Defalcation Defined

Bullock began as a dispute among family members over administration of their father's life insurance trust and ultimately resulted in the Chapter 7 bankruptcy of one of the children, Randy Bullock, who had been appointed by his father as trustee when the trust was created in 1978. The trust's sole asset was the father's life insurance policy, which featured a $1 million death benefit and accumulated cash value. Bullock and his siblings were named as beneficiaries. Until his father approached him about a loan from the trust, Bullock did not know that he was the trustee.

The dispute involved three loans taken against the cash value of the life insurance policy. All three loans ultimately were repaid in full, with 6% interest. The first loan, for $117,545.96, was made in 1981 at the request of Bullock's father, the settlor of the trust. The loan went to Bullock's mother so that she could repay a debt that she owed to the family garage-construction business. The second loan, for $80,257.04, was made in 1984 to Bullock and his mother. The loan proceeds were used, along with other funds, to purchase a garage fabrication mill for approximately $200,000.00. The third loan, for $66,223.96, was made in 1990 to Bullock and his mother and used in the purchase of real estate near the mill. The loans, totaling $264,026.96, were fully secured by first mortgages on the property. Payments were made on the loans over the course of 13 years. Relying on the insurance agent who sold his father the policy and advised him on creation of the trust, Bullock did not believe the loans were improper. The trust instrument itself did not expressly prohibit transactions with family members or with the trustee.

Bullock resigned as the trustee for the trust in 1998 at the request of some of the beneficiaries. BankChampaign, N.A., was designated successor trustee. Within a few months after resigning, Bullock paid the remaining balance of the loans, with interest. The trust's sole asset, the life insurance policy, then had the same value it had when the trust was created. Nonetheless, Bullock's two brothers brought an Illinois state court action for breach of fiduciary duty. In 2002, after a hearing, the Illinois court found that Bullock did “not appear to have had a malicious motive in borrowing funds from the trust.” The court also found that Bullock “has shown his willingness to make the Trust whole by a pattern of payments he has made to repay the loans from the Trust.” The court made no other finding concerning Bullock's intent, knowledge, purpose, or state of mind. But the court granted summary judgment in favor of Bullock's brothers because the fully repaid loans were deemed self-dealing transactions and thus breaches of fiduciary duty under Illinois law.

The court awarded damages to the trust of $250,000, which the court estimated to be the benefit obtained by Bullock from the breaches of duty. The court added an award of $35,000 in attorneys' fees to the trust, $25,000 of which BankChampaign, as successor trustee, was directed to pay to Bullock's two brothers. The Illinois court also imposed a constructive trust on the assets of Bullock and of two affiliated entities in the amount of the judgment against Bullock. The constructive trust expressly included the Springfield mill property and Bullock's beneficial interest in his father's trust. The effect of this order was to put Bullock's assets, which he might have used toward payment of the judgment, in the Bank's control.

Over the years following entry of the Illinois judgment in 2002, the Bank rejected Bullock's repeated pleas and demands that the property subject to the constructive trust be liquidated to pay the judgment. In 2009, Bullock filed for Chapter 7 bankruptcy. The Bank, as trustee of the trust, filed an adversary proceeding to except Bullock's obligations under the Illinois judgment from discharge under 11 U.S.C. ' 523(a)(4). Bullock answered and, though not a lawyer, defended himself pro se in the adversary proceeding. The Bank filed a motion for summary judgment, contending that Bullock should be collaterally estopped from contesting issues that were decided by the Illinois court, and that the court's judgment established ' 523(a)(4) “defalcation” as a matter of law. The Bank submitted no other evidence in support of the motion, which the bankruptcy court granted. Though sharply criticizing the Bank for its own administration of the trust, the district court affirmed in an unpublished order.

On further appeal, the Eleventh Circuit noted a three-way split among the circuits as to the definition of “defalcation” and aligned itself with the Fifth, Sixth, and Seventh Circuits to hold that “defalcation requires a known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless.” 670 F.3d 1160, 1166 (11th Cir. 2012). The Eleventh Circuit deemed “self-dealing” to be objectively reckless per se, and from that concluded that Bullock's actions amounted to defalcation sufficient to except his debt from discharge.

The Supreme Court Weighs In

The Supreme Court granted Bullock's petition for certiorari. In a unanimous decision written by Justice Breyer, the Court vacated the Eleventh Circuit's judgment. The Court began by observing that the dictionary definitions of defalcation were inconsistent and not particularly helpful. The Court declined to reach the question of whether defalcation “can cover a trustee's failure (as here) to make a trust more than whole.” The Court focused on the state-of-mind question and, as urged by Bullock, relied heavily on its decision in Neal v. Clark, 95 U.S. 704 (1877). Applying the canon of statutory interpretation noscitur a sociis, Neal held that that the association of fraud with embezzlement in the statute suggested that fraud meant “positive fraud, or fraud in fact, involving moral turpitude or intentional wrong” and not “implied fraud, or fraud in law, which may exist without the imputation of bad faith or immorality.” Id. at 709. The Bullock Court, noting the subsequent addition of “larceny” to “embezzlement” and fiduciary fraud in the same clause with “defalcation” in paragraph (a)(4), held as follows:

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 violate a 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). Cf. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194, n. 12 (1976) (defining scienter for securities law purposes as “a mental state embracing intent to deceive, manipulate, or defraud”).

