• Kyle Dickson

U.S. Supreme Court Defines Standard for Defalcation

IN LANDMARK CASE, U. S. SUPREME COURT RESOLVES AGE OLD DISPUTE OVER MEANING OF TERM IN BANKRUPTCY CODE; SETS NEW STANDARD FOR EXCEPTION OF DEBTS FROM DISCHARGE BY REASON OF DEFALCATION



Introduction

In the landmark decision of Bullock v. BankChampaign, NA, 133 S. Ct. 1754 (May 13, 2013), the United States Supreme Court settled a question confounding courts and litigants since 1867. The Court accepted this case after noting that there were numerous lower court interpretations of the term defalcation resulting in at least three different applications of the term in bankruptcy cases. In oral arguments, it was noted that this case presented one of the most confounding questions of bankruptcy law, the meaning of defalcation, which is found in Section 523(a)(4) of the United States Code, 11 U.S.C. § 101 et seq. (the "Bankruptcy Code").

It is an undefined term in the Bankruptcy Code with more than 100 defined terms and has been so in every version since 1867. There is no plain contemporary, ordinary meaning that can settle the dispute regarding interpretation of the word because it is not in common use. Legal authorities have long disagreed about its meaning. Broad definitions of the term in modern and older dictionaries are unhelpful, and courts of appeals have disagreed about what mental state must accompany the definition of defalcation.


This case presented both the question of the action required to establish defalcation and the mental state that must accompany it.


There are two main purposes for bankruptcy:

  1. to give debtors a fresh financial start by eliminating most if not all of their debts; and

  2. to fairly distribute debtors’ assets amongst creditors.

According to statistics released by the Administrative Office of the U.S. Courts, 936,795 bankruptcies were filed in the year ended December 31, 2014 (909,812 personal and 26,983 business). Kmart Corp. is the biggest U.S. retailer to declare bankruptcy, according to data going back to 1980, with total pre-bankruptcy assets of more than $17 billion, Reuters reported.


The statistics for personal bankruptcies are as follows: average age: 38; 44% of filers are couples; 30% are women filing alone; 26% are men filing alone; slightly better educated than the general population; two out of three have lost a job; half have experienced a serious health problem; fewer than 9% have not suffered a job loss, medical event or divorce; highest bankruptcy rates: Tennessee, Utah, Georgia, Alabama.


The primary expected outcome of filing for bankruptcy is a discharge of most if not all of one’s debt. Creditors may object to the discharge of the debt owing to them, and under certain circumstances, the debt may be deemed to be non-dischargeable under the Bankruptcy Code. Section 523 of Title 11 of the Bankruptcy Code, provides that certain debts may not be discharged, including debts incurred by "fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny." 11 U.S.C. § 523(a)(4).



Background of the Case

Bullock was the trustee of a Life Insurance Trust (the “Trust”), created by his father for the benefit of Bullock and his four siblings. On several occasions, Bullock borrowed funds from the Trust for various investments which resulted in profit for himself. Bullock repaid the Trust in full, but his brothers sued him in Illinois state court, alleging that he breached his fiduciary duty to the Trust, as these loans were not authorized by the terms and conditions of the Trust. The state court held that even though he had repaid the Trust in full, Bullock had breached his fiduciary duty as trustee by engaging in self-dealing. Interestingly, the state court issued this opinion while noting the absence of a malicious intent on Bullock's part. The state court awarded Bullock's brothers the sum of $250,000 (representing the "benefit received" by Bullock from his breach) plus $35,000 in attorneys' fees. Additionally, it imposed constructive trusts on some of Bullock’s property and on the original trust.


Bullock then filed for bankruptcy relief and his brothers opposed discharge of Bullock’s debts to the Trust on the grounds of defalcation. The issue before the Supreme Court was the scope of the term defalcation, including the conduct and state of mind required to constitute and exception to discharge of debts under the Bankruptcy Code.


Oral Argument

The transcript of the oral argument before the Supreme Court makes it clear that the Justices and counsel had significant difficulty in analyzing this case. The Justices attempted to have counsel define the mental state required and the kind of loss, if any, required for defalcation. The Court looked to the requirements for fraud in the general sense, as well as embezzlement and larceny as those terms are nearest to defalcation in the Bankruptcy Code.


The Court questioned the parties regarding what mental state should be required: whether it mattered if Bullock knew taking out the loans constituted self-dealing and constituted a breach of fiduciary duty; whether some higher standard was required. The specifics of the conduct involved and the nature of the terms of the Trust were also examined.


The Decision

In the final analysis, the Supreme Court held that where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term defalcation requires an intentional wrong. The Court went further to state that its definition of intentional conduct included 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. Therefore, in situations where actual knowledge of wrongdoing is lacking by the fiduciary, the conduct satisfies the requirement if the fiduciary consciously disregards or is willfully blind to a substantial and unjustifiable risk that such conduct will result in a violation of a fiduciary duty.


To summarize, the term defalcation in the Bankruptcy Code includes a culpable state of mind requirement involving knowledge of, or gross recklessness in respect to the improper nature of the fiduciary behavior.


Conclusion

Before Bullock, the standard for defalcation ranged from no specific state of mind to some degree of fault to extreme recklessness. Bullock resolved the circuit split and set forth the minimum culpability required by a fiduciary to make a debt non-dischargeable as one closer to the extreme recklessness end of the spectrum. This higher standard is likely to result in more debts arising from a debtor’s breach of fiduciary duty to be dischargeable, and furthers the bankruptcy policy of providing debtors with a fresh start.


The result is one clearly articulated standard, but there still remains ample room for courts to be inconsistent in their application of this defalcation exception to discharges in bankruptcy.

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