Earlier this week, the U.S. Supreme Court finally defined
a word that has troubled legal authorities for more than a century.
The term “defalcation” was first included as an exception
to a bankruptcy discharge in 1867, and “legal authorities have disagreed about
its meaning ever since,” Bullock v. BankChampaign, N.A., Slip Op. at 4. This
disagreement has involved whether defalcation requires a showing of “scienter,”
(i.e. intent or knowledge of wrongdoing,) in connection with a breach of
fiduciary duty.
Some courts, such as the U.S. Court of Appeals for the
Ninth Circuit, have held that defalcation includes, “even innocent acts of
failure to fully account for money received in trust.” Conversely, the U.S.
Court of Appeals for the First Circuit, for example, has determined that
defalcation requires conduct that is “objectively reckless,” Bullock, Slip Op.
at 3.
Recognizing the longstanding disagreement and confusion
over the definition of the term, the Supreme Court finally decided to provide
us with a definitive meaning in its recent case of Bullock v. BankChampaign,
N.A.. Randy Bullock was appointed as the trustee under a trust created by his
father. The trust contained a single asset—a life insurance policy.
The policy had a cash value which, as with most such
policies, the owner of the policy could borrow against at a set rate of
interest. Two times during his term as trustee, Bullock borrowed funds from the
life insurance policy for his own personal reasons, each time repaying the
trust for the principal of the loan plus the interest due to the insurance
company. In 1999, Bullock’s brothers sued him in state court for breach of
fiduciary duties relating to his borrowing from the trust.
The state court held that Bullock did indeed breach his
fiduciary duties to the beneficiaries of the trust and that while he “does not
appear to have had a malicious motive in borrowing funds from the trust . . .
[he] was clearly involved in self-dealing.” Bullock, Slip Op. at 2. The state
court then entered a substantial judgment against Bullock to pay to the trust,
“the benefits he received from his breaches.” Bullock, Slip Op. at 2.
When Bullock was unsuccessful in coming up with the funds
to pay the judgment, he filed for bankruptcy relief in federal court to attempt
to obtain a discharge of his debts to the trust. The bankruptcy court determined
that Bullock’s debts to the trust fell within the exceptions to discharge as debts
for “defalcation while acting in a fiduciary capacity.” Bullock appealed the
decision all the way to the Supreme Court.
In trying to craft a workable definition for
“defalcation,” the court used several classic cannons of statutory construction
to attempt to discern the intended meaning of the term in this context. The
result is a heightened standard for excepting a debt from discharge in
bankruptcy for defalcation in a fiduciary capacity: “Where the conduct at issue
does not involve bad faith, moral turpitude, or other immoral conduct, the term
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. . . . Where actual knowledge is
lacking, we consider as equivalent if the fiduciary ‘consciously disregards’
(or is willfully blind to) ‘a substantial and unjustifiable risk’ that his
conduct will turn out to violate a fiduciary duty.” Bullock, Slip Op. at 6.
The court noted that this result is consistent with the
long-standing principle that exceptions to discharge in bankruptcy should be
narrowly construed and “confined to those plainly expressed.” It also stated
that its decision is “consistent with a set of statutory exceptions that congress
normally confines to circumstances where strong, special policy considerations,
such as the presence of fault, argue for preserving the debt.” Bullock, Slip
Op. at 8.
It is interesting to note that the court made reference
to criminal law several times in its opinion, suggesting that defalcation may
require something akin to criminal intent. It is also worth noting that the court
went out of its way to remind the reader that Bullock is a nonprofessional
trustee. Perhaps this implies that a different standard may apply to
professional trustees, (such as investment firms and banks,) - only time will
tell.
In light of its new definition, the Supreme Court vacated
the bankruptcy court’s judgment and remanded the case for a determination as to
whether Bullock had the necessary level of scienter, under the new definition
of defalcation, to prevent his debts from being discharged.
Spencer
A. Stone, Esq.
Photo credit: Microsoft
