Defining “Defalcation” in the Context of Dischargeability

A central purpose to the filing of a bankruptcy is to provide an individual debtor with the opportunity to discharge their debts and obtain a fresh start. However, not all debts are dischargeable under the Bankruptcy Code. One category of debt which is not dischargeable is a debt “for fraud or defalcation while acting in a fiduciary capacity. . .” 11 U.S.C. § 523(a)(4). However, until the recent ruling in the case of In re Bullock (Bullock v. BankChampaign, N.A.), 2012 WL 446279 (11th Cir.), the precise meaning of the term “defalcation” was not entirely clear, in the Eleventh Circuit.

In deciding In re Bullock, the Eleventh Circuit recognized a split among the circuits regarding the meaning of defalcation under § 523(a)(4). The Fourth, Eighth, and Ninth Circuits concluded that even an innocent act by a fiduciary can be a defalcation. In re Uwimana, 274 F.3d 806 (4th Cir. 2001); In re Cochrane, 124 F.3d 978 (8th Cir. 1997); In re Sherman, 658 F.3d 1009 (9th Cir. 2011). The Fifth, Sixth, and Seventh Circuits require a showing of recklessness by the fiduciary. In re Harwood, 637 F.3d 615 (5th Cir. 2011); In re Patel, 565 F.3d 963 (6th Cir. 2009); In re Berman, 629 F.3d 761 (7th Cir. 2011). The First and Second Circuits require a showing of extreme recklessness. In re Baylis, 313 F.3d 9 (1st Cir. 2002); In re Hyman, 502 F.3d 61 (2d Cir. 2007). The Third Circuit has not addressed the issue, and the Tenth Circuit made a brief statement in an unpublished opinion that defalcation requires some portion of misconduct. In re Millikan, 188 F.App’x 699 (10th Cir. 2006). Ultimately, the Eleventh Circuit aligned itself with the Fifth, Sixth and Seventh Circuits and found that defalcation under §523(a)(4) requires more than mere negligence, i.e., defalcation requires a known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless. Id. at 5.

In In re Bullock, the debtor was the trustee and beneficiary of his father’s trust. The debtor engaged in self-dealing by using the cash value of a trust life insurance policy as collateral for loans. Id. at 1. Thereafter, the trustee’s brothers, who were also beneficiaries to the trust, successfully sued the debtor alleging a breach of his fiduciary duty by engaging in self-dealing. Id. In awarding damages for the self-dealing, the trial court stated that the debtor/trustee did “not appear to have a malicious motive in borrowing funds from the trust” but that cannot “excuse him from liability.” Id. Thereafter, the debtor filed a chapter 7 bankruptcy seeking to discharge the judgment against him. Id. at 2. However, the bankruptcy court found the debt arose from fraud or defalcation while the debtor was acting in a fiduciary capacity and therefore ruled that the debt was not dischargeable, pursuant to §523(a)(4). Id. The district court affirmed the bankruptcy court’s decision which was then appealed to the Eleventh Circuit.

In applying the recklessness standard for defalcation, the Eleventh Circuit concluded that the bankruptcy court was correct in determining that the debtor committed a defalcation by making the loans while he was the trustee of his father’s trust. Id. at 5. The Eleventh Circuit found that because the debtor was the trustee of the trust, he certainly should have known that he was engaging in self-dealing, given that he knowingly benefited from the loans. Thus, the court concluded, his conduct could be characterized as objectively reckless, and as such, it rose to the level of a defalcation under § 523(a)(4). Id.

This article was submitted by Marc P. Barmat, Furr and Cohen, P.A., One Boca Place, Suite337 West, 2255 Glades Road, Boca Raton, FL 33431; mbarmat@furrcohen.com

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