In In re Smith, (B.A.P. 10th Cir., Aug. 18, 2020), the U.S. Bankruptcy Appellate Panel for the U.S. Court of Appeals for the Tenth Circuit recently joined the majority of circuit courts of appeals in finding that a creditor seeking a judgment of nondischargeability must demonstrate that the injury caused by the prepetition debtor was both willful and malicious under Section 523(a)(6) of the Bankruptcy Code.

Factual Background

Michael Smith, an attorney, worked for 22 years for Equity Title Insurance Company (Equity Title) and served as Equity Title’s chief operating officer and general counsel. In 2008, First American Title Co. and an affiliate (First American), a competitor of Equity Title, acquired a majority interest in Equity Title and changed Smith’s title to “State Underwriting and Legal Counsel.” In 2012, First American and Equity Title officially completed their merger.

Before the merger, in 2004, Smith had entered into an employment agreement with Equity Title that contained a noncompete clause and a non-solicitation clause. After the merger, Smith did not sign a new employment agreement with First American. First American, however, regularly required its employees to review and acknowledge the First American Employee Handbook and Code of Ethics and Conduct online; employees would receive a prompt to access the Employee Handbook and Code of Ethics, and a further prompt to clink an “I Acknowledge” button, which would confirm that they had read and agreed to the terms thereof. Smith did not deny making such an acknowledgment.

In 2014, Smith began taking steps to form a new title insurance company while still an employee of First American. He incorporated Northwest Title, negotiated a lease for office next door to First American, and obtained the necessary regulatory licenses and permits for Northwest Title to conduct business.

In early 2015, Smith resigned from First American, taking First American documents with him when he left. Smith opened Northwest Title the next day, and within the following two weeks, 27 other First American employees left First American to join Smith at Northwest Title. Many of these employees contacted First American customers to let their former customers know that they had moved to Northwest Title. Northwest Title ultimately profited from approximately 150 transactions that had been opened at First American, but closed at Northwest Title.

First American consequently filed a complaint in the U.S. District Court for the District of Utah against Smith, Northwest Title and other former First American employees for breach of contract, tortious interference with contract, breach of fiduciary duty, misappropriation of trade secrets, and unfair competition.

In defense, Smith justified that he could not be in breach of contract because his employment agreement with Equity Title was no longer binding after the merger with First American and because he never entered into an employment agreement with First American. However, Smith did not deny that, as counsel, he owed a fiduciary duty and a duty of undivided loyalty to his employer until such time that he resigned his employment.

Ruling on summary judgment, the district court found that Smith’s employment agreement with Equity Title remained in force after the merger with First American, and that Smith had breached the nonsolicitation provision by directing a significant number of First American employees to their new employment with Northwest Title. At trial, the jury found that Smith had: breached the non-solicitation provision, the Employee Handbook and the Code of Ethics, and awarded First American $500,000 in compensatory damages; breached his fiduciary duty to First American while employed there, and that such breach was willful and malicious or with knowing and reckless indifference, and awarded First American $600,000 in compensatory damages; and tortiously interfered with First American’s contract in a way that was willful and malicious or with knowing and reckless indifference, and awarded First American an additional $525,000 in compensatory damages. The jury also awarded First American attorney fees and costs in the amount of $3,097,816.36. After appeal to the Tenth Circuit, this figure increased to $3,141,122.23.

The Tenth Circuit Court of Appeals affirmed the district court’s judgment against Smith, and Smith subsequently filed a voluntary Chapter 7 bankruptcy petition with the Bankruptcy Court for the District of Utah.

Procedural Background of the Bankruptcy Case

After the filing of Smith’s Chapter 7 petition, First American initiated an adversary proceeding against Smith seeking an order excepting its judgment from discharge under Sections 523(a)(4) and 523(a)(6) of the Bankruptcy Code, but later voluntarily dismissed its count under Section 523(a)(4) (for “fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny”).

Section 523(a)(6) of the code provides that a debt arising from the “willful and malicious injury by the debtor to another entity or to the property of another entity” will not be discharged at the conclusion of the debtor’s bankruptcy case. In order for First American to succeed in its nondischargeability claim under Section 523(a)(6), the bankruptcy court correctly noted that First American would be required to demonstrate that Smith’s actions “constituted both a willful act and a malicious injury.”

Applying Utah law on claim preclusion, the court determined that Smith was precluded from re-litigating the validity or the amount of the debt owed to First American, and found that “for the purposes of Section 523(a)(6), [Smith]’s actions caused a quantifiable injury to First American in the total amount of $4,766,122.23.”

