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United States Supreme Court Protects Innocent Trustees by Holding that “Defalcation” under Bankruptcy Code § 523(a)(4) Requires a Culpable State of Mind

In Bullock v. Bankchampaign, N.A., 569 U.S. ___ (2013), the United State Supreme Court held that 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 giving rise to liability.

Factual Background and Procedural History

In 1978, Petitioner’s father established a trust for the benefit of his five children. He made Petitioner the trustee and transferred to the trust a single asset, a life insurance policy. The trust instrument permitted Petitioner, as trustee, to borrow funds from the insurer that issued the life insurance policy against the policy’s value. Initially at his father’s request, and later on his own, Petitioner borrowed money from the trust. All of the money borrowed by Petitioner was repaid with interest.

In 1999, Petitioner’s brothers sued Petitioner in Illinois state court. The state court held that Petitioner had committed a breach of fiduciary duty, stating that Petitioner “does not appear to have had a malicious motive in borrowing the funds from the trust” but was nonetheless “clearly involved in self-dealing.” After Petitioner tried unsuccessfully to liquidate certain assets to make court-ordered payments, Petitioner filed for bankruptcy. BankChampaign, as trustee for the constructive trust imposed by the state court on Petitioner’s assets in order to secure Petitioner’s payment of the judgment against him, opposed Petitioner’s effort to obtain a bankruptcy discharge of his debts to the trust. The bankruptcy court granted summary judgment in BankChampaign’s favor, holding that Petitioner’s debts were non-dischargeable under Bankruptcy Code § 523(a)(4) “as a debt for defalcation while acting in a fiduciary capacity.” The Federal District Court and the Court of Appeals both affirmed, with the Court of Appeals finding that “defalcation requires a known breach of fiduciary duty, such that the conduct can be characterized as objectively reckless.”

Petitioner sought certiorari, asking the Supreme Court to decide whether the bankruptcy term “defalcation” applies “in the absence of any specific finding of ill intent or evidence of an ultimate loss of trust principal.” Noting lower courts’ disagreement over whether “defalcation” includes a scienter (intent) requirement and, if so, what kind of scienter it requires, the Supreme Court granted certiorari.

Holding and Analysis

Noting the long-standing disagreement over the mental state required by the term “defalcation” contained in Bankruptcy Code § 523(a)(4), after reviewing dictionary definitions of the word “defalcation,” which it found unhelpful, the Supreme Court turned to its own analysis and interpretation of the term “fraud” in the sections of the Bankruptcy Code containing exceptions to discharge. Citing its opinion in Neal v. Clark, 95 U.S. 704, 709 (1878), in which it held that “fraud” must mean “positive fraud, or fraud in fact, involving moral turpitude or intentional wrong” rather than “implied fraud, or fraud in law, which may exist without the imputation of bad faith or immorality,” the Supreme Court held that “the statutory term “defalcation” should be treated similarly.”

The Supreme Court therefore went on to hold that “where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term [defalcation] requires an intentional wrong. 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) “substantial and unjustifiable risk” that his conduct will turn out to violate a fiduciary duty. 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.””

Commentary

Bullock is a significant case, particularly in the Ninth Circuit, where prior cases have held that “even innocent acts of failure to fully account for money received in trust will be held as non-dischargeable defalcations; no intent to defraud is required,” meaning that most obligations of a trustee, even a non-professional trustee such as a family member under a family trust, were non-dischargeable in bankruptcy. Bullock changes this. Now, absent “knowledge of, or gross recklessness in respect to,” the improper nature of the fiduciary conduct giving rise to the fiduciary’s liability, a fiduciary’s obligations are no longer non-dischargeable in bankruptcy under the “defalcation” exception to discharge contained in Bankruptcy Code § 523(a)(4).

The opinion can be found at: http://www.supremecourt.gov/opinions/12pdf/11-1518_97be.pdf