1. INTRODUCTION - Robert and Sharon Kubick, the debtor defendants, have moved to set aside a default judgment entered by the bankruptcy court for over one-half million dollars in which their debt to Kleberg First National Bank of Kingsville (Kleberg) was declared to be nondischargeable. The motion will be denied as to Robert Kubick       3 ABR 417  and granted as to Sharon Kubick.

     2. FACTUAL AND PROCEDURAL BACKGROUND - On December 19, 1990, Kleberg recovered a judgment against Robert Kubick in Texas state district court for about $470,000. The judgment was entered by default against Kubick.

The debt to Kleberg arose out of the guarantee of Robert Kubick of a loan made by Kleberg to CDS Agency, Inc., an insurance related corporation doing business in Texas. CDS borrowed $400,000 from Kleberg represented by a note dated July 8, 1988. The note was extended by a rollover of the loan in the form of a note for $384,509.59 dated March 10, 1989.

Kubick had three other partners in the CDS Agency venture, who also guaranteed the notes and are also subject to the judgment, but there is no indication that Sharon Kubick was involved in CDS.

In conjunction with the loan, Robert Kubick gave Kleberg three financial statements, entitled "Robert and Sharon Kubick, Statement of Financial Condition" dated June 30, 1986, December 31, 1987, and December 31, 1988. These are extensive documents summarizing the assets and liabilities of the Kubicks.

The first page of each financial statement has a summary balance sheet. See, Exhibits D, E, and F to the complaint. The following table summarizes these balance sheets:

The Kubicks filed a voluntary chapter 7 case on August 30, 1991, in the Bankruptcy Court in the Northern District of Texas. Their schedules and statements show a negative net worth of <$43,629,983>, calculated from the following figures:

Real property		$6,181,500
Personal property		$6,573,440
	Total assets	$12,754,940
Creditors holding secured claims		$14,688,055
Creditors w/ unsec. priority claims		$300,000
3 ABR 418  Creditors w/ unsec. nonpriority claims		$41,396,868
	Total liabilities	$56,384,923

See, Summary of Schedules in the multi-paged schedules and statements filed October 9, 1991 (Docket Entry 20).

The Kubicks amended their schedules on July 22, 1993 (Docket Entry 205) to show a negative net worth of <$18,875,542>:

Real property		$3,180,000
Personal property		$21,437,640
	Total assets	$24,617,640
Creditors holding secured claims		$9,243,757
Creditors w/ unsec. priority claims		$340,000
Creditors w/ unsec. nonpriority claims		$33,909,425
	Total liabilities	$43,493,182

Kleberg, seeing that the Kubicks were trying to discharge about $56 million of indebtedness in their bankruptcy, began a FRBP 2004 exam to determine if there were grounds to challenge the dischargeability of the Kleberg debt. Kleberg contends that it did not get cooperation from the debtor and had to commence the present adversary proceeding before it was fully apprised of the facts. Kleberg filed this adversary complaint in the Texas bankruptcy court under 11 USC § 523(a)(2)(B), and a discharge action under §§ 727(a)(2),(3),(5).

The Kubicks were initially represented in the bankruptcy case by Stephen Stasio, Esq., of Ft. Worth, who also filed an answer in the adversary proceeding.

In about April, 1992, the Kubicks left their home in Ft. Worth due to a pending foreclosure, and traveled around the country looking for a new location to reestablish themselves. They alleged that they always left an address where they could be reached by Stasio, and Stasio alleged that the Kubicks were often out of touch.

The bankruptcy case and adversary proceeding were transferred to this bankruptcy court in the District of Alaska in November, 1992. The bankruptcy court in Alaska conducted pre-trial procedures in which the Kubicks did not appear.

Mr. Stasio appeared reluctantly, and said that despite his efforts he was unable to reach the Kubicks to gain their participation. After several hearings, the court entered a default for the Kubicks failure to appear, and required Kleberg to file a declaration establishing the amount of its judgment.

      3 ABR 419  In support of the default judgment in the bankruptcy court, the president of Kleberg, Scott Dodds, indicated that Kleberg received or reviewed the financial statements, and that they were a substantial factor in making the loan to CDS. He indicated that the bankruptcy documents showed substantially more liabilities than reflected in the financial statements, and led him to believe that the financial statements were not accurate, since the bankruptcy was filed approximately two and a half years after the last financial statement.

Upon the filing of papers by Kleberg to prove up its claim, this court entered a final default judgment in favor of Kleberg against the Kubicks for $563,820.22 plus attorney fees of $11,918.31 (Docket Entry 21, entered on July 12, 1993). This amount was declared to be non-dischargeable.