The bankruptcy court further determined that the necessary “willful” intent existed based upon the preclusive effect of the jury’s finding that Smith had intentionally interfered with First American’s existing or economic relations, and that Smith’s intentional concealment of his actions, together with his plans to poach First American’s employees and directly compete for business, demonstrated the requisite “malicious” intent. The court considered and rejected Smith’s defenses that: he formed Northwest Title to improve his employment opportunities and without intent to harm First American; and that he believed his employment agreement was not in force based upon the advice of counsel.

On appeal, the Tenth Circuit Bankruptcy Appellate Panel joined the majority of circuit courts of Appeals in holding that “willful intent” and “malicious intent” are separate elements that must be proven by a creditor seeking a judgment of nondischargeability under Section 523(a)(6).

‘Willful’

The BAP noted that, under Section 523(b)(6), it is not enough for an intentional act to cause injury, but that, for an injury to be “willful,” there must be an intentional injury. The BAP concluded that the bankruptcy court had not erred in using indirect evidence in support of its determination that Smith had subjective knowledge that his actions were substantially certain to cause harm to First American.

‘Malicious’

The BAP applied the Tenth Circuit’s definition of “malicious” adopted in In re Pasek, 983 F.2d 1524 (10th Cir. 1993), which the BAP noted was “generally in accord with the caselaw in other circuits.” Joining the First, Second, Sixth, Seventh, Ninth and Eleventh circuit courts of appeals, the BAP reasoned that the totality of circumstances must be examined, including any justification or excuse proffered by the debtor, to determine whether a wrongful state of mind was present when the injury was caused.

Smith argued that the Bankruptcy Court erred in refusing to consider his justifications and excuses for his actions. Smith insisted that his actions were justified because they were taken to further his own employment without intending harm to First American and that he had believed that he was not subject to the employment agreement with Equity Title. However, the BAP found that the Bankruptcy Court had specifically considered and rejected Smith’s justifications and excuses for his actions, and determined there was more than ample evidence in the record demonstrating that Smith knew his actions were substantially certain to cause harm to First American. Specifically, the BAP quoted from the opinion of the bankruptcy court:

Based on the totality of the facts regarding the debtor’s experience in the title industry; his understanding of the consequences to a title company’s reputation and cash flow from the disruption of its business; his understanding of the issues of employees going to work for a competitor title company; his feelings of animosity towards First American; and his testimony at trial as to his knowledge of the substantial certainty of harm from taking employees and business from First American; … Smith knew that his actions were substantially certain to cause harm …

Also of note to the BAP were numerous emails that Smith wrote, both before and after First American initiated suit against him. In certain of these emails, Smith indicated his intent to do financial harm to First American. Other emails, the BAP noted, demonstrated that Smith “took satisfaction” in the harm that he had wrought on First American. Yet others, the appellate court noted, indicated that Smith didn’t necessarily believe his prior employment agreement was unenforceable; but instead, that he simply intended to “out-litigate” First American, touting the fact that his company was being represented by “some of the best employment specialists in the state.”

The BAP found that the Bankruptcy Court had properly applied the totality of the circumstances standard in finding that Smith acted with wrongful, malicious intent. Accordingly, it affirmed the judgment of the bankruptcy court excepting from discharge First American’s claim against Smith.

This case serves as a warning to counsel that properly drafted non-compete and nonsolicitation clauses in employment agreements may be enforced, with devastating results. Another lesson of the Smith case is glaringly obvious, but it merits restatement here. Lawyers can be very effective in providing advice to our clients: we tell them to exercise caution when engaging in email communication; we advise them to “sleep” on a questionable e-mail message before clicking the “Send” key; we urge them to consider the impact of the content of their e-mail message were it to be published in a newspaper; we explain that while they may get some psychic satisfaction by firing off a strongly worded email message, the content of that message may very well come back to haunt them. Yet too often, these very same lawyers fail to adhere to the advice that they are paid to provide, and they wind up in the same hot water that they successfully advise their clients to avoid. Had Smith heeded this advice, perhaps the nondischargeability case against him would have ended differently.

Rudolph J. Di Massa, Jr., a partner at Duane Morris' Philadelphia and New York offices, 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.

Keri L. Costello, an associate at Duane Morris' Boston office, practices in the area of business reorganization and financial restructuring with a focus on bankruptcy and creditors’ rights. Ms. Costello represents trustees, corporate debtors, creditors and creditor committees in Chapter 7 and 11 cases.