Supreme Court Rules on What Constitutes "Defalcation" By a Fiduciary

The Bankruptcy Code embodies the “fresh start” principle, the idea that people who have made mistakes in their financial lives, or who have simply been the victims of bad luck, can seek refuge in bankruptcy, and discharge their debts.  As noted by the Supreme Court in a 1934 opinion,

“One of the primary purposes of the Bankruptcy Act is to 'relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh free from the obligations and responsibilities consequent upon business misfortunes.' . . . . This purpose of the act has been again and again emphasized by the courts as being of public as well as private interest, in that it gives to the honest but unfortunate debtor who surrenders for distribution the property which he owns at the time of bankruptcy, a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of pre-existing debt.”  Local Loan Co. v. Hunt.

Consequently, most debts can be discharged in bankruptcy.  However, for public policy and other reasons, some debts cannot, or potentially cannot, be discharged.  The major exceptions to discharge include most taxes, most student loans, child and spousal support, criminal fines and penalties, and debts incurred by fraud.

One of the less common exceptions to discharge involves debts “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”Concepts of “fraud”, “embezzlement”, and “larceny” are fairly common and well understood.  However, the concept of “defalcation” while acting in a fiduciary capacity (where money or property is entrusted to one person for the benefit of another) is less well defined and understood.

The Supreme Court in the recent case of Bullock v. BankChampaign wrestled with how to construe “defalcation”.  In that case, Mr. Bullock’s father established a trust for the benefit of his five children (Mr. Bullock and his four brothers), and named Mr. Bullock as the trustee to manage the assets of the trust.  At various times, Mr. Bullock borrowed from trust assets, as was allowed by the trust document.

The first loan from the trust was made at Mr. Bullock’s father’s request, the proceeds of which were given to his mother who used the funds to repay a debt owing to his father’s business.  A second loan was made three years later so that Mr. Bullock and his mother could buy a mill.  The final loan was made six years later; that money was used to buy real estate for Mr. Bullock and his mother.

Mr. Bullock repaid all of the borrowed money with interest at 6%.  Nonetheless, his brothers sued him in state court for breach of fiduciary duty, alleging that all of the loans obtained from the trust involved self-dealing, even though there was no malicious motive in borrowing from the trust.  The state court agreed, and required to repay the trust the benefits he received from his breach of duty, along with costs and attorney fees.  After unsuccessfully attempting to liquidate assets in order to pay that debt, Mr. Bullock filed for bankruptcy.

BankChampaign, the successor trustee, opposed Mr. Bullock’s attempt to discharge the debt in bankruptcy, alleging that Mr. Bullock’s actions constituted “defalcations” while acting as a fiduciary.  The Bankruptcy Court, the District Court, and the Court of Appeals all held that Mr. Bullock’s actions in taking loans from the trust constituted “defalcation”.  The Court of Appeals noted that “defalcation requires a known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless,” and found that Mr. Bullock’s conduct satisfied this standard.

In a unanimous opinion, the Supreme Court reversed the Court of Appeals.  In arriving at that decision, the Supreme Court grappled with differing decisions of the various Courts of Appeals on this issue.  One previous opinion held that even innocent acts of failure to fully account for money received in trust constituted “defalcation”.  Another held that negligence or an innocent mistake would qualify.  Yet another required something close to a showing of extreme recklessness.

In determining the proper standard to apply, the Supreme Court reviewed the historical definitions of “defalcation” which it found not particularly helpful:

“Congress first included the term “defalcation” as an exception to discharge in a federal bankruptcy statute in 1867. . . . And legal authorities have disagreed about its meaning almost ever since.”

To resolve this question, the Court examined the text of the statute as a whole, which rendered debts incurred by “fraud”, “embezzlement”, and “larceny” non-dischargeable, in addition to those incurred by “defalcation”.  It found that fraud, embezzlement, and larceny were all types of conduct that involved intentional wrongdoing, and that “defalcation” should be treated in the same way.  In defining intentional conduct for this purpose, the Court explained that

“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. ALI, Model Penal Code . . . (explaining that the Model Penal Code’s definition of ‘knowledge’ was designed to include ‘wilful blindness’). 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.’”

As the Supreme Court did not find that Mr. Bullock’s conduct met this requirement for “defalcation”, it reversed the previous opinions holding the debt non-dischargeable.

One commentator summarized the effect of the Court’s ruling:

“The result in Bullock dictates that care must be taken in evaluating whether a non-dischargeability action against a trustee or other fiduciary can be successfully maintained. It is remarkable that not only was the decision from a unanimous court, but also a reversal of all three courts below. Another item worth noting is that the Supreme Court made no analysis whatsoever of the res judicata effect of the prior state court judgment from Illinois. The solidarity of the Court in Bullock underscores the necessity of properly evaluating a potential non-dischargeability case. Where intentional wrongs can be demonstrated, the ability to pursue an exception to discharge is obvious. But, the Court’s holding that reckless conduct may also constitute defalcation opens a host of factual considerations and may include the necessity of providing expert testimony to establish the ‘standard of conduct’ for a fiduciary as an element of proof at trial. Because of this heightened level of proof and the prospect that expert testimony may also be required to meet the burden of proof, a careful cost-benefit analysis is something the prudent practitioner and potential plaintiff must consider before making the decision to file suit to avoid a discharge.”  Welcome To The Linguistic Neighborhood: Defalcation After Bullock v. Bankchampaign, N.A. - http://www.martindale.com/litigation-law/article_Stites-Harbison-PLLC_1808284.htm - Retrieved 6/20/13.

This post is intended to be purely informational in nature, and cannot be considered legal advice.  If you have questions related to dischargeability of debt in bankruptcy, please call our office at (503) 545-1061 (Oregon cases) or (360) 836-4238 (Washington cases) to schedule a free initial consultation.