Opinion
Case No. 97-50092-JRG Chapter 7, Adversary No. 97-5142
November 5, 1999
MEMORANDUM DECISION
I. FACTUAL BACKGROUND
Robert Patrick Fisher ("Defendant"), an attorney, represented Hagen Sons ("Plaintiff"), who were contractors, in various litigation matters during the past twenty years. Due to the personal relationship between Defendant and Plaintiff, Defendant did not always provide regular fee statements to Plaintiff and, in fact, would work for years without payment of fees. Between 1990-1992 Plaintiff also performed construction services for Defendant on numerous personal projects, for which Defendant still owes Plaintiff money.
In 1993, Defendant represented Plaintiff in a lawsuit against Philippe Kahn that arose out of a construction project. Defendant settled the lawsuit and received a $171,089.83 check from the opposing party. Defendant deposited the check in his client trust account (Acct. # 10-015098-6) on June 17, 1993. At the time of this deposit, the trust account contained $311.35. Defendant did not disclose to Plaintiff the terms of the settlement, the receipt of the settlement funds, nor did he distribute the settlement funds to Plaintiff. Defendant instead told Plaintiff that it would be paid in installments. Bank records indicate that at this time Defendant's law firm was experiencing financial problems and had numerous checks returned due to insufficient funds in the firm's account.
Defendant used the settlement funds for his own purposes by making payments out of his client trust account. He made a $53,493 payment on a personal loan. He transferred a total of a $36,500 to his law firm's accounts. He paid $70,800 to a former client, Woodside Commons, pursuant to a malpractice judgment. By the end of June, Defendant had used all the settlement funds without making a payment to Plaintiff, leaving the client trust account with a balance of $354.23.
Defendant claims that he did not distribute the full amount of the funds to Plaintiff due to an offset arrangement, under which Defendant would deduct from the settlement funds for attorney's fees and other money owed by Plaintiff to Defendant's law firm. Mark Hagen, a partner of Plaintiff Hagen Sons, claims that he never discussed this offset arrangement with Defendant.
Shortly after the settlement, Defendant sent several checks to Plaintiff. Defendant tendered payments to Plaintiff in July 1993, December 1993, January 1994 and March 1994, which totaled approximately $100,000. However, only the January 1, 1994 payment of $25,000 referenced the Kahn settlement. Plaintiff claims that the payments represented money owed to it for construction projects and that only the January 1 check was a settlement payment from the Kahn matter. Defendant testifies that these later payments reflected an agreement to reverse the fee offset in order to help Plaintiff with its financial troubles.
During this same period Defendant continued making disbursements to other parties. Defendant made several payments to McDow Electric, one of the other parties involved in the Kahn litigation whom he represented. These checks specifically referenced the Kahn matter.
In general, Defendant did not provide an accounting of attorney's fees. In fact, Mark Hagen claimed that he never received any billing statements from Defendant on the Kahn matter. Mark Hagen requested an accounting of Defendant's attorney fees and a copy of the settlement agreement, but received no response. In April 1995, Defendant finally provided an accounting to Plaintiff of the settlement funds, which reflected the December and January payments and the setoff for $44,000 in attorney's fees.
Defendant filed for chapter 11 bankruptcy on January 7, 1997. On or about March 18, 1997, Plaintiff filed an adversary proceeding to determine the dischargeability of the debt owed to it by Defendant. Plaintiff alleged in its Complaint and Pre-Trial Statement that Defendant committed fraud, breached his fiduciary duties to Plaintiff, breached an oral contract, and committed legal malpractice. Defendant filed a counter-claim based on negligence for construction services, which was settled. Defendant is currently incarcerated for mail fraud and wire fraud and has been disbarred.
The trial was held on July 15 and 16, 1999. At trial, Plaintiff argued that Defendant had taken the settlement funds that were owed to Plaintiff, deposited them in the client trust account without informing the Plaintiff and proceeded to spend those funds for his own purposes, thereby breaching his fiduciary duty. Plaintiff claimed that it was owed $146,000.83 remaining on the Kahn settlement plus $61,000 interest.
