The U.S. Court of Appeals for the Seventh Circuit recently affirmed a district court’s refusal to enjoin a bank’s state court action to collect on a promissory note and related guaranties, holding that the borrower’s appeal was frivolous and that sanctions were appropriate under Federal Rule of Appellate Procedure 38.

A copy of the opinion is available at:  Link to Opinion.

A bank sued a corporate borrower and related parties in federal district court in 2012 to collect on a promissory note and enforce guaranties. The defendants moved to dismiss, arguing that because the bank had purchased the subject loans from the Federal Deposit Insurance Corporation as receiver for the failed original lender, the federal district court did not have diversity jurisdiction under the Seventh Circuit’s ruling in Federal Deposit Ins. Corp. v. Elefant. 

The district court dismissed the complaint without prejudice, allowing the plaintiff 60 days to file an amended complaint. Before the deadline expired, the bank filed a notice under Federal Rule of Civil Procedure 41 announcing that it was dismissing the case without prejudice. The following day, the district court entered an order dismissing the case without prejudice pursuant to the notice of voluntary dismissal under Rule 41.

Within less than a week, the bank filed a similar complaint in Illinois state court. The defendants moved to dismiss the state court action, arguing that the dismissal of the bank’s prior federal action precluded the bank’s state court claims. The state court rejected this argument, but found that the bank’s complaint “inadequately alleged that the relevant loan documents had been transferred to [the bank]” and gave the bank leave to amend.

The borrower then filed a second federal action, seeking to enjoin the bank’s state court action pursuant to the All Writs Act, 28 U.S.C. § 1651(a) and the relitigation exception to the Anti-Injunction Act, 28 U.S.C. § 2283.

The district court denied the request and dismissed the borrower’s federal case with prejudice because there was never a judgment on the merits in the bank’s original federal case, and the borrower’s action was “an unreasonable and vexatious multiplication of proceedings already pending in state court.”

The borrower appealed the federal district court’s ruling.  On appeal by the borrower, the Seventh Circuit explained that under the Anti-Injunction Act, “[a] court of the United States may not grant an injunction to stay proceedings in a State court except as expressly authorized by Act of Congress, or where necessary in aid of its jurisdiction, or to protect or effectuate its judgments.”

The borrower argued that an injunction against the state court action was needed because, under the “religitation exception” under the Anti-Injunction Act, “a party with a favorable federal judgment may ‘protect that judgment by enjoining repetitive state court proceedings instead of relying on a claim or issue preclusion defense.’”

Reasoning that “[a]s a general rule, federal common law borrows the preclusion principles of the laws of the state in which the federal court that dismissed the diversity suit sat,” the Seventh Circuit applied Illinois law to decide “the preclusive effect of the dismissal of [the bank’s] first federal case, which was brought in federal court in Illinois under diversity jurisdiction,” finding that the “relitigation exception does not authorize an injunction here. Under Illinois law the dismissal of [the bank’s] federal case simply did not preclude a later suit because a dismissal ‘without prejudice’ is not final … and a non-final decision is not subject to preclusion defenses. … If a court dismisses a complaint without prejudice but with leave to amend, and then allows the plaintiff to dismiss voluntarily without prejudice, the dismissal has no res judiciata or claim preclusive effect.”

The Seventh Circuit also rejected the borrower’s two remaining arguments. First, it distinguished its decision in Muhammad v. Oliver, which held that “when a suit is abandoned after an adverse ruling against the plaintiff, the judgment ending the suit, whether or not it is with prejudice will generally bar bringing a new suit that arises from the same facts as the old one” because in the case at bar, “there was no final judgment on any claim by [the bank]. The only ruling that preceded its voluntary dismissal was expressly ‘without prejudice’ to its ability to file an amended complaint curing the problems the court had perceived.”

Second, the Seventh Circuit rejected the borrower’s argument that the doctrine of “springing finality” ended the first case on the merits. Under that doctrine, a dismissal that ‘gives the plaintiff time to fix the problem that led to dismissal’ becomes final once the time to cure has elapsed.” The Court reasoned that a final judgment under Federal Rule of Civil Procedure 58 is a better and clearer way of disposing of lawsuits in federal district court and, in any event, “a conditional dismissal ripens into a final order only when the plaintiff fails to act within the specified time” and, in the case at bar, the bank voluntarily dismissed without prejudice before the 60 days to amend expired.

The Court then explained that even if the state court wrongly denied the borrower’s motion to dismiss, “[t]he relitigation exception to the Anti-Injunction Act still would not authorize an injunction … because [the borrower] took its claim preclusion argument to the state court first. The state court ruled that preclusion does not apply to [the borrower’s] case, and federal courts must respect that ruling.” This is because the Supreme Court of the United States held in Parsons Steel, Inc. v. First Alabama Bank that “when a state court has rejected a claim preclusion or res judicata defense based on a prior federal court judgment, then ‘the Full Faith and Credit Act requires that federal courts give the state-court judgment, and particularly the state court’s resolution of the res judicata issue, the same preclusive effect it would have had in another court of the same State.’”

The Seventh Circuit affirmed the district court’s judgment, concluding that the district court “correctly refused to enjoin [the bank’s] litigation in state court.” Once the borrower “lost in state court it had no reasonable grounds to seek an injunction in federal court. Its proper remedy was to appeal the decision in the state court system and, if necessary, to seek review by the Supreme Court of the United States.”

The bank moved for sanctions under Federal Rule of Civil Procedure 11 after the parties filed their briefs on the merits. The Court found that the bank’s reference to Rule of Civil Procedure 11 was incorrect because sanctions on appeal are governed by Federal Rule of Appellate Procedure 38 instead of Rule 11, but held that did not matter because Rule 38 requires “either a separate motion by the appellee or notice from the court as well as a reasonable opportunity to respond” and the borrower received both because it responded to the motion and suffered no prejudice due to the bank’s “labelling mistake.”

The Court explained that “Rule 38 authorizes a United States Court of Appeals to award damages and single or double costs to an appellee when an appeal is frivolous” and “[a]n appeal is frivolous ‘when the result is obvious or when the appellant’s argument is wholly without merit.”

Although it cautioned that Rule 38 should not be invoked lightly because “sanctions could discourage parties from presenting reasonable and good faith arguments,” the Court found the appeal was “clearly frivolous.”

By continuing to litigate its preclusion defenses in both federal and state courts, the Court found that the borrower’s “conduct flaunts the principles of comity and federalism that animate both the Full Faith and Credit Act and the Anti-Injunction Act” and “that sanctions are appropriate to protect the interests of the courts, [the bank], and other litigants.”

The judgment of the district court was affirmed and the Court established a briefing schedule for the parties to establish the bank’s damages caused by the frivolous appeal.