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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. § 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). 

This recent case may help to prevent severe punishment for mismanagement stemming from an innocent misunderstanding. The first part of this article investigates whether managers of a family business fall within the scope of "fiduciary capacity" under section 523(a)(4) of the Bankruptcy Code, an issue that has created a split among several circuits. The second part of this article explores Bullock's effect on managers of closely held family businesses. The conclusion of the article reviews the significance of Bullock for family-business litigation.

Section 523(a)(4) Applies to Managers of a Closely Held Business
The Bankruptcy Code attempts to organize many competing interests in the limited resources available in the debtor's estate. For example, the code balances the financial interests of victims of a fiduciary's defalcation and the fiduciary's interest in the "fresh start" granted by a discharge in bankruptcy. As between these two interests, the code, in section 523(a)(4), favors the interest of the victims and excepts from discharge debts arising from a defalcation made in a fiduciary capacity. Just how far the scope of fiduciary capacity under section 523(a)(4) stretches has spurred contentious litigation in several circuits. 

Whether the scope of "fiduciary capacity" in section 523(a)(4) includes managers of a closely held business presents a question under federal law. Carlisle Cashway, Inc. v. Johnson (In re Johnson), 691 F.2d 249, 251 (6th Cir. 1982). Federal law limits the definition of defalcation to a breach of fiduciary duties arising from an express or technical trust. See Upshur v. Briscoe, 138 U.S. 365, 378 (1891) (discussing a predecessor statute to section 523(a)(4)); Davis v. Aetna Acceptance Co., 293 U.S. 328, 333 (1934) (same). The two Supreme Court cases, taken together, stand for the proposition that a fiduciary relationship must exist prior to the defalcation; without a prior fiduciary relationship, a constructive trust resulting from a defalcation does not give rise to section 523(a)(4) treatment.

With the Upshur and Davis test in mind, bankruptcy courts then look to the duties that the relevant state laws assign to managers of a closely held business. E.g., LSP Inv. P'ship v. Bennett (In re Bennett), 989 F.2d 779, 784–85 (5th Cir. 1993); accord In re Frain, 230 F.3d 1014, 1017 (7th Cir. 2000); In re Lewis, 97 F.3d 1182, 1186 (9th Cir. 1996). Most circuits that have reviewed the duties of managers of a closely held business have found that these managers owe a fiduciary duty to the business. See Bennett, 989 F.2d at 787–89; accord Frain, 230 F.3d at 1017; Lewis, 97 F.3d at 1186; see also Sheerin v. Davis (In re Davis), 3 F.3d 113, 115 (5th Cir. 1993) (finding a majority shareholder to be bound to the fiduciary duties discussed in section 543(a)(4)). Therefore, the majority rule stands for the notion that a debtor may not discharge a debt arising from a defalcation made while serving as a manager of a business.

A minority of bankruptcy courts have refused to categorize managers of closely held businesses as fiduciaries under section 523(a)(4) of the code. The courts generally limit the section's scope to fiduciaries appointed pursuant to a written declaration of trust. E.g., KMK Factoring, L.L.C. v. McKnew (In re McKnew), 270 B.R. 593, 625 (Bankr. E.D. Va. 2001) (citing an unpublished Fourth Circuit decision). Arguably, this reading of the fiduciary relationship central to section 523(a)(4) misunderstands the test set forth in Upshur and Davis that examines whether the fiduciary relationship existed before the defalcation. See Upshur, 138 U.S. at 378; Davis, 293 U.S. at 333. Even though a business manager's fiduciary duties may not derive from a written trust instrument, the business manager of a closely held business generally does have a fiduciary relationship that predates the manager's defalcation. As such, managers of a family business should satisfy the Upshur and Davis test for a fiduciary relationship under section 523(a)(4).

To give effect to the protections that section 523(a)(4) affords to victims of a defalcation by a fiduciary, most circuits refuse to discharge a debt arising from a defalcation by a manager of a closely held business. This reading recognizes the fiduciary duties imposed on managers by state law and does not stretch the scope of section 523(a)(4) further than a defalcation made in the context of a preexisting fiduciary relationship. Thus, the majority's analysis of the statute accords with the Upshur and Davis test.   

Supreme Court's Definition of "Defalcation" Benefits Managers of Closely Held Businesses
In Bullock, the Supreme Court addresses the severe consequences of section 523(a)(4)'s exception to discharge by narrowing the universe of actions that fall within the definition of a defalcation. The Bullock decision's heightened standard for finding a defalcation requires that the fiduciary commit an intentional wrong. Citing criminal law standards, the Bullock Court includes within the ambit of intentional wrongs "not only conduct that the fiduciary knows is improper but also reckless conduct . . . of the kind set forth in the Model Penal Code." Bullock, 133 S. Ct. at 1759. Furthermore, the Court includes in the defined mental state a conscious disregard or willful blindness to a substantial and unjustifiable risk that the wrongful act may violate a fiduciary duty. Id. As a second guidepost, the Court mentions the scienter standard already established in securities law. Id. at 1761 (citing In re Hyman, 502 F.3d 61, 69 (2d Cir. 2007)). Both referenced standards, the Model Penal Code and securities law, provide volumes of case law that will help to guide courts seeking to apply the heightened mental state now included in the definition of defalcation.