II. DISCUSSION
In this action, Plaintiff prays for relief under §§ 523(a) (4) and 523(a) (6). Section 523(a) (4) states that a discharge under Chapter 7 does not discharge an individual debtor from any debt for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny. See 11 U.S.C. § 523(a) (4). In order to find a debt nondischargeable under § 523(a) (4), the creditor/plaintiff must show that the debt was obtained through fraud or defalcation while acting as a fiduciary, larceny or embezzlement. To establish a claim for fraud or defalcation under § 523(a) (4), a plaintiff must first prove that a fiduciary relationship existed between the plaintiff and the defendant, that the requisite trust relationship existed prior to and without reference to the wrongdoing, and that the defendant committed fraud or defalcation while acting in a fiduciary capacity. See In re Baird, 141 B.R. 198 (B.A.P. 9th Cir. 1990). Claims arising under § 523 need only be proven by a preponderance of the evidence. See Grogan v. Garner, 498 U.S. 279 (1991).
Plaintiff's complaint alleges only breach of fiduciary duty, breach of oral contract, legal malpractice and fraud. Although the Plaintiff does not use the word defalcation, this court is not restricted by the four corners of the complaint. See Jodoin v. Samyoa (In re Jodoin) , 209 B.R. 132 (B.A.P. 9th Cir. 1997) (affirming bankruptcy court's judgment for relief based on Code section not mentioned in complaint). The court has discretion to grant relief based on a theory not specifically pled so long as the Defendant has ample notice of the issue.
Procedurally, the court may, in certain circumstances, grant relief not specifically sought. The court is obliged by Federal Rule of Civil Procedure 54(c) and Bankruptcy Rule 7054(a) to award the party the relief to which the party is entitled under the evidence introduced at trial, even if the party has not demanded such relief in the pleadings. The key qualification is that the failure to demand the appropriate relief must not have prejudiced the adversary in the defense of the matter. See Samayoa v. Jodoin (In re Jodoin) , 196 B.R. 845, 852 (Bankr.E.D.Cal. 1996), aff'd 209 B.R. 132 (B.A.P. 9th Cir. 1997).
Case law supports the court's ability to grant relief on theories not explicitly stated in the pleadings. The 5th Circuit Court of Appeals addressed the failure to specifically plead defalcation inSchwager v. Fallas (In re Shwager) , 121 F.3d 177, 187 (5th Cir. 1997). In that case, the defendant argued that the plaintiffs failed to raise defalcation as a ground for dischargeability because they did not use the word "defalcation" in their complaint. The court stated, "[defendant] had ample notice of a defalcation claim because the [plaintiffs] pleaded § 523(a) (4) as a basis of nondischargeability." Id. at 187.
The 9th Circuit Bankruptcy Appellate Panel ("B.A.P.") has concluded on a number of occasions that a debt may be found nondischargeable, despite the fact that the specific grounds were not raised in the complaint. The B.A.P. in In re Jodoin, 209 B.R. 132, 143 (B.A.P. 9th Cir. 1997), affirmed the bankruptcy court's judgment that certain debts were nondischargeable under § 523(a) (5), despite the fact that the complaint only stated a cause of action under § 523(a) (15). The BAP found that the defendant implicitly consented to the 523(a) (5) issue when he failed to object to the reference to 523(a) (5) during trial and to evidence offered in support of the 523(a) (5) determination. Id. at 137. The B.A.P. made a similar determination in Sarbaz v. Feldman (In re Sarbaz) , 227 B.R. 298 (B.A.P. 9th Cir. 1998), when it held that, since the defendant did not object to plaintiff's opening statement or evidence, the defendant implicitly consented to a 523(a) (6) claim not raised in the complaint. See also Talliant v. Kaufman(In re Talliant) , 218 B.R. 58, 63 n. 9 (B.A.P. 9TH Cir. 1998) (affirming bankruptcy court's finding of nondischargeability of a claim under § 523(a) (2), which was not alleged in the complaint, but raised at trial without objection).
Based on the case law, the court finds that it may make a determination of nondischargeability for defalcation under § 523(a) (4). There was no prejudice to Defendant as the pleadings put him on notice that Plaintiff brought the claim for relief under § 523(a) (4) and the evidence established Defendant's fiduciary capacity and misappropriation and failure to account for funds. Based on this reasoning, it is proper to examine the elements of defalcation under 523(a) (4).
Defalcation consists of failing to produce funds while in a fiduciary capacity. A debt is nondischargeable under § 523(a) (4) where "1) an express trust existed, 2) the debt was caused by [fraud or] defalcation, and 3) the debtor acted as a fiduciary to the creditor at the time the debt was created." Otto v. Niles (In re Niles) , 106 F.3d 1456, 1459 (9th Cir. 1997) (quoting Klingman v. Levinson, 831 F.2d 1292, 1295 (7th Cir. 1987)).
