The United States Supreme Court yesterday issued a unanimous opinion clarifying that the term “defalcation while acting in a fiduciary capacity” “includes a culpable state of mind requirement . . . . We describe that state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.” This decision, authored by Justice Breyer, resolves a longstanding (150 year) split among the courts on the proper interpretation of this phrase with respect to denial of a bankruptcy discharge. Bullock v. Bankchampaign, N.A.

Background

Randy Bullock was appointed trustee of a trust set up by his father for the benefit of the father’s five children. The sole asset of the trust was a life insurance policy. The life insurance policy permitted the owner of the policy (the trust) to borrow against the value of the policy. Bullock caused the trust to borrow against the insurance policy three times. Two of those times, he caused the trust to lend the proceeds of the borrowings to himself and his mother to permit them to buy a mill and real property. All of the funds were repaid to the trust along with 6% interest – the same rate charged by the life insurance company.

Bullock’s brothers, who were beneficiaries of the trust, sued Bullock in Illinois state court alleging that he had breached his fiduciary duty by making the loans for his own benefit. The brothers conceded in their lawsuit that “Bullock does not appear to have had a malicious motive in borrowing funds from the trust [but] was clearly involved in self-dealing.” The Illinois court found that Bullock had breached his fiduciary duty to the trust and ordered him to pay the trust “the benefits he received from his breaches” and attorneys’ fees. The state court also imposed a constructive trust over the mill and Bullock’s interest in the trust set up by his father. Bankchampaign acted as trustee over the constructive trusts.

After Bullock tried unsuccessfully to liquidate his interests in the assets over which the constructive trust was imposed to permit him to pay the court-ordered fees, he filed a bankruptcy petition. Bankchampaign opposed Bullock’s discharge of the state-court judgment, arguing that the debt fell within Bankruptcy Code Section 523(a)(4)’s exception to discharge as a debt for “defalcation while acting in a fiduciary capacity.” The bankruptcy court granted summary judgment in the bank’s favor. Each of the district court and the Court of Appeals affirmed the decision.

The Supreme Court’s Decision

The Supreme Court first framed the issue before it as “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’” The Court went on to note that “[t]he lower courts have long disagreed about whether ‘defalcation’ includes a scienter requirement and, if so, what kind of scienter it requires.” Finally, the Court “assume[d] without deciding” that the Bankruptcy Code’s use of “’defalcation’ can cover a trustee’s failure (as here) to make a trust more than whole.”

In seeking to resolve this issue, the Court first looked at dictionary definitions of “defalcation” dating back to 1867, the year that Congress first included the term “defalcation” as an exception to a bankruptcy discharge. The Court concluded that dictionary definitions “are not particularly helpful.”
Instead, the Court chose to resolve the issue based on its own precedent, including its 1878 interpretation of the term “fraud” in connection with the bankruptcy law’s exception to discharge:

“[D]ebts created by ‘fraud’ are associated directly with debts created by ‘embezzlement.’ Such association justifies, if it does not imperatively require, the con¬clusion 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 ex¬ist 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 reck¬less 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 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 cir¬cumstances 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.”

Conclusion

While the Bullock decision provides a level of clarity for interpretation of “defalcation,” litigation over interpretation of this term is likely to continue.