In a case appealed from the Eleventh Circuit Court of Appeals, the United States Supreme Court ruled on a case involving the definition of "defalcation" in 11 U.S.C. § 523(a)(4).  The case, decided yesterday, May 13, 2013, is Randy Bullock v. BankChampaign NA, 2013 U.S. LEXIS 3521 (U.S. May 13, 2013) (click here for .pdf of opinion). The issue before the Court was the definition and meaning of the term "defalcation," which is not defined in the Code.  The Court held that  “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.

 Section 523(a)(4) provides that:

(a) A discharge under section 727, 1141, 1228 (a), 1228 (b), or 1328 (b) of this title does not discharge an individual debtor from any debt— (4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.

The brief facts of this case are the following.  In 1978, Debtor’s father established a Trust for his five children and made Debtor the trustee.  The sole asset of the Trust was an insurance policy, and the Trust allowed the Debtor to borrow against the policy.  Debtor subsequently borrowed money from the Trust and used the funds to purchase property and a mill for himself and his mother.  Debtor repaid the borrowed funds.

Debtor’s siblings filed suit in state court, and the court held that Debtor breached his fiduciary duties in the self-dealing, albeit without malicious motive.  The court awarded damages of the "benefits he received from his breaches" plus attorneys fees and costs, and appointed BankChampaign as the constructive trustee of the properties and mill.  Debtor was unable to liquidate his interests to pay the judgment, and filed for Bankruptcy.  The Bank sought an exception to the Debtors discharge pursuant to section 523(a)(4) based on the alleged defalcation while acting in a fiduciary capacity. The Bankruptcy Court held in favor of the Bank, and the decision was affirmed by the District Court and the Eleventh Circuit (click here for Eleventh Circuit opinion).  Debtor appealed to the Supreme Court, contending that the debt should not be excepted from discharge absent ill intent or loss of trust principal.  As there was a disagreement on the issue among the lower courts, the Supreme Court granted the petition.

Justice Breyer, writing for the unanimous Court, found that definitions of "defalcation" in treatises and dictionaries "not particularly helpful" but limited the discussion to the debtor’s state of mind:

In resolving these differences, we note that this longstanding disagreement concerns state of mind, not whether “defalcation” can cover a trustee’s failure (as here) to make a trust more than whole. We consequently shall assume without deciding that the statutory term is broad enough to cover the latter type of conduct and answer only the“state of mind” question.

The Court then looked to precedent defining the term "fraud" for guidance"

In 1878, this Court interpreted the related statutory term “fraud” in the portion of the Bankruptcy Code laying out exceptions to discharge. Justice Harlan wrote for the Court:

 “[D]ebts created by ‘fraud’ are associated directly with debts created by ‘embezzlement.’ Such association justifies, if it does not imperatively require, the conclusion that the ‘fraud’ referred to in that section means positive fraud, or fraud in fact, involving moral turpitude or intentional wrong, as does embezzlement; and not implied fraud, or fraud in law, which may exist without the imputation of bad faith or immorality.”  Neal v. Clark, 95 U. S. 704, 709 (1878).

 We believe that the statutory term “defalcation” should be treated similarly.

Thus, 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. 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) “a substantial and unjustifiable risk” that his conduct will turn out to violated fiduciary duty. ALI, Model Penal Code §2.02(2)(c), p.226 (1985). See id., §2.02 Comment 9, at 248 (explaining that the Model Penal Code’s definition of “knowledge” was designed to include “‘wilful blindness’”). 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.” Id., §2.02(2)(c), at 226 (emphasis added).

 The Court held that such an interpretation does not make the term "defalcation" identical to its "statutory neighbors" (embezzlement, fraud, larceny) and that "defalcation," unlike "fraud," may refer to a non-fraudulent breach of fiduciary duty under the language of the statute.

In this case, the Eleventh Circuit applied a standard of "objective recklessness." The Supreme Court remanded the case "to permit the court to determine whether further proceedings are needed and, if so, to apply the heightened standard that we have set forth."