In the Matter of John Smith Mcmillan, John S. Mcmillan, John Mcmillan,bankrupt. (d. C. No. B-75-150 in Bankruptcy) in the Matterof Mary Mcmillan, Bankrupt. (d. C. No. B-75-151in Bankruptcy)appeal of Freedom Finance Co., Inc, 579 F.2d 289 (3d Cir. 1978)

John S. Giava, Newark, N. J., for appellant.

Paul C. Gretchyn, Ocean-Monmouth Legal Services, Inc., Toms River, N. J., for appellee.

Before GIBBONS and HUNTER, Circuit Judges and WEBER,^*  District Judge.

OPINION

WEBER, District Judge.

This case raises the question of whether a bankrupt's creditor has made a prima facie case that his claim is nondischargeable under 11 U.S.C. § 35(a) (2) (Supp.1977)¹  by introducing into evidence only the state court record and default judgment grounded in fraud.² 

Appellees John and Mary McMillan filed voluntary petitions in bankruptcy on January 27, 1975, and were duly adjudicated bankrupt and released from all dischargeable debts. On April 2, 1975, the appellant, Freedom Finance Company, filed in bankruptcy court a complaint which sought to have the McMillans' obligation to it declared nondischargeable. In support of this claim, appellant argues that a default judgment by the Ocean County, New Jersey district court that the bankrupts had been guilty of fraud in failing to disclose the full amount of their indebtedness when applying to Freedom Finance for a loan, as a matter of law, compelled a determination that the debt in question was nondischargeable. After this issue was briefed and argued by the parties, the bankruptcy judge ruled that he was

"still bound to ascertain for . . . (himself) that the elements of an exception to dischargeability established by § 17a(2), have been fully proven by the Plaintiff. This cannot be accomplished by mere reference to the wording of an earlier judgment. Rather this court must review the prior proceedings and determine whether Plaintiff has shown the elements of conduct required of the Bankrupt. . . . "

under that section.³ 

At the hearing on this claim, appellant failed to produce any proof other than the Ocean County judgment and record and, having found this insufficient, the bankruptcy judge dismissed the complaint and held the debt to be dischargeable. On appeal, the district court adopted the opinion of the bankruptcy judge and affirmed.

Prior to 1970, a bankruptcy court granted the bankrupt a general discharge but did not rule on whether any specific obligation was nondischargeable on statutory grounds. Any judgment creditor could seek to enforce or execute on his claim in the appropriate forum, which would litigate the issue of dischargeability if the bankrupt raised his discharge as a bar. To do this, the court would examine the record of the judgment sought to be enforced to determine the nature of the judgment. In 1970, Section 17 c was amended to its present form. The effect of this change was to vest in the bankruptcy court exclusive jurisdiction to determine the dischargeability of debts allegedly falling within 17 a(2). See Herzog, Bankruptcy Act and Rules, 1975 Collier Pamphlet Edition at 61. The problem in this case, then, involves two analytically separate questions:

(1) Apart from any special nature of a bankruptcy case, what is the collateral estoppel effect of the state court judgment in this case on the bankruptcy proceedings?

(2) If the doctrine of collateral estoppel would apply so that the bankrupt could be barred from relitigating facts necessary to the judgment rendered by the state court, do the federal policies in bankruptcy cases supersede the policy of finality of judgments represented by the doctrine of collateral estoppel?

One of the recent cases on collateral estoppel in this Circuit is Haize v. Hanover Insurance Co., 536 F.2d 576, 579 (3d Cir. 1976) wherein the doctrine was defined as follows:

"Restatement of Judgments § 68(1) (1942) states:

'Where a question of fact essential to the judgment is actually litigated and determined by a valid and final judgment, the determination is conclusive between the parties in a subsequent action on a different cause of action . . .'.

Thus, there are at least four requirements which must be met before collateral estoppel effect can be given to a prior action: (1) the issue sought to be precluded must be the same as that involved in the prior action; (2) That issue must have been actually litigated; (3) it must have been determined by a valid and final judgment; and (4) the determination must have been essential to the prior judgment." (footnotes omitted).⁴ 

At this point, an examination of what actually happened in the state court proceedings is illuminating. Freedom Finance Co. commenced that action with a complaint which alleged that:

"2. On or about September 21, 1973, defendants borrowed money from plaintiff and executed a promissory note therefor upon which note a balance of $1,082.37 is past due and owing, inclusive of accrued interest.

