Pemstein v. Pemstein (In re Pemstein)

492 B.R. 274

In re Martin PEMSTEIN and Diana Pemstein, Debtors.Harold Pemstein, Appellant,

v.Martin Pemstein; Diana Pemstein, Appellees.

BAP No. CC–12–1430–TaPaMk.

Bankruptcy No. 2:12–bk–15900–RK.

Adversary No. 2:12–ap–01291–RK.

United States Bankruptcy Appellate Panel of the Ninth Circuit.

Argued and Submitted on May 16, 2013.

Decided June 5, 2013.

Christopher L. Blank, Newport Beach, CA, for Appellant Harold Pemstein; Alan Wayne Forsley, Los Angeles, CA, of Fredman Knupfer Lieberman LLP for Appellees Martin Pemstein and Diana Pemstein.

Before: TAYLOR, PAPPAS, and MARKELL, Bankruptcy Judges.

MEMORANDUM ^*

INTRODUCTION

This appeal presents the question whether defalcation under § 523(a)(4)¹ pertains solely to funds actually received by a fiduciary. ² The bankruptcy court interpreted Ninth Circuit authority to so require. As a result, in plaintiff Harold Pemstein's nondischargeability action against debtor/defendant Martin Pemstein,³ the bankruptcy court did not give preclusive effect to Harold's state court judgment against his business partner Martin for damages for breach of Martin's duty of care in the collection of rents. And, it also found that Harold failed otherwise to show that Martin committed defalcation because Harold had not offered sufficient evidence that Martin actually received rents for which he failed to account. We conclude that the bankruptcy court defined defalcation too narrowly. We also conclude that this error was not harmless, as we cannot otherwise affirm the decision. We, therefore, REVERSE the bankruptcy court's narrow application of § 523(a)(4) defalcation, we VACATE the denial of Harold's § 523(a)(4) claim,⁴ and we REMAND for further findings with respect to the applicability of issue preclusion for defalcation under § 523(a)(4) consistent with this Memorandum or, if the bankruptcy court does not enter a judgment based on issue preclusion, for reconsideration by the bankruptcy court of its conclusions after trial.

On remand, the bankruptcy court also should be mindful of the Supreme Court's recent decision in Bullock v. BankChampaign, N.A., ––– U.S. ––––, 133 S.Ct. 1754, 185 L.Ed.2d 922 (2013).⁵ In Bullock, the Supreme Court resolved the split among the circuits regarding the mental state that must accompany defalcation under § 523(a)(4) (in doing so, it considered and spoke to the meaning of § 523(a)(4) “defalcation”). Although we reverse here based on the bankruptcy court's application of an incorrect legal interpretation of defalcation, and not based on the scienter standard articulated in Bullock, on remand the bankruptcy court should consider reopening evidence regarding intent, given that Bullock requires a heightened standard not previously required in the Ninth Circuit.

FACTS

Harold and Martin are brothers and were partners in a California general partnership, as well as directors of and shareholders in a small, closely-held family corporation. The partnership owned industrial real property that it leased to the corporation and from which the corporation ran the family business. Harold filed lawsuits against Martin in state court based on disputes that arose between them regarding the corporation and the partnership (the “State Court Action”).

During the course of the litigation, the state court filed a Statement of Decision and Judgment in the State Court Action on June 30, 2005 (the “2005 Decision”). The 2005 Decision primarily ordered dissolution of the corporation and the partnership. On January 5, 2010,⁶ Harold obtained a money judgment in the State Court Action against Martin in the amount of $696,218.03 (the “2010 Judgment”).⁷ The state court did not issue a statement of decision in connection with the 2010 Judgment, as neither party requested it. ⁸ The 2010 Judgment states as follows:

The Court finds for the Plaintiff Harold Pemstein against Martin Pemstein finding that Martin Pemstein breached his duty of care to Harold Pemstein in the collection of rent on behalf of HMS Properties. The Court finds that the breach caused Harold Pemstein damagesof $295,871.00 in principal and $400,347.03 in interest.

The State Court Complaint, in particular the fifth cause of action for breach of fiduciary duty against Martin as partner of the partnership, cited statutory authority that would support findings that Martin had breached the duty of loyalty to Harold in the management and winding up of the partnership. ⁹ It also alleged facts that would support findings that Martin had breached both the duty of loyalty and the duty of care owed to Harold, although it did not include a citation to the statute defining the duty of care. ¹⁰ The 2010 Judgment was based on the finding that Martin had breached his duty of care to Harold. Under California law, this finding necessarily means that the state court found that Martin had engaged in “grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law” while acting as a trustee over partnership assets. Cal. Corp.Code § 16404(c). And, as specifically stated in the 2010 Judgment, that conduct related to the “collection of rent on behalf of” the partnership.

