Tenant Security Deposits: You May Be Closer to Defalcation Than You Think

In re Hall, 483 B.R. 281 (Bankr. D. Conn. 2012) –

In Hall a residential tenant argued that the debtor landlord’s failure to return a security deposit gave rise to a non-dischargeable debt in his chapter 7 bankruptcy.

Under applicable state law a landlord is required to hold residential security deposits in an escrow account.  Within 30 days after a tenancy is terminated, the landlord must deliver to the tenant either (i) the full amount of the security deposit or (ii) the balance of the security deposit after deducting for damages as itemized in a written statement.  Failure to comply with this requirement results in liability for two times the amount of the security deposit.

In this case the landlord’s response was three weeks late.  Consequently, the court found as a threshold matter that the landlord was liable for double the security deposit ($3,600).  Although the court noted that there is a difference of opinion about whether there could be a reduction in a landlord’s statutory liability for proper damages, the court did not have to deal with this issue since the tenant in this case conceded that deductions could be made.  So, the court went on to evaluate the landlord’s deductions from the security deposit.

The landlord claimed that he was entitled to deduct damages totaling more than $2,000 (which exceeded the security deposit of $1,800) for items such as repairing a toilet (because the tenant’s children supposedly dropped things into the toilet causing it to clog), expenses from several occasions when the tenant locked herself out of the premises, repair to a screen door, replacement of a garbage disposal (again because the tenant’s children supposedly dropped marbles down the disposal), and replacement of a countertop.  However, the court only allowed a deduction of $106 for replacement of the garbage disposal.  For the most part, the claims were rejected because the receipts produced by the landlord did not support the claims.

Once the landlord’s liability was established, the tenant contended that the obligation was non-dischargeable in his chapter 7 bankruptcy because the debt was for “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”  (See Non-Dischargeable Debts: Some Lies Matter More Than Others.)

As an initial question the court had to determine whether the landlord was acting in a fiduciary capacity.  Although state law is relevant in defining rights and obligations, the determination of whether a person is acting in a “fiduciary capacity” for purposes of Section 523(a)(4) of the Bankruptcy Code is ultimately a matter of federal law.

Although fiduciary capacity is not limited to trustees of actual or technical trusts under state law in the Second Circuit, that was not an issue in this case since a technical trust was created because the security deposit statute (i) defined a trust res (i.e. the security deposit), (2) spelled out fiduciary duties (e.g. open an escrow account and maintain the funds except as authorized), and (3) imposed the trust before and without reference to the wrong that created the debt.  Once the court determined that the landlord was acting in a fiduciary capacity, it turned to whether there was “defalcation.”

It noted a split among the circuits with the Fourth, Eighth and Ninth Circuits finding that an innocent act is enough to constitute a defalcation, while the Fifth, Sixth, Seventh and Eleventh Circuits require a showing of recklessness to establish defalcation, and the First Circuit requires a showing of extreme recklessness.  The Second Circuit went along with the First Circuit and requires a showing of “conscious misbehavior or extreme recklessness – a showing akin to the showing required for scienter in the securities context.”  This is not intended to reach fiduciaries who fail to account for funds “only as a consequence of negligence, inadvertence or similar conduct not shown to be sufficiently culpable.”

Although this is intended to require a showing of “actual wrongful intent,” it appears that this standard can be relatively easy to meet.  In this case the court concluded that the landlord withdrew the security deposit from escrow in violation of the statute for his personal purposes.  Since the withdrawal of funds from the escrow account was “consciously undertaken” and the debtor had 25 years’ experience so knew what his responsibilities as a landlord were, the court concluded that the conduct constituted a defalcation.  Consequently the obligation was non-dischargeable.

Although this case is driven by the special protections given to residential security deposits and dischargeability issues that are applicable only to individuals, it serves as an illustration of the broader principle that a landlord can easily get in trouble if it does not keep proper records and follow required procedures.

It also highlights that, depending on the jurisdiction, the threshold for finding a defalcation can be very low.  Note that the standard for defalcation may be clarified in the relatively near future.  The U.S. Supreme Court has accepted certiorari in the case of Bullock v. BankChampaign, N.A., with oral arguments scheduled for March 2013.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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