Although an individual debtor can generally obtain a discharge of debts in bankruptcy as part of a “fresh start,” there are certain exceptions. In particular, Section 523(a)(4) of the Bankruptcy Code provides that a debtor is not discharged from a debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” In Bullock the Supreme Court resolved a long standing issue about the proper standard for establishing defalcation.
As noted in prior blog post (Tenant Security Deposits: You May Be Closer to Defalcation Than You Think), there was a split among the Circuits regarding the showing required to establish defalcation, with the 4th, 8th and 9th Circuits finding that an innocent act was enough to constitute a defalcation, while the 5th, 6th, 7th and 11th Circuits required a showing of recklessness, and the 1st and 2nd Circuits required a showing of at least extreme recklessness.
The Supreme Court considered the proper scope of the term “defalcation” and concluded:
We hold that it includes a culpable state of mind requirement akin to that which accompanies application of the other terms in the same statutory phrase. We describe that state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.
In Bullock a father established a trust for the benefit of his five children, and appointed one of his sons as the trustee. The sole asset of the trust was an insurance policy on the father’s life, and under the trust instrument the trustee was allowed to borrow against the policy’s value.
In fact, the trustee borrowed money from the trust on several occasions: At his father’s request, he first borrowed money for his mother, who used the funds to repay a debt to his father’s business. The trustee next borrowed funds to pay for certificates of deposit that he and his mother used to buy a mill. He borrowed funds a third time to buy real property for himself and his mother. All of the money was repaid to the trust along with the required 6% interest.
Almost 10 years after the final loan, the trustee’s brothers sued him, and a state court held that he committed a breach of fiduciary duty. Although the court did not find a “malicious motive,” the loans clearly involved self-dealing. The court ordered the trustee to pay the benefits he received from his breaches. After he was unable to liquidate assets to pay the judgment, the trustee filed for bankruptcy. The bankruptcy court, the federal district court and the 11th Circuit agreed that his conduct constituted defalcation while acting in a fiduciary capacity, which supported a finding that the judgment was not dischargeable. The 11th Circuit identified the standard for defalcation as “objectively reckless.”
The Supreme Court began by noting that defalcation has been an exception to discharge in the federal bankruptcy statutes since 1867. “And legal authorities have disagreed about its meaning almost ever since.” The Court based its interpretation on several considerations:
- Given the statutory context that the other terms in the list of conduct include embezzlement, larceny and fraud (which has been construed to require wrongful intent), there is good reason to require a similar kind of finding for defalcation.
- Imposing the more stringent standard does not make defalcation the same as the other items in the list (i.e. it is not “surplusage”). It does not involve conversion (embezzlement), taking and carrying away another’s property (larceny) or a false statement or omission (fraud).
- There is a longstanding principle that discharge exceptions must be plainly expressed, and are normally confined to circumstances where there are strong special policy considerations for preserving the debt. Without fault, the Court did not see any strong policy reasons for an exception from discharge.
- It appears that some Circuits have adopted a similar interpretation for years without any difficulties.
- It is important to have a uniform interpretation, and none of the parties came up with a good argument for a different approach.
Since the lower Bullock courts applied an objective recklessness standard, the case was remanded for consideration under the heightened standard adopted by the Supreme Court.
It is interesting that it took so many years to bring this issue to a head. It will also be interesting to see whether the heightened standard makes any difference.
Vicki R. Harding, Esq.