Harold, but apparently not Martin,¹¹ appealed from the 2010 Judgment. ¹² The Court of Appeal resolved Harold's appeal by affirming the 2010 Judgment in an unpublished opinion on May 16, 2011 (“DCA Opinion”).¹³

Martin and his wife Diana Pemstein filed their joint petition under chapter 11 on April 28, 2010, and Harold filed his complaint objecting to discharge and dischargeability thereafter (“Adversary Complaint”). Pemstein v. Pemstein (In re Pemstein), 476 B.R. 254, 256 (Bankr.C.D.Cal.2012). The Adversary Complaint incorporated the 2010 Judgment. Pursuant to the first cause of action, Harold sought an exception to discharge under § 523(a)(4), solely as to Martin, on multiple alleged factual grounds. All such grounds were based on alleged breaches of fiduciary duties Martin owed to Harold as his partner in the partnership. The Adversary Complaint also asserted that Martin was liable to Harold based on larceny and conversion of rental income and based on fraud or defalcation by Martin's violation of his duty of loyalty and the duty of care owed to Harold as his partner. At paragraphs 23 and 24 of the Adversary Complaint, Harold virtually quoted, without citation, § 16404(b) & (c) of the California Corporations Code:

23. A partner's duty of loyalty to the partnership and the other partners includes all of the following:

(A) To account to the partnership and hold as trustee for it any property, profit, or benefit derived by the partner in the conduct and winding up of the partnership business or derived from a use by the partner of partnership property or information, including the appropriation of a partnership opportunity.

(B) To refrain from dealing with the partnership in the conduct or winding up of the partnership business as or on behalf of a party having an interest adverse to the partnership.

(C) To refrain from competing with the partnership in the conduct of the partnership business before the dissolution of the partnership.

24. A partner's duty of care to the partnership and the other partners in the conduct and winding up of the partnership business is limited to refraining from engaging in grossly negligent or reckless conduct, intentional misconduct, or a knowing violation of law.

The bankruptcy court conducted a trial on November 30, 2011.¹⁴ It requested or allowed three rounds of post-trial briefs on specifically identified legal questions regarding defalcation under § 523(a)(4). ¹⁵ The bankruptcy court twice heard post-trial oral arguments. Thereafter, it issued its Memorandum Decision denying all claims under the Adversary Complaint and entered judgment in favor of both Debtors on August 2, 2012. Harold timely filed his notice of appeal. Harold appeals only from the bankruptcy court's denial of his § 523(a)(4) claim; ¹⁶ he primarily challenges the bankruptcy court's interpretation and application of the standard for defalcation, its refusal to apply issue preclusion, and its conclusion that Harold failed to carry his burden of proof at trial.

JURISDICTION

The bankruptcy court had jurisdiction pursuant to 28 U.S.C. §§ 1334 and 157(b)(2)(I) & (J). We have jurisdiction under 28 U.S.C. § 158.

ISSUES

Did the bankruptcy court err in determining that Harold's § 523(a)(4) defalcation claim fails because neither the 2010 Judgment nor evidence admitted at trial established that Martin actually received rents for which he failed to account?

STANDARD OF REVIEW

In reviewing a bankruptcy court's dischargeability determination, we review its findings of fact for clear error and its conclusions of law de novo. Oney v. Weinberg (In re Weinberg), 410 B.R. 19, 28 (9th Cir. BAP 2009). The availability of issue preclusion is a question of law, which we review de novo. Wolfe v. Jacobson (In re Jacobson), 676 F.3d 1193, 1198 (9th Cir.2012). If issue preclusion is available, the decision to apply it is reviewed for abuse of discretion. Lopez v. Emergency Serv. Restoration, Inc. (In re Lopez), 367 B.R. 99, 103 (9th Cir. BAP 2007). A bankruptcy court abuses its discretion if it bases a decision on an incorrect legal rule, or if its application of the law was illogical, implausible, or without support in inferences that may be drawn from the facts in the record. United States v. Hinkson, 585 F.3d 1247, 1261–62 & n. 21 (9th Cir.2009) (en banc).

DISCUSSION

A creditor objecting to the dischargeability of its claim bears the burden of proving, by a preponderance of the evidence, that the particular debt falls within one of the exceptions to discharge enumerated in section 523(a). Grogan v. Garner, 498 U.S. 279, 286–91, 111 S.Ct. 654, 112 L.Ed.2d 755 (1991). The bankruptcy court here correctly allocated to Harold the burden to prove that Martin was acting in a fiduciary capacity and that, while doing so, he committed defalcation. In re Pemstein, 476 B.R. at...