In the most recent Supreme Court decision issued on bankruptcy, Bullock v. BankChampaign, N.A., No. 11-1518, slip op. (May 13, 2013), the High Court finally defined “defalcation” as that term is used in section 523(a)(4) of the Bankruptcy Code. That provision excepts debts from discharge where the debts arise from “fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny.” 11 U.S.C. § 523(a)(4).
In this case, the debtor was the nonprofessional trustee of a family trust established by the debtor’s father for the benefit of the father’s five children. The trust agreement allowed the trustee to borrow money from the trust, provided that the money was repaid with interest. Over the life of the trust, the debtor, acting as trustee, borrowed money on several occasions, each time for non-trust purposes—for example, to repay the father’s debts, to purchase a mill for the mother and debtor, and to purchase real property for the debtor and his wife. Each time, however, the debtor repaid the trust funds with interest as required by the trust documents. The present issue came to light when the debtor’s brother, a trust beneficiary, sued the debtor in state court for breaches of fiduciary duty—specifically, for self-dealing with money borrowed from the trust. The state court found that the debtor’s self-dealing constituted a breach of fiduciary duty and entered judgment against the debtor to return all ill-gotten gains, including the debtor’s interests in the mill, to the trust and its beneficiaries. When the debtor was unable to liquidate his interests in the mill to repay the court-ordered judgment, he filed for bankruptcy.
In bankruptcy, the new trustee (BankChampaign) brought an action under section 523(a)(4) to have the debtor’s obligations to the trust declared non-dischargeable. The bankruptcy court agreed that the debt arose from “defalcation while acting in a fiduciary capacity,” and it awarded judgment in favor of BankChampaign. The district court affirmed but questioned BankChampaign’s motives for pursuing the debtor rather than liquidating the trust principal. The Eleventh Circuit applied an objective standard and concluded that the debtor’s actions were “objectively reckless,” thus warranting a finding of defalcation.
Collier paraphrases a three-way split of authority on the meaning of “defalcation” as follows: (1) innocent mistakes with some degree of culpability, (2) negligent conduct on the part of a fiduciary, or (3) reckless conduct by a fiduciary. See generally Collier on Bankruptcy, ¶ 523.10[b] (16th ed. 2009) (citations omitted). Recognizing this broad split among lower courts, the Supreme Court granted certiorari. The Court noted, however, that it decided only what level of culpability is required to demonstrate defalcation. It expressly passed on the issue of whether defalcation could exist in the absence of actual harm (as, here, the debtor repaid all principal with interest, as required by the trust instruments).
Writing for the Court, Justice Breyer explained that “defalcation” first appeared in a federal bankruptcy statute in 1867, “[a]nd legal authorities have disagreed about its meaning almost ever since.” Bullock, No. 11-1518, slip op. at 4. The Court acknowledged that modern dictionaries and treatises offer no real assistance in defining the term, which, in turn, has led to wide disagreement among bankruptcy, district, and circuit courts. In this decision, the Supreme Court concluded that all three standards paraphrased by Collier fall short.
Citing defalcation’s statutory neighbors—fraud, embezzlement, and larceny—Justice Breyer applied the canon of noscitur a sociis and reasoned that the surrounding language implied a criminal-like degree of culpability. Borrowing from the ALI Model Penal Code, the Court held that “defalcation” must require a heightened level of culpability—not merely mistake, negligence, or even objective recklessness. Instead, the Court held, a debtor must have knowledge of his or her improper conduct while acting in a fiduciary capacity or, at least, a conscious disregard of (or willful blindness to) a substantial and unjustifiable risk that the conduct would violate a fiduciary duty. “That risk,” the Court continued, “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.” Bullock, No. 11-1518, slip op. at 6 (internal quotation omitted, emphasis in the original).
The Court explained that this standard “does not make the word identical to its statutory neighbors” but gives meaning to each neighbor while remaining consistent with a long-standing policy of construing discharge exceptions narrowly in favor of discharge for the honest debtor. See id. at 7–8; see also Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998). This decision is also consistent with the oft-cited Central Hanover Bank decision of Judge Learned Hand, in which he suggested that a debtor is “guilty of a ‘defalcation’ though it may not be a ‘fraud,’ or an ‘embezzlement,’ or perhaps not even a ‘misappropriation.’” See Cent. Hanover Bank & Trust Co. v. Herbst, 93 F.2d 510, 512 (2d Cir. 1937).
In the Bullock decision, the Supreme Court concluded that objective recklessness, as applied by the Eleventh Circuit, still allowed too broad an exception to this debtor’s discharge:
In the absence of fault, it is difficult to find strong policy reasons favoring a broader [discharge] exception here, at least in respect to those whom a scienter requirement will most likely help, namely nonprofessional trustees, perhaps administering small family trusts potentially immersed in intrafamily arguments that are difficult to evaluate in terms of comparative fault.
Bullock, No. 11-1518, slip op. at 8 (emphasis in the original).
Instead, the Court vacated the judgment and remanded for the lower court “to apply the heighted standard” outlined in this decision.
In light of the Court’s reminder that bankruptcy policy favors a discharge for the “honest debtor,” this brief and arguably narrow decision could affect dischargeability litigation in other contexts. See, e.g., 11 U.S.C. §§ 523(a)(2), (6), (8), (10), (12), (18) & 727(a).
Keywords: bankruptcy and insolvency litigation, defalcation, embezzlement, larceny, fiduciary duty, fraud, honest debtor, noscitur a sociis