The court permitted Kleberg to drop its § 727 action since the chapter 7 trustee had obtained a default judgment denying dischargeability in a separate action. It is my understanding that there are negotiations between the trustee and the Kubicks to set aside the judgment denying debtors' discharge in the other adversary proceeding in exchange for a global settlement.

Shortly after the default judgment was entered, the Kubicks present attorneys appeared and moved to set aside the default judgment.

The Kubicks claim that they were not negligent in allowing the default to be entered. They say that Kleberg has not been prejudiced. They also claim that Kleberg made no justifiable reliance on these financial statements, although the Kubicks imply that they were valid financial statement, citing the fact that Robert Kubick was able to obtain loans partially based on these same financial statements from Bank of America in Seattle for over $6,000,000.

In the proceedings involving the Kubicks' motion to set aside the default judgment, the court indicated that default would not be set aside on a rubber-stamp basis, but that the debtors would have to establish a basis for it. In particular, the court entered an Order Denying Kleberg's Motion to Compel and Second Order Regarding Defendants' Motion For Reconsideration, dated September 16, 1993, requiring a detailed rebuttal of the Scott Dodds' affidavit. The order provided that:

[t]he declarations will require analysis of a multitude       3 ABR 420  of assets and liabilities which were disclosed in the Kubicks' financial statements on which KFNBK alleges it relied in granting the loan which the Kubicks guaranteed.

The Kubicks filed supplemental affidavits in support of the motion to set aside the default judgment, but did not show by detailed analysis the validity or basic reliability of the financial statements which Robert Kubick had given to Kleberg.

The lengthy affidavits of the Kubicks offered an explanation of how they lost touch with their Texas attorney, Mr. Stasio, and laid much of the blame to ineffective assistance of counsel. They deny they are culpable in allowing the default to happen.

     3. ANALYSIS -

     3.1.  Standard For Setting Aside Default Judgment - The standards guiding a judge's discretion in refusing to set aside a default is found in In re Hammer, 940 F2d 10 (9th Cir 1991). Hammer sends several messages.

The first message is that a trial on the merits is favored and defaults disfavored. Where the defendant seeks timely relief and has a meritorious defense, all doubts should be resolved in favor of the motion to set aside the judgment. Hammer at 11.

The second message is that a judge may refuse to set aside a default judgment if one of three conditions exist: (a) the plaintiff will be prejudiced if the judgment is set aside; (b) the defendant has not stated a meritorious defense; or, (b) the defendant's culpable negligence led to the default. Hammer at 11-12.

After reviewing the affidavits and arguments in this case, I find that the Kubicks have made a sufficient case to overcome the grounds of culpable negligence (although I am certainly suspicious of some of their statements) or prejudice to Kleberg (which has not argued it was prejudiced). The only grounds remaining open for exercising my discretion not to set aside the default judgments under the Hammer tests is lack of a meritorious defense.

     3.2.  Relief Should Not Be Granted To Robert Kubick Since He Has Not Shown A Meritorious Defense - Viewing the bankruptcy file as a whole, the Kubicks do not appear to have been diligent or forthcoming in providing information to their creditors or cooperating with the       3 ABR 421  trustee. A bankruptcy judge can take notice of the entire file. In re Canyon Partnership, 55 BR 520, 524 (Bankr SD Cal 1985). While I have not based my ruling on the Kubicks' apparent intransigence, it has effected the structuring of the proceeding to set aside the default judgment.

After entering the default against the Kubicks, I ordered Kleberg to file sworn testimony establishing its right to a nondischargeable judgment. Kleberg complied, and I then entered a default judgment, because I felt that the grounds for nondischargeability and the amount of the judgment were established. See In re Siriani, 967 F2d 302, 304 (9th Cir 1992) and In re Greene, 96 BR 279 (9th Cir BAP 1989).

Before the default judgment would be set aside, I determined that the Kubicks would have to show a meritorious defense with some specificity so that Kleberg and the court would not be burdened with a complicated, expensive trial in the face of a frivolous or illusory defense.

Robert Kubick has not provided affidavits which in any material way explain the vast difference in his net worth between the time a loan renewal was obtained by CDS Agency and the Kubicks chapter 7 petition. The explanation was cursory, conclusionary, and not with the degree of specificity the Order Denying Kleberg's Motion to Compel and Second Order Regarding Defendants' Motion For Reconsideration, dated September 16, 1993, required. Thus, Robert Kubick has not raised a meritorious defense. See, Cassidy v Tenorio, 856 F2d 1412 (9th Cir 1988) (naked allegation of fraud not sufficient to raise meritorious defense), and Girlsongs & Warner Bros., Inc. v Starkey, 108 FRD 275, 277 (ND Cal 1985).

The meritorious defense need not be proved by a preponderance, but the defendant must produce competent evidence establishing a factual and legal basis for the tendered defense. Conclusionary affidavits by defendant are not sufficient on the accuracy of Kubick's financial statements. Tri-Continental Leasing Corp., Inc. v Zimmerman, 485 F Supp 495, 497-98 (ND Cal 1980).

