Shielding Fraud Judgments from Discharge: Making your Case Before the Petition Date

By Cole Hayes

Your client bought into an existing business after reviewing the books, which showed a six-figure net revenue. He was shown letters of intent from eight new customers promising to double that figure in a year. Unfortunately, it was all a sham; the business had not actually turned a profit since 2015. Your client has a slam dunk fraud claim and will easily be awarded punitive damages.

After negotiating a substantial contingency fee, you plead every cause of action you can come up with: breach of contract, fraud, unfair and deceptive practices, negligence, negligent misrepresentation, breach of fiduciary duty, etc. You collect dozens of boxes of documentary evidence, depose former employees, the defendant, his wife, and the manager of the casino in Atlantic City where they blew your client’s “investment” playing craps.

After the defendant knocked out a few of your claims prior to the trial, opening arguments begin. Two weeks of testimony later, you are sitting with a coy smile as the superior court judge reads the pattern jury instructions to the twelve good folks who will certainly see through the defendant’s fairy-tale and award your client a hefty judgment. They do, of course, and after just three minutes.

The verdict sheet reads:

  1. Did the defendant commit fraud: YES;
  2. Was the plaintiff harmed by the defendant’s negligence: YES;
  3. Was the plaintiff harmed by the defendant’s negligent misrepresentations: YES;
  4. If you answered yes to any of the forgoing, in what amount was the plaintiff actually damaged by the defendant’s actions: $1,150,000;
  5. What amount, if any, is the plaintiff entitled to receive in punitive damages: $300,000.

After adding statutory interest and attorney fees, the judge enters judgment for $1,900,000.

A month after the trial, you are leaning back in your office chair admiring the now-framed judgment adorning your office wall when you get a call from the sheriff who was attempting to levy on the defendant’s bank accounts. The sheriff mentions automatic stay, United States Code, and, finally, bankruptcy. Your heart sinks for a bit, but you remember something from law school about fraud being a non-dischargeable debt in bankruptcy. Surely, punitive damages are non-dischargeable. And, what about res judicata, collateral estoppel, and issue preclusion? You have not used those words since studying for the bar, but they will help you out. Right?


To successfully assert collateral estoppel, a party must show that the issue in question was identical to an issue actually litigated and necessary to the judgment. Turner v. Hammocks Beach Corp., 681 S.E.2d 770, 773−74 (N.C. 2009). So, you will need to compare the elements of each claim supporting your judgment to the various actions under Section 523 of the Bankruptcy Code that would make a debt non-dischargeable. Your verdict sheet covers state law fraud and various forms of negligence.

To prove fraud in North Carolina, a plaintiff must show: “(1) [f]alse representation or concealment of a material fact, (2) reasonably calculated to deceive, (3) made with intent to deceive, (4) which does in fact deceive, (5) resulting in damage to the injured party.” Ragsdale v. Kennedy, 209 S.E.2d 494, 500 (N.C. 1974). “Without the element of intent to deceive, the required scienter for fraud is not present.” Myers & Chapman, Inc. v. Thomas G. Evans, Inc., 374 S.E.2d 385, 391 (N.C. 1988). By contrast, section 523(a)(2)(A) of the Bankruptcy Code excepts a debt from discharge that was obtained by “false pretenses, a false representation, or actual fraud” and covers more conduct than the North Carolina cause of action for fraud as Section 523(a)(2)(A) does not require that the defendant had an intent to deceive. Rather, the fraudulent misrepresentation requirement “is satisfied if the debtor’s representation was known to be false or recklessly made without knowing whether it was true or false.” Boyuka v. White (In re White), 128 Fed. App’x 994, 998 (4th Cir. 2005). Actual fraud in bankruptcy “consists of any deceit, artifice, trick or design involving direct and active operation of the mind, used to circumvent and cheat another—something said, done or omitted with the design of perpetrating what is known to be a cheat or deception.” 4 Collier on Bankruptcy ¶ 523.08 (Alan N. Resnick & Henry J. Sommer, eds., 16th ed.). In short, when you have made your case for fraud in North Carolina state court, you have met the requirements to except that debt from discharge under Section 523 of the Bankruptcy Code.

Your judgment for negligence, however, will not survive bankruptcy. “Negligence excludes the idea of intentional wrong.” Lynn v. Burnette, 531 S.E.2d 275, 279 (N.C. Ct. App. 2000) (citation omitted). By contrast, Section 523(a)(6) of the Bankruptcy Code requires a “willful and malicious injury by the debtor to another entity or to the property of another entity.” The act underlying a claim under Section 523(a)(6) must be done with the actual intent to cause injury. Duncan v. Duncan (In re Duncan), 448 F.3d 725, 729 (4th Cir. 2006).