133 S. Ct. at 1759-60.

The Court reasoned that its interpretation did not render the word “defalcation” identical to its statutory neighbors, and that it was consistent with the principle that “exceptions to discharge 'should be confined to those plainly expressed.'” Id. at 1760 (quoting Gleason v. Thaw, 236 U.S. 558, 562 (1915)). Alluding to Bullock's situation, the Court noted its decision would most likely preserve the bankruptcy discharge for non-professional trustees “perhaps administering small family trusts potentially immersed in intrafamily arguments that are difficult to evaluate in terms of comparative fault.” Id. at 1761. The Court remanded the case for application of “the heightened standard that we have set forth.” Id.

Observations

First, as a practical matter, Bullock is likely to limit the circumstances in which issue preclusion is available in exception to discharge proceedings premised on “defalcation” under ' 523(a)(4). Creditors that claim breach of fiduciary duty in an underlying civil action would be prudent to seek findings consistent with Bullock to foreclose a later bankruptcy discharge. The Court's intentional wrongdoing or gross recklessness standard will mean that the mere finding of breach of fiduciary duty in a prior civil action will not establish defalcation in bankruptcy. A prior civil action, instead, will need to include a finding of the culpable mental state required by Bullock. If there is no admission or finding of intentional wrongdoing by a fiduciary, then gross recklessness will need to be established by a finding in the prior action. And that gross recklessness finding will need to be consistent with willful blindness or conscious disregard of a “substantial and unjustifiable” risk, as specified in Bullock.

Second, pre-Bullock cases on defalcation's mental state requirement are no longer good law on that point. The Court selected a standard more restrictive than any of the three standards that had divided the circuit courts, but one adapted to the facts in Bullock. Although the Court cited with a “Cf.” the securities-law scienter standard imported by the First and Second Circuits (Denton v. Hyman (In re Hyman), 502 F.3d 61, 68 (2d Cir. 2007); Rutanen ex rel. Quevillon v. Baylis (In re Baylis), 313 F.3d 9, 20 (1st Cir. 2002)), in which “something close to a showing of extreme recklessness” can be a surrogate for fraudulent intent, the Court chose a somewhat more rigorous and better-established standard for recklessness, the definition found in section 2.02(2)(c) of the Model Penal Code.

Recklessness under the Model Penal Code entails an element of subjectivity, i.e., did the actor consciously disregard a substantial and unjustifiable risk and proceed in the face of it? The nature and purpose of the actor's conduct and the “circumstances known to him” must be evaluated in determining whether there is “a gross deviation from the standard of conduct that a law-abiding person would observe in the actor's situation.” A finding of “objective recklessness” will no longer be sufficient, as the Court expressly rejected the Eleventh Circuit standard.

Third, Bullock stands as a strong endorsement of a narrow construction of discharge exceptions. Although the Court again avoided stating in so many words that exceptions to discharge should be strictly or narrowly construed, the Court quoted the somewhat more elegant yet kindred statement from its 1915 Gleason v. Thaw decision that exceptions to discharge “should be confined to those plainly expressed.” Eschewing the phrase “strict construction” may have avoided friction with some members of the Court who might object to that freighted language. Along with Kawaauhau v. Geiger, 523 U.S. 57 (1998), however, Bullock demonstrates that the Court will be vigilant for infringements on bankruptcy's core “fresh start” policy that are not specified in the Code.

Thomas Byrne is a partner in Sutherland Asbill and Brennan LLP's Litigation Practice Group. His practice focuses on complex business litigation, primarily the defense of consumer and policyholder class actions and bankruptcy litigation. Mr. Byrne represented the petitioner in Bullock v. BankChampaign, N.A. and argued the case before the Supreme Court. He may be reached at [email protected].'

'

'

Section 523(a)(4) of the Bankruptcy Code excepts from discharge debts “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny ' .”

Bullock v. BankChampaign, N.A ., 133 S. Ct. 1754 (May 13, 2013), at last resolves the long-standing uncertainty over the meaning of “defalcation.” Bullock holds that defalcation requires a culpable state of mind involving knowledge of, or gross recklessness in respect to, the improper nature of fiduciary behavior. It means that all prior lower court decisions addressing the mental state requirement for defalcation have little or no precedential value. Litigants hoping to preserve the bankruptcy option for errant fiduciaries or avoid the risk of bankruptcy discharge of debts owed by them should study the decision carefully.

The Decision

Bullock began as a dispute among family members over administration of their father's life insurance trust and ultimately resulted in the Chapter 7 bankruptcy of one of the children, Randy Bullock, who had been appointed by his father as trustee when the trust was created in 1978. The trust's sole asset was the father's life insurance policy, which featured a $1 million death benefit and accumulated cash value. Bullock and his siblings were named as beneficiaries. Until his father approached him about a loan from the trust, Bullock did not know that he was the trustee.

