Fourth Circuit: Debt Incurred As a Result of Willful and Malicious Injury May Be Dischargeable

Having been awarded judgment in the Arizona action, TKCA then moved for summary judgment in the Alaska action, which the Alaska state court granted. Although Muhs was not a defendant in the Arizona action, the Alaska court found that Muhs had agreed to be bound by the decision in the Arizona action. In awarding a judgment against Muhs identical to the judgment that had been awarded in the Arizona action, the Alaska court based its finding on the Alaska Uniform Trade Secrets Act, which provides that such awards are warranted "if willful and malicious injury exists." However, the Alaska court's decision contained no specific finding that Muhs intended to injure TKCA.

Following entry of the judgment against him, Muhs filed for bankruptcy protection with the U.S. Bankruptcy Court for the Eastern District of Virginia, seeking to discharge his nearly $20 million indebtedness arising from the Alaska judgment. TKCA moved for summary judgment and a finding that the Alaska judgment was nondischargeable pursuant to, among other Bankruptcy Code provisions, 11 U.S.C. Section 523(a)(6), which provides that debts incurred as a result of "willful and malicious injury by the debtor to another entity" are nondischargeable. TKCA asserted that since the Alaska court had made a finding that a willful and malicious injury had occurred, Muhs was collaterally estopped from contesting dischargeability of the Alaska judgment debt under 11 U.S.C. Section 523(a)(6). The bankruptcy court initially denied TKCA's motion, and TKCA moved for leave to appeal the bankruptcy court's interlocutory order. The district court granted TKCA's motion and then reversed the bankruptcy court's denial of summary judgment. It remanded the case for further proceedings. On remand, the bankruptcy court granted TKCA's motion for summary judgment and the district court affirmed. Muhs then appealed to the U.S. Court of Appeals for the Fourth Circuit.

Fourth Circuit Opinion

The circuit court initiated its inquiry by discussing the elements of collateral estoppel. Collateral estoppel prohibits re-litigation of issues actually decided in earlier proceedings where: the party against whom the preclusion is sought was a party to, or in privity with, a party to the first action; the issue precluded from re-litigation is identical to the issue decided in the first action; the issue was resolved in the first action by a final judgment on the merits; and the determination of the issue was essential to the final judgment. Muhs was a party to the Alaska action and the Alaska judgment was final, the appellate court focused its inquiry on the second and fourth factors.

The court first analyzed whether the issue of Muhs' misconduct adjudicated in the Alaska proceeding was identical to the issue of misconduct that had been decided by the bankruptcy court. Notwithstanding the fact that a finding of Muhs' willful and malicious conduct was crucial to inquiries under both the Bankruptcy Code and the Alaska Uniform Trade Secrets Act, the appellate court reasoned that it could not necessarily "conclude that just because the words [of both statutes] are the same, their meaning is also the same."

The court of appeals analyzed precedent from the U.S. Supreme Court which provided that, under the Bankruptcy Code, deliberate or intentional conduct that leads to an injury is, without more, insufficient to provide the basis for a finding of a willful or malicious injury for purposes of Section 523(a)(6). Drawing on the Supreme Court's and its own precedent, the court concluded that Section 523(a)(6) additionally requires a specific finding of deliberate and intentional injury: it is not enough "that the conduct underlying the injury was intentional." The Alaska Uniform Trade Secrets Act, by contrast, requires only a finding of "intentional acts or gross neglect of duty so as to evince a reckless indifference to the rights of others." Consequently, the appellate court concluded that the misconduct issue adjudicated in the Alaska proceeding was not identical to the misconduct issue before the bankruptcy court.

Perhaps more importantly, the appellate court opined that, even were the issues deemed to be the same, the Alaska court had not explicitly found that Muhs intended to injure TKCA, noting that such a finding was not essential to the Alaska proceeding. Instead, the Alaska court's award of punitive damages under the Alaska Uniform Trade Secrets Act was based upon a finding of willful and malicious conduct. For Section 523(a)(6) purposes, however, what mattered was whether Muhs intended to injure TKCA.

Based on this rationale, the Fourth Circuit reversed and remanded for further proceedings consistent with its opinion.

Analysis

The distinction drawn in this case, while nuanced, made a $20 million difference for both Muhs and TKCA. Indeed, regardless of whether Muhs' conduct was intentional, what remained to be proven was whether Muhs intended to injure to TKCA. This relatively discrete distinction is an important practice point. In the wake of In re Muhs, counsel should be well advised to craft state court pleadings with this foresight, in order to avoid the need to relitigate the "same" case in order to establish an additional element that might be necessary to establish nondischargeability in the defendant's subsequent bankruptcy case.

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Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. Drew S. McGehrin, an associate at the firm, practices in the areas of commercial finance, financial restructuring and bankruptcy. This article also appeared in The Legal Intelligencer, an ALM sibling of The Bankruptcy Strategist.