Having compared the claims and determined your damages for fraud will not be discharged, all you need to do is figure out how much the jury awarded for fraud versus negligence, file a Section 523 complaint in bankruptcy court, and immediately move for summary judgment. That is easier said than done in your case. You have made a critical mistake: your verdict sheet does not draw a line between damages for fraud and damages for negligence.

As recently explained by the Bankruptcy Court in the Western District of North Carolina in In re Jacobs, 582 B.R. 654 (Bankr. W.D.N.C. 2017), “where the state verdict is not specific, parties who have fought for and obtained a judgment in state court can find themselves in a difficult spot . . . A plaintiff with a state court judgment on fraud and negligence would have likely presented evidence in state court bearing on the following Section 523 dischargeability claim. However, state court verdict sheets are usually not written with a mind toward a subsequent bankruptcy. They are rarely sufficiently detailed to include all of the elements required to later find a debt is nondischargeable.” That is common and actually encouraged in leading treatises on North Carolina law. But, it does you no favors when the defendant files a bankruptcy petition because you can no longer rely on collateral estoppel.

A series of decisions from the District Court in Western District of North Carolina clarify how the Bankruptcy Court is to reconcile a mixed bag judgment for fraud and negligence. Understanding the following procedure before heading to trial in state court will protect your eventual judgment from discharge in bankruptcy court.

In a post-state court judgment dischargeability action, the United States District Court instructed the bankruptcy court to first consider the state court verdict sheet. Keever v. Gallagher (In re Gallagher), No. 3:10-CV-00237-W, 2011 WL 1130878, at *5 (W.D.N.C. Mar. 25, 2011), aff’d, 464 F. App’x 163 (4th Cir. 2012). While considering the verdict sheet, the court must review the jury instructions to see if the state court judge used language that mirrors Section 523. For example, the pattern jury instructions on punitive damages offer alternative reasons to support such an award, including actual malice, oppression, a gross and willful wrong, insult, rudeness, indignity, or a reckless or wanton disregard of the plaintiff’s rights,’ N.C.P.I−Civil 810.90, or maliciousness, willful or wanton injury, or gross negligence, N.C.P.I.−Civil 810.91. If the jury was instructed to award punitive damages only upon a finding of willful injury, Code Section 523(a)(6) deems the punitive damages non-dischargeable. However, punitive damages for rudeness will find no protection in the Bankruptcy Code. Duncan, 448 F.3d at 730.

When the verdict sheet lumps the damages for fraud and negligence, the bankruptcy court is to review the state court transcript of the evidence presented to the jury. Id.; 4 Collier on Bankruptcy ¶ 523.06. This exercise is not always fruitful. For instance, in Jacobs, a case in which the state court jury lumped compensatory and punitive damages for fraud, breach of fiduciary duty, and negligence, the Bankruptcy Court read the entire 2322-page state court transcript and examined each of the exhibits presented to the jury. Even then, the Court was unable to parse the dischargeable from the non-dischargeable claims.

If the bankruptcy court is still unable to draw a line between dischargeable and non-dischargeable debts, all is not yet lost. While dischargeability may depend on an underlying state law claim, it is still a matter of federal law. Grogan v. Garner, 498 U.S. 279, 289 (1991). A Claim under Section 523 can stand on its own without the support of a state law judgment. In other words, a plaintiff facing a wholesale discharge of a judgment for fraud and negligence may present additional evidence in bankruptcy court to support a 523 claim in what is essentially a duplicate trial of the state court action. If successful, the fraud claims will be deemed non-dischargeable, but the endeavor will no doubt frustrate the client, drive up legal fees, and delay a final resolution. Or, worse, as in Jacobs, the plaintiff was unable to re-establish its fraud claims in Bankruptcy Court. The entire judgment was discharged.

It is hard to fault anything that the plaintiff did in Jacobs; the attorneys won in state court but ran into the long-held presumption that exceptions to discharge are construed strictly against creditors. That said, their misfortune should serve as a warning to state court litigators to work to protect their wins before ever filing suit. Review Section 523 of the Bankruptcy Code while writing the state court fraud complaint. Ensure that each element of a non-dischargeable claim is pled. Argue in favor of jury instructions that will protect your judgment. Engage bankruptcy counsel to help draft a verdict sheet that is specific enough to evoke collateral estoppel so that a subsequent non-dischargeability action can be resolved quickly at summary judgment. Present the state court with the Western District of North Carolina’s Jacobs decision and explain the potential collection difficulties and waste of judicial resources that may arise down the road.

Cole Hayes is an associate at Moon Wright & Houston, PLLC in Charlotte. Cole’s practice focuses on representation of parties in Chapter 7 and 11 cases as well as parties in commercial litigation.  He also serves as a bankruptcy trustee.