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DOES A JUDGMENT FOR FRAUD ISSUED BY A STATE COURT ACT AS RES JUDICATA IN A BANKRUPTCY DISCHARGEABILITY PROCEEDING?

Simply put, no.

I'll start by stating that fraud and its appendages as found under 11 U.S.C. 523 are nondischargeable debts (meaning they survive bankruptcy).

Now we must define res judicata (or claim preclusion). In its most basic terms, res judicata prevents a dispute already ruled upon by a previous court to be disputed again in another court.

Being found liable for fraud or absolved of same in a state court proceeding will carry res judicata effect on any subsequent proceeding minus appeal and a very important exception: Bankruptcy.

In Brown v. Felsen, 442 U.S. 127, 1979, the U.S. Supreme Court held that "the bankruptcy court is not confined to a review of the judgment and record in the prior state-court proceedings when considering the dischargeability of a debt."

Part of the reasoning behind this holding is that a debtor is now presenting the new defense of "bankruptcy" and such a defense must be overcome by claims found in the Bankruptcy Code and their proof, not under State causes of action.

In sum, res judicata does not apply when determining the dischargeability of a debt in a bankruptcy court, and the bankruptcy court, who would be in a better position to determine whether an exception to discharge applies and who "Congress intended…to resolve these issues," can consider extrinsic evidence to this end.

This does not mean that a judgment creditor cannot use the prior judgment as evidence for the exception to bankruptcy discharge, but it does mean that such evidence may not be conclusive in a bankruptcy court.

What this means for debtors who are facing potentially nondischargeable debts (outside of those whose nondischargeablity require no adversary proceeding) is that a creditor must continue to extend themselves, exhaust their resources and fight if they want their nondischargeability claims to stick in a bankruptcy court (assuming the debtor backhands the ball to the creditor's side of the tennis court by answering the complaint - and this is always a must if a debtor has been formally accused of an exception to discharge after filing).

On the flip side, according to Brown v. Felson, a creditor may present additional evidence in their pursuit of a nondischargeability claim if a debtor was held innocent of any intentional wrongdoing in a state proceeding, so a debtor must always be prepared for any new surprises sprung by a savvy creditor alleging foul play.

Categories: Bankruptcy Exceptions

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