"Fiduciary" is a narrowly defined term in the bankruptcy context. "[T]he fiduciary relationship must be one arising from an express or technical trust that was imposed before and without reference to the wrongdoing that caused the debt." In re Lewis, 97 F.3d 1182, 1185 (9th Cir. 1996). Although determination of a fiduciary relationship for § 523(a) (4) purposes is a question of federal law, this determination relies upon the existence of an express or technical trust pursuant to state law. See Ragsdale v. Haller, 780 F.2d 794 (9th Cir. 1986).
Although attorneys hold the position of fiduciaries of their clients, more is required in order to be considered a "fiduciary" for the purposes of 523(a) (4). "It is well established in California that the relationship of attorney and client is one of trust and confidence and that the attorney owes to his client all of the obligations of a trustee." In re Stokes, 142 B.R. 908, 909 (Bankr.N.D.Cal. 1992). However, the attorney must hold the position of trustee of an actual or express trust in order to be elevated to trustee status under California law. See id. at 909.
Defendant occupied the position of trustee in relation to the Attorney Trust Fund, in which he deposited the settlement funds. Although, the attorney-client relationship generally does not rise to the level of trustee, the one exception is the relationship created by California Rule of Professional Conduct 4-100, which requires the creation of a separate client trust account. See Stokes, 142 B.R. at 910 n. 3. Rule 4-100(A) requires "[a]ll funds received or held for the benefit of clients by a member or law firm, . . . shall be deposited in one or more identifiable bank accounts labelled [sic.] `Trust Account,' `Client's Funds Account' or words or similar import. . . ." This rule prohibits commingling of attorney funds with the client trust funds and requires the attorney to notify the client of the receipt of funds, maintain complete records and provide an accounting to client and promptly pay or deliver any funds the client is entitled to receive. See id. at 4-100(A) (B). The Bankruptcy Court for the Northern District of California has interpreted this rule as elevating the attorney-client relationship to one of trustee-beneficiary status. See Stokes, 142 B.R. at 910 n. 3. This interpretation is similar to that of courts in other states with similar rules. See, e.g. Bennett v. Hollingsworth (In re Hollingsworth) , 224 B.R. 822 (Bankr.M.D.Fla. 1998); Ball v. McDowell (In re McDowell) , 162 B.R. 136 (Bankr.N.D.Ohio 1993);Ducey v. Doherty (In re Ducey) , 160 B.R. 465 (Bankr.D.N.H. 1993); People v. Kaemingk, 770 P.2d 1247 (Colo. 1989).
A trustee-beneficiary relationship existed between Defendant and Plaintiff at the time Defendant received the settlement funds. The $171,089.83 deposit made up the trust res in question. Defendant had a duty to act as a fiduciary with respect to these funds under Rule 4-100. However, Defendant did not act as a fiduciary with the settlement funds. Instead, he used the funds to pay off his own debts as well as transferring a portion of the funds to his law firm accounts.
The definition of defalcation is quite broad and encompasses a number of misuses of funds, intentional or not. Defalcation is defined as "the misappropriation of trust funds or money held in any fiduciary capacity; the failure to properly account for such funds. . . . An individual may be liable for defalcation without having the intent to defraud." In re Lewis, 97 F.3d 1182, 1186-87 (9th Cir. 1996). When Defendant received the settlement funds, failed to notify Plaintiff and used the funds for his own purposes he committed defalcation. Because the debt is nondischargeable under § 523(a) (4), an analysis of the claim for relief under § 523(a) (6) is unnecessary at this time. The only remaining issue is to determine the measure of damages.
Plaintiff requests compensatory damages equal to the amount of settlement funds still owed to it, plus interest, as well as punitive damages, recovery of Defendant's secret profits and attorney's fees and costs.
Based on the evidence, it appears that Defendant made only one payment to Plaintiff from the Kahn settlement. The January 1, 1994 check for $25,000 expressly noted that it was for Kahn. None of the other checks, written both before and after the January 1994 payment for Kahn, referenced any specific matter. The Plaintiff states that it assumed that these other checks were for their construction services and the court finds that assumption reasonable.
Defendant appears to have made a regular practice of referencing matters when making payments from the client trust account. The evidence indicates that when Defendant made payments to McDow Electric pursuant to the Kahn settlement he referenced the Kahn matter on the checks. If Defendant was making payments to Plaintiff on the Kahn settlement he would have so noted as he did on the other checks. Accordingly, Plaintiff is entitled to compensatory damages equal to the remaining settlement funds, totaling $146,089.83.
