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Supreme Court Rules on Meaning of “Defalcation” in Statutory Provision for Nondischargeable Debts in Bankruptcy

undefined from morguefile.comFederal bankruptcy law generally prohibits the discharge of debts related to the debtor’s own fraud or theft. One statutory provision says that debts “for fraud or defalcation” by a fiduciary, such as a trustee, are not dischargeable. 11 U.S.C. § 523(a)(4). Courts have reached differing interpretations of the meaning of “defalcation” over the years, particularly the required mental state. Some courts held that it only required some breach of fiduciary duty by the debtor, while others required intent or knowledge of wrongdoing. The U.S. Supreme Court recently addressed the question, holding unanimously that “defalcation,” in the absence of “bad faith, moral turpitude, or other immoral conduct,” requires proof of an “intentional wrong” on the part of the debtor. Bullock v. BankChampaign, N.A. (“Bullock 2”), 569 U.S. ___, No. 11-1518, slip op. at 6 (May 13, 2013).

The debtor’s father created a trust in 1978, naming his five children as beneficiaries. He made the debtor the trustee, and transferred a life insurance policy to the trust as its sole asset. As trustee, the debtor was permitted to borrow against the insurance policy’s value. He did so three times, in 1981, 1984, and 1990, each time to pay funds to or purchase property for his mother, including a mill he and his mother purchased together. He repaid all borrowed funds at the six percent interest rate set by the insurance company.

The debtor’s brothers sued him for breach of fiduciary duty in an Illinois state court in 1999. The court held that the debtor committed “self-dealing” by borrowing funds from the trust, although it did not find any “malicious motive.” Id. at 2. It assessed the debtor’s benefit from self-dealing at $250,000, and ordered him to pay that amount plus $35,000 in attorney’s fees. It placed the mill in a constructive trust as collateral for the judgment and named BankChampaign as trustee. In re Bullock (“Bullock 1”), 670 F.3d 1160, 1162 (11th Cir. 2012).

The debtor alleged that the bank blocked his efforts to dispose of the mill through sale or lease, making him unable to pay the judgment. He filed for Chapter 7 bankruptcy in 2009, and the bank filed an adversary proceeding to have the judgment declared nondischargeable under § 523(a)(4). The bankruptcy court and the district court both held that the debt was nondischargeable due to the fraud or defalcation of a fiduciary. Id. at 1163. The Eleventh Circuit acknowledged that it had never established a clear definition of “defalcation,” id. at 1164, but concluded that it requires a “known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless.” Id. at 1166. It affirmed the lower courts.

The Supreme Court, after reviewing the many different definitions of “defalcation” among the circuit courts, vacated the judgment and remanded the case to the appellate court. It found that 19th-century definitions of “defalcation” required fraud or criminal negligence, not mere recklessness. Bullock 2 at 4-5. It noted an earlier court’s interpretation of “fraud,” which required proof of “positive fraud, or fraud in fact…and not implied fraud, or fraud in law, which may exist without the imputation of bad faith or immorality.” Id. at 6, quoting Neal v. Clark, 95 U.S. 704, 709 (1878). The court limited the application of “defalcation” to intentional or criminally reckless conduct, and found that the debtor’s conduct, ruled by the Illinois state court to lack “malicious motive,” did not meet this definition.

Individuals whose income is not enough to allow them to pay their debts may be able to seek relief through the bankruptcy system. A Chapter 13 Bankruptcy allows people to propose a plan for repaying a potion of their bills. Typically, an individual would use a Chapter 13 to re-pay debts such as back mortgage and/or vehicle payments; delinquent taxes; etc. They are also able to discharge some or all of their unsecured debts, such as credit card debts, personal loans, and pay day loans. On the other hand, an individual or couple may be able to file for Chapter 7, in which case they would be able discharge their unsecured debts in their entirety. Bankruptcy attorney Devin Sawdayi has helped countless clients in the Los Angeles area through the process of personal bankruptcy since 1997. To schedule a free and confidential consultation, contact us today online or at (310) 475-9399.

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Illness or Other Misfortune Often Leads to Bankruptcy, as Shown by a Los Angeles Chapter 13 Case, Los Angeles Bankruptcy Lawyer Blawg, June 25, 2013

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