The Bullock decision's definition of defalcation retains the protections that section 523(a)(4) affords to victims of a defalcation. Additionally, the heightened standard avoids an overly broad exception to discharge that might frustrate the "fresh start" that the Bankruptcy Code gives to deserving debtors. Because of the severe consequences of an exception to a bankruptcy discharge, Supreme Court jurisprudence endorses a narrow reading of these exceptions. Under the high court's precedent, an appropriate interpretation of the discharge exceptions limits the exceptions to those debts clearly enumerated in the relevant code section. By requiring a finding of scienter for defalcation, the Bullock decision upholds the principle of reading exceptions to discharge narrowly. Bullock, 133 S. Ct. at 1760–61 (citing Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998)).

The heightened standard endorsed by Bullock eliminates prior concerns that innocent misunderstandings of a fiduciary's responsibilities could result in a non-dischargeable debt pursuant to section 523(a)(4). See generally Herbst, 93 F.2d at 511 (discussing the harsh treatment of a predecessor statute to section 523(a)(4)). In rendering its heightened standard, the Bullock Court notes the benefit that the stricter definition of defalcation might provide to fiduciaries "administering small family trusts potentially immersed in intrafamily arguments that are difficult to evaluate in terms of comparative fault." Bullock, 133 S. Ct. at 1761. Indeed, the dispute at issue in Bullock arose from a family trust.

In a family business context, the Bullock standard for defalcation might appear in a number of situations, though perhaps most likely in the context of an action for breach of fiduciary duties stemming from a manager's self-dealing. The Bullock Court's scienter requirement clarifies that a manager's act of self-dealing in the context of a closely held business would need to rise to at least the level of conscious disregard of the fact that the self-dealing violates the fiduciary duty of loyalty. In addition to innocent self-dealing, Bullock may exclude from section 523(a)(4) other innocent events of mismanagement, such as negligent omissions of disclosure, a mistaken usurpation of a corporate opportunity, or a misunderstanding resulting in a diversion of corporate assets. Pursuant to the heightened requirement of scienter, innocent defaults in management, such as a misunderstanding of formalities related to insider transactions, no longer give rise to an exception to discharge in bankruptcy. 

While Bullock may protect managers of closely held businesses from non-dischargeability for a judgment for breach of fiduciary duties arising from an innocent error, Bullock does not shelter such debts arising from willful blindness. Bullock sets forth a heightened standard for proving a defalcation, but the Court's repeated references to willful blindness signal a clear limitation on the scope of innocent defaults that may escape from section 523(a)(4). Managers should not take Bullock as a license to remain completely ignorant of the fiduciary duties of a manager.

By interpreting defalcation as an intentional wrong, the Bullock decision eliminates the last remaining method of preventing a fiduciary from discharging judgments for breach of fiduciary duties arising from an innocent mistake. See 11 U.S.C. § 523(a)(4) (in addition to acts of defalcation, section 523(a)(4) except debts arising from fraud in a fiduciary capacity, embezzlement, and larceny; all require a showing of scienter). The new standard may not afford significant relief to professional trustees, but for managers of a closely held business, especially in the context of a family business, the new standard could mean the difference in successfully defending against a section 523(a)(4) defalcation action.

Potential Gains and the Alternative Applications of Defalcation's New Standards
The heightened standard for section 523(a)(4) presented by Bullock provides managers of closely held businesses relief from potentially severe consequences resulting from innocent, technical defaults in the manager's fiduciary duties. By its own language, the Bullock decision helps to limit the liability of a fiduciary active in a family enterprise. For managers that attempt to fulfill their fiduciary duties in good faith and avoid reckless risk-taking, the Bullock standard should provide a strong tool in defending against a defalcation exception to discharge.

Managers of family businesses should recognize another potential application of section 523(a)(4) and the new Bullock standard. Along with the fiduciary duties that state laws may create for managers of a closely held business, the Employee Retirement Income Security Act (ERISA) may also impose fiduciary duties on entities or individuals for contributions owed to the business's retirement plan. Just as some bankruptcy courts do not acknowledge the fiduciary duties of managers as sufficient for the type of relationship mentioned by section 523(a)(4), many courts have also determined that ERISA fiduciaries fall outside the scope of section 523(a)(4). See generally Jennifer Liotta, Comment, "ERISA Fiduciaries in Bankruptcy: Preserving Individual Liability for Defalcation and Fraud Debts under 11 U.S.C. § 523(a)(4)," 22 Emory Bankr. Dev. J. 725 (2006). 

Keywords: litigation, commercial, business, defalcation, fiduciary duty, self-dealing, closely held business, family business

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