Plaintiff requests prejudgment interest on the compensatory damages. Since this is a matter under federal statute the determination of interest is governed by federal law. The award of prejudgment interest under federal law is left to the sound discretion of the trial court. See Acequia, Inc. v. Clinton, 34 F.3d 800, 818 (9th Cir. 1994). Although § 523(a) (4) does not mention interest, the Supreme Court has held that "the failure to mention interest in [federal] statutes which create obligations has not been interpreted by this Court as manifesting an unequivocal Congressional purpose that the obligation shall not bear interest." Rodgers v. United States, 332 U.S. 371, 373 (1947). Prejudgment interest is computed at the Federal Rate equal to the 52-week treasury bill rate. See 28 U.S.C. § 1961 (1991);Beguelin v. Volcano Vision, Inc. (In re Beguelin) , 220 B.R. 94 (B.A.P. 9th Cir. 1998). Since Defendant was, in effect, withholding funds that belonged to Plaintiff, it is appropriate that Plaintiff receive interest on its damages from the time the settlement check was deposited on June 17, 1993 until the date of this judgment.
The award of punitive damages by a bankruptcy court is an issue involving federal law. It is clear that a bankruptcy court may award punitive damages under § 523. See Cohen v. De La Cruz, 523 U.S. 213 (1998) (affirming award of punitive damages under 523(a) (2)); Bugna v. MacArthur (In re Bugna) , 33 F.3d 1054, 1059 (9th Cir. 1994) (barring discharge of punitive damages under 523(a) (4)); Klause v. Thompson (In re Klause) , 181 B.R. 487, 492 (Bankr.C.D.Cal. 1995) (citing In re Adams, 761 F.2d 1422 (9th Cir. 1985)). Bankruptcy courts look to state law for guidance in awarding punitive damages. See Klause, 181 B.R. at 492; Sunclipse, Inc. v. Butcher (In re Butcher) , 200 B.R. 675, 678-79 (Bankr.C.D.Cal. 1996).
California Civil Code § 3294(a) provides for punitive damages for "oppression, fraud, or malice." Under § 3294, Plaintiff must prove, by clear and convincing evidence, that Defendant's conduct was fraudulent, oppressive, or malicious. Section 3294(c) (1) defines malice as "conduct which is intended by the defendant to cause injury to the plaintiff or despicable conduct which is carried on by the defendant with a willful and conscious disregard of the rights or safety of others." Plaintiff failed to meet the elements of fraud and offered no evidence that Defendant intended to inflict injury on Plaintiff.
Policy reasons further illustrate that punitive damages would be inappropriate in this case. Punitive damages are imposed to deter future misconduct by the defendant. See Adams v. Murakami, 54 Cal.3d 105, 110 (1991). Defendant is currently incarcerated for conduct similar to the conduct at issue in this proceeding. An award of punitive damages will not provide significantly more deterrence than imprisonment. Similarly, the court takes into consideration the defendant's wealth in setting an award of punitive damages. See Professional Seminar Consultants, Inc. v. Sino Am. Technology Exch. Council, Inc., 727 F.2d 1470, 1473 (9th Cir. 1984). Defendant in this case is in bankruptcy, is imprisoned and has been disbarred by the California State Bar. Based on the nature of Defendant's acts, the amount of compensatory damages, and Defendant's current and potential wealth, punitive damages seem improper in this case.
Plaintiff also requests damages in the form of attorney's fees and costs. An award of attorney's fees and costs in this type of action is proper and will be granted. See Cohen v. De La Cruz, 523 U.S. 213 (1998). Plaintiff also requests Defendant's secret profits. However, Plaintiff offered no evidence that Defendant profited from this misappropriation of funds. On the contrary, it appears that Defendant was only trying to keep his practice afloat. The request for attorney's fees and secret profits is denied.
The Court finds that Defendant's debt to Plaintiff of $146,089.83 is nondischargeable under § 523(a) (4) for defalcation. The Court also awards pre-judgment interest on the damages and attorney's fees and litigation costs.
The foregoing shall constitute the court's findings of fact and conclusions of law pursuant to Bankruptcy Rule 7052 and Federal Rule 52.
Counsel for Plaintiff shall lodge a proposed form of judgment with the court within 15 days. It need not contain the findings and conclusions which the court has made orally on the record.