February 05, 2014 Articles

The Unclear Application of Bullock

What constitutes a defalcation in a closely held business context?

by Devin Burke Hahn

The fiduciary duties imposed on managers of a closely held business add to the many concerns that family members must consider when participating in a family business. When the finances of the family business go awry, litigation may ensue. A manager of a family business may be surprised to face litigation brought by an owner of the family business, an executor of an owner's estate, a trustee of an owner's bankruptcy estate, or a trustee of a family trust holding the ownership interest in the family business. If he or she does face a lawsuit, the manager of the family business may need to defend against claims premised on innocent management mistakes made by the manager. Of those actions, some may be brought on grounds of defalcation, which may present a serious problem for the defendant manager. 

"Defalcation" has persisted as a hard-to-define and easy-to-allege cause of action in business litigation. Courts generally define defalcation as any deficiency in an account held in trust caused by a management default of the account's fiduciary. E.g., Cent. Hanover Bank & Trust Co. v. Herbst, 93 F.2d 510, 511 (2d Cir. 1937) (Hand, J.). The cause of action yields especially contentious bankruptcy litigation because the Bankruptcy Code provides harsh treatment for judgments arising from a defalcation: A debtor cannot discharge a debt arising from a defalcation committed while acting in a fiduciary capacity. See 11 U.S.C. ยง 523(a)(4). Reflecting on this contentious exception to discharge, the Supreme Court recently limited the application of the broad definition of defalcation by requiring a showing of the fiduciary's scienter. Bullock v. BankChampaign, N.A., 133 S. Ct. 1754 (2013). 

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