The underlying concern is to determine whether the outcome after a full trial might be different than that resulting from the default judgment. Hawaii Carpenters' Trust Funds v Stone, 794 F2d 508,       3 ABR 422  513 (9th Cir 1986). Robert Kubick has not convinced me that there is a meritorious defense given his conclusionary affidavits, and for that reason, the default will not be set aside as to him.

     3.3.  Should Relief Be Granted To Sharon Kubick As The "Innocent Spouse?" - On my own motion, I raised the question of the propriety of the judgment against Sharon Kubick and asked for briefing. Kleberg has not cited any factual basis why a judgment should have been entered against Sharon Kubick in the first place. No mention has been made of the community property law in Texas as a basis for her liability.

Sharon Kubick's only involvement in the business dealings and loans between Kleberg and her husband, Robert Kubick, was the appearance of her name on the joint personal financial statements given by Robert to Kleberg (Exhibits D, E, and F to the complaint). The record contains no inference that Sharon was directly involved in the CDS Agency business or made any representations to Kleberg.

There is 9th Circuit case law on the subject of vicarious liability for nondischargeability. In In re Cecchini, 780 F2d 1440, 1444 (9th Cir 1986), the court held the discharge of the debt a partner (Robustelli), who had filed an individual case, should be denied where another partner (Cecchini) had acted willfully and maliciously pursuant to § 523(a)(6) of the Bankruptcy Code. The court applied a straight agency analysis:

Although there is no evidence in the record concerning Robustelli's direct involvement in converting the funds, it is undisputed that Robustelli and Cecchini were partners . Robustelli, at a minimum participated in the benefits of the conversion . Therefore, applying basic partnership law, Cecchini's knowledge and intent are imputed to Robustelli. [citations omitted].

      3 ABR 423  The trial court, based on substantial evidence of John's misrepresentations, found the debt nondischargeable as to both. The Bankruptcy Appellate Panel affirmed as to John, but reversed as to Cecily because there was no evidence that she had authorized John to act as her agent.

The 9th Circuit said the BAP misread the record. The parties themselves had tried the case as if the husband and wife's liability for nondischargeability was on the same par. That is, no issue was made of the wife's lesser involvement, so no record was made on the point. Nonetheless, the court was troubled by the breadth of Cecchini's holding of vicarious liability for nondischargeability. The court said in dicta, Lansford at 904-05:

Were the record devoid of evidence from which to infer that Cecily Lansford was in some way culpably responsible for the fraudulent financial statement, we would be faced with the difficult legal issue of whether her debt would nevertheless be non-dischargeable by virtue of principles of agency. In In re Cecchini, 780 F.2d 1440 (9th Cir.1986), this court cited basic partnership law to hold that a business partner's debt was non-dischargeable because he had "participated in the benefits" of his partner's misconduct, which had been undertaken on behalf of the partnership and in the ordinary course of business. Id. at 1444. Were we to rely on strict agency or partnership principles, we might be forced to conclude that Cecily Lansford's debt is non-dischargeable regardless of her knowledge of the fraud or her own culpability. In light of the bankruptcy code's purpose of providing a fresh start, see Gleason v. Thaw, 236 U.S. 558, 562, 35 S.Ct. 287, 289, 59 L.Ed. 717 (1915), and the decisions of other circuits refusing to apply agency principles absent some culpability on the part of the party to be charged, see In re Walker, 726 F.2d 452, 454 (8th Cir.1984) (per curiam); In re Bardwell, 610 F.2d 228, 229 (5th Cir.1980) (per curiam); David v. Annapolis Banking & Trust Co., 209 F.2d 343, 344 (4th Cir.1953); In re Lovich, 117 F.2d 612, 614-15 (2d Cir.1941), we believe the breadth of the proposition stated in Cecchini deserves more thorough consideration before its application to the circumstances presented in this case.

I will not stretch Cecchini even further. The default judgment against Sharon Kubick shall be set aside.

     4.  CONCLUSION - The default judgment shall not be set aside as to Robert Kubick (§ 3.2 of this memorandum), but will be set aside as to Sharon Kubick (§ 3.3).

This may have the effect of making the default judgment entered on July 21, 1993 (Docket Entry 23) non-final, since it is only against one of the two defendants. See FRCivP 54(b) and FRBP 7054. If Kleberg chooses not to proceed against Sharon Kleberg, this finality issue will be resolved.

Before entering an order (and possibly triggering a premature appeal), the court will schedule a status conference to discuss the completion of this adversary proceeding.

DATED: June 8, 1994

HERBERT A. ROSS
U.S. Bankruptcy Judge