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Supreme Court Alert: “Defalcation” Defined to Determine Discharge of Debt

May 21, 2013


For years, the term “defalcation” as used in the Bankruptcy Code has been largely undefined, leaving courts to fashion their own views when considering the discharge of certain debts in chapter 7 bankruptcies.  As a result, there were different standards created at the Circuit Court level with regard to a discharge under section 523(a)(4) of the Bankruptcy Code.  The Supreme Court has recently determined the correct standard to be used under this section in an opinion rendered on May 13, 2013 in the case of Bullock v. BankChampaign, N.A., No. 11-1518, 2013 WL 1942393 (May 13, 2013).

Under section 523(a)(4), a debt is non-dischargeable if it arises from “fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny.” In interpreting defalcation, some Circuit Courts ruled that innocent acts by a fiduciary met the test; others required a showing of recklessness or in some instances extreme recklessness.  This resulted in a split among the Circuit Courts on the issue.

The genesis of the Supreme Court’s ruling started out with a 1999 judgment against Randy Bullock, the eventual chapter 7 debtor in bankruptcy.  Bullock was the trustee of an account containing his father’s life insurance proceeds naming himself and his brothers as the beneficiaries.  The trust agreement contained restrictions on Bullock’s ability, as trustee, to borrow funds.  Bullock entered into three transactions in violation of these restrictions.  In the first transaction, Bullock borrowed trust assets to allow his mother to repay a debt owed to his father’s business which he entered into at his father’s request.  In the second and third transactions, Bullock borrowed from the trust to allow him and his mother to buy a fabrication mill and other real estate.  All three of the loans were paid back in full, with interest.

An Illinois court, without finding any malicious motive on Bullock’s part, entered the 1999 judgment against him for breach of fiduciary duty in favor of his brothers based on Bullock’s “self dealing.”  The state court imposed a constructive trust on the mill assets, naming BankChampaign as trustee over the assets as well as the original trust so as to secure payment of the judgment from Bullock’s interests in the assets and the original trust.  Bullock attempted, without success, to liquidate his interests in the constructive trust assets in order to satisfy the judgment.  He then filed for chapter 7 protection in 2009.  BankChampaign commenced an adversary proceeding against him in the bankruptcy case under Bankruptcy Code section 523(a)(4) seeking a determination that the debts were nondischargeable.  The bank alleged that the debts were obtained by Bullock as a result of his defalcation while acting in a fiduciary capacity as trustee.

The bank obtained summary judgment against Bullock in the bankruptcy case which was affirmed on appeal by both the district court and the 11th Circuit, with the Circuit Court noting the split among the Circuit Courts as to what meets the criteria for fiduciary defalcation under the statute.

The Supreme Court ruled that defalcation required a “state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.” Id. at *5.  Justice Breyer, writing for a unanimous panel noted that “…the term requires an intentional wrong.”  He further opined:

“We include as intentional not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent. Thus, we include reckless conduct of the kind set forth in the Model Penal Code.  Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary ‘consciously disregards’ (or is willfully blind to) ‘a substantial and unjustifiable risk’ that his conduct will turn out to violate a fiduciary duty.  That risk ‘must be of such a nature and degree that, considering the nature and purpose of the actor’s conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor’s situation.'”

Id.

The matter was then remanded to the 11th Circuit to determine whether a defalcation had occurred under the heightened standard set forth by the Supreme Court, since previously, the Circuit Court used a standard of “objective recklessness.”

The case puts to rest a longstanding debate dating back to 1867 over the term “defalcation” as a discharge exception.  It is important to note that, under the facts of the Bullock case, all of the debts at issue were fully repaid to the original trust with interest and the trust beneficiaries therefore suffered no actual harm.  Had this not been the case the result may have turned out different, since Bullock’s conduct may have risen to the level of fraud or embezzlement.