3. That before making said loan defendants submitted their statement in writing showing all their outstanding obligations and listed 3 debts totalling $2480, on which plaintiff relied.

4. That in truth and in fact defendants had 7 or more obligations totalling over $10,000.

5. Had plaintiff known the truth it would not have made such a loan.

6. That plaintiff has been damaged in the sum of $1,082.77 by defendants' misrepresentation." Appendix at 10.

At the hearing, appellant's president testified substantially to this effect and added that, in a telephone conversation, John McMillan had admitted that he had known of the debts which had not been listed in the loan application at the time of its submission.

From this, two conclusions must be drawn. First, Freedom Finance did not adequately plead in the state court complaint elements required by § 17 a that either of the McMillans had made the false representations knowing at the time that they were false and with the intention and purpose of deceiving the creditor. Public Finance Corp. of Redlands v. Taylor, 514 F.2d 1370 (9th Cir. 1975). Second, even if the proof at trial was sufficient to justify a finding by the trier of fact that John McMillan had had such knowledge and intent, no proof was offered that Mary McMillan had also committed "actual fraud involving moral turpitude," Wright v. Lubinko, 515 F.2d 260, 263 (9th Cir. 1975).⁵ 

In any case, we conclude that, because the bankrupts did not "actually litigate" the Ocean County case, not even facts which were necessary to that judgment can collaterally estop them from relitigating the same issues in the bankruptcy case. This holding is consistent both with general rules of collateral estoppel and with the federal policies in bankruptcy cases. See Vol. 1B Moore's Federal Practice P 0.419(3. 6), at p. 3121.

The theory underlying the doctrine of collateral estoppel, as well as res judicata, is that, as between the parties and their privies, an issue need and should be judicially determined only once. Where the bankrupt or his trustee has actually litigated a suit prior to the determination of factually related issues in bankruptcy court, the collateral estoppel principle should and does apply in accordance with the requirements of Haize, supra. However, the preponderant view is that preferred by the Restatement, especially in comments d and e to Section 68 (1942): a default judgment has no collateral estoppel effect.⁶ 

"To invoke the doctrine of collateral estoppel in default causes is not only an oppressive application of the doctrine, but it misconceives the nature of a default judgment.

The defendant in a suit should not be compelled, at his peril, to embark on extensive litigation involving perhaps some minor matter 'in order to prevent the operation of a judgment which would be held conclusively to have established against him every material fact alleged and not denied in the declaration, so as to preclude him from showing the truth if another controversy should arise between the same parties.' There may be various reasons why the defendant does not wish to contest a suit . . . In any event a default judgment should be given the precise effect it merits. It should, of course, be conclusive in a subsequent suit on the same cause of action involving the same parties or their privies. But it should not, in a subsequent suit on another cause of action between the parties preclude the litigation of issues not litigated in the defaulted action, whether alleged or not. A plaintiff 'cannot justly complain that the defendant has not seen fit to set up defenses and raise issues for the purpose of enabling him to settle facts for future possible controversies.' " Vol. 1B Moore's Federal Practice P 0.444(2) at 4006-07 (footnotes omitted).

This is in accordance with the approach preferred by the treatise writers dealing with this question in the bankruptcy context, who advocate a rule allowing the bankruptcy court to relitigate factual issues determined by the state court in every § 17 a(2) case. See Volume 1A Collier on Bankruptcy, (14th Ed.), P 17.16, pp. 1650-1650.3; Cowan's Bankruptcy Law and Practice, Supplement, § 433 at p. 102 (1973). Clearly, adoption of the result urged upon us by the appellant giving full collateral estoppel effect to all facts necessarily determined by a prior default judgment would in bankruptcy court determinations under § 17 a(2)

" . . . necessarily defeat a major federal policy of granting exceptions to discharge only in certain circumstances specified by the bankruptcy Act . . .

The court also wishes to point out that creditors should not be encouraged to go into state courts prior to bankruptcy seeking default judgments based upon fraud. Such a circumstance would create an injustice greater than that which the 1970 amendments were intended to cure."