Dischargeability of a state-court judgment; Debts incurred by embezzlement or defalcation while acting in a fiduciary capacity; 11 USC § 523(a)(4); Collateral estoppel; Fraud; Whether partners were in a “fiduciary relationship”

In this appeal arising from an adversary proceeding to have a state-court judgment declared nondischargeable, the court held that the bankruptcy court erred by ruling that plaintiff-Long was collaterally estopped from litigating the issue of fraud. He successfully sued his business partners, defendants-Piercys, in state court over the percentage of profits they were required to pay him under their partnership agreement. After he obtained a judgment, they filed for bankruptcy. Long brought an adversary proceeding in bankruptcy court seeking a declaration that the debt could not be discharged under § 523(a)(4). The bankruptcy court granted the Piercys summary judgment, ruling that “Long was collaterally estopped from arguing that the debt arose from embezzlement because the state-court judgment was based only on breach of contract, and that there was no fiduciary relationship that would support a claim under the defalcation prong because there was no express trust created by the parties.” The district court affirmed. On appeal, the court discussed the differences between collateral estoppel and res judicata as applied to dischargeability in bankruptcy proceedings, and held that because the dischargeability issue could not have been litigated in state court, the Piercys could not assert res judicata as a defense. As to collateral estoppel, the bankruptcy court “must review the record of the state-court proceeding to determine if any factual issues relevant to dischargeability have been actually and necessarily determined by the state court.” Long asserted a claim for conversion under Tennessee law, and not contract breach alone, and the state court “judgment was just as likely based on the conversion claim as on the contract claim.” The bankruptcy court “erred in failing to consider whether the fraud issue was necessary to the state court’s judgment.” The court concluded it erred by ruling he was collaterally estopped from litigating the issue of fraud. As for § 523(a)’s “defalcation prong,” under Tennessee law, partners are in fiduciary relationships. Thus, the state-court judgment may “be declared nondischargeable as a debt for fraud or defalcation while the Piercys were acting in a fiduciary capacity under § 523(a)(4), provided that Long can produce evidence of their wrongful intent.” Reversed and remanded.