debt based on a state court judgment, a court may determine that issue preclusion applies when the state court “necessarily found” the existence of certain facts in its decision even in the absence of findings of fact and conclusions of law.

The bankruptcy court found that the record showed definitively that the facts were fully litigated in the arbitration proceeding and that the defendant’s fraudulent conduct under the CTFA was essential to the state court judgment. The court noted that the defendant admitted to full participation in the state court proceedings, that there was no dispute as to the findings in arbitration and no appeal of the judgment. Thus, all three requirements for application of collateral estoppel were established.

In an extensive footnote, the court addressed the general concern that the arbitration may not have been free of legal error, but it noted that such error would render the judgment voidable rather than void. Under Texas law, the state court judgment was more insulated from attack due to its arising out of an arbitration proceeding. In Texas, an arbitration award “has the same effect as a judgment of a court of last resort, and is conclusive on the parties as to all matters of fact and law.” The state court must confirm unless there are statutory grounds not to. The court noted that, under state law, an arbitration judgment may not be overturned on appeal even where there is a mistake of fact or law. Moreover, even assuming that the underlying judgment was void rather than merely voidable, the court found that that would not alter the result because the defendant did not challenge the state court jurisdiction when he had the opportunity, and the Rooker-Feldman doctrine prevented the bankruptcy court from independently examining that issue.

Stating that the “bankruptcy court retains exclusive jurisdiction to determine whether a debt is dischargeable,” the court turned to whether the state court judgment satisfied the elements for nondischargeability under section 523(a)(4) due to fraud or defalcation while acting in a fiduciary capacity. Under section 523(a)(4), the concept of fiduciary duty, while informed by state law, is narrower than the concept in general common law.

Examining the CTFA, the court found that it creates a trust under which funds paid toward a construction project are held in trust by the contractor (or subcontractor) for the benefit of subcontractors and property owners. While the court noted that the statute does not elevate every contractor who accepts funds to the position of fiduciary, it found that courts have applied a practical test under which, when funds are used or diverted by the trustee-contractor for use other than for the construction project, the elements of section 523(a)(4) are satisfied. Thus the state court’s finding that the defendant had diverted the $98,737.99 in trust funds with an intent to defraud the plaintiffs, was sufficient to show that the debt was nondischargeable under section 523.

In addition, the scope of the nondischargeability finding was broad enough to encompass all debt related to the fraud. Therefore, the state court’s award of attorney fees and costs, in proportion to the part of the state court judgment attributable to the fraud, was likewise nondischargeable.


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