The dispute involved three loans taken against the cash value of the life insurance policy. All three loans ultimately were repaid in full, with 6% interest. The first loan, for $117,545.96, was made in 1981 at the request of Bullock's father, the settlor of the trust. The loan went to Bullock's mother so that she could repay a debt that she owed to the family garage-construction business. The second loan, for $80,257.04, was made in 1984 to Bullock and his mother. The loan proceeds were used, along with other funds, to purchase a garage fabrication mill for approximately $200,000.00. The third loan, for $66,223.96, was made in 1990 to Bullock and his mother and used in the purchase of real estate near the mill. The loans, totaling $264,026.96, were fully secured by first mortgages on the property. Payments were made on the loans over the course of 13 years. Relying on the insurance agent who sold his father the policy and advised him on creation of the trust, Bullock did not believe the loans were improper. The trust instrument itself did not expressly prohibit transactions with family members or with the trustee.

Bullock resigned as the trustee for the trust in 1998 at the request of some of the beneficiaries. BankChampaign, N.A., was designated successor trustee. Within a few months after resigning, Bullock paid the remaining balance of the loans, with interest. The trust's sole asset, the life insurance policy, then had the same value it had when the trust was created. Nonetheless, Bullock's two brothers brought an Illinois state court action for breach of fiduciary duty. In 2002, after a hearing, the Illinois court found that Bullock did “not appear to have had a malicious motive in borrowing funds from the trust.” The court also found that Bullock “has shown his willingness to make the Trust whole by a pattern of payments he has made to repay the loans from the Trust.” The court made no other finding concerning Bullock's intent, knowledge, purpose, or state of mind. But the court granted summary judgment in favor of Bullock's brothers because the fully repaid loans were deemed self-dealing transactions and thus breaches of fiduciary duty under Illinois law.

The court awarded damages to the trust of $250,000, which the court estimated to be the benefit obtained by Bullock from the breaches of duty. The court added an award of $35,000 in attorneys' fees to the trust, $25,000 of which BankChampaign, as successor trustee, was directed to pay to Bullock's two brothers. The Illinois court also imposed a constructive trust on the assets of Bullock and of two affiliated entities in the amount of the judgment against Bullock. The constructive trust expressly included the Springfield mill property and Bullock's beneficial interest in his father's trust. The effect of this order was to put Bullock's assets, which he might have used toward payment of the judgment, in the Bank's control.

Over the years following entry of the Illinois judgment in 2002, the Bank rejected Bullock's repeated pleas and demands that the property subject to the constructive trust be liquidated to pay the judgment. In 2009, Bullock filed for Chapter 7 bankruptcy. The Bank, as trustee of the trust, filed an adversary proceeding to except Bullock's obligations under the Illinois judgment from discharge under 11 U.S.C. ' 523(a)(4). Bullock answered and, though not a lawyer, defended himself pro se in the adversary proceeding. The Bank filed a motion for summary judgment, contending that Bullock should be collaterally estopped from contesting issues that were decided by the Illinois court, and that the court's judgment established ' 523(a)(4) “defalcation” as a matter of law. The Bank submitted no other evidence in support of the motion, which the bankruptcy court granted. Though sharply criticizing the Bank for its own administration of the trust, the district court affirmed in an unpublished order.

On further appeal, the Eleventh Circuit noted a three-way split among the circuits as to the definition of “defalcation” and aligned itself with the Fifth, Sixth, and Seventh Circuits to hold that “defalcation requires a known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless.” 670 F.3d 1160, 1166 (11th Cir. 2012). The Eleventh Circuit deemed “self-dealing” to be objectively reckless per se, and from that concluded that Bullock's actions amounted to defalcation sufficient to except his debt from discharge.

The Supreme Court Weighs In

The Supreme Court granted Bullock's petition for certiorari. In a unanimous decision written by Justice Breyer, the Court vacated the Eleventh Circuit's judgment. The Court began by observing that the dictionary definitions of defalcation were inconsistent and not particularly helpful. The Court declined to reach the question of whether defalcation “can cover a trustee's failure (as here) to make a trust more than whole.” The Court focused on the state-of-mind question and, as urged by Bullock, relied heavily on its decision in Neal v. Clark , 95 U.S. 704 (1877). Applying the canon of statutory interpretation noscitur a sociis, Neal held that that the association of fraud with embezzlement in the statute suggested that fraud meant “positive fraud, or fraud in fact, involving moral turpitude or intentional wrong” and not “implied fraud, or fraud in law, which may exist without the imputation of bad faith or immorality.” Id. at 709. The Bullock Court, noting the subsequent addition of “larceny” to “embezzlement” and fiduciary fraud in the same clause with “defalcation” in paragraph (a)(4), held as follows:

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 violate a 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). Cf. Ernst & Ernst v. Hochfelder , 425 U.S. 185, 194, n. 12 (1976) (defining scienter for securities law purposes as “a mental state embracing intent to deceive, manipulate, or defraud”).

133 S. Ct. at 1759-60.

The Court reasoned that its interpretation did not render the word “defalcation” identical to its statutory neighbors, and that it was consistent with the principle that “exceptions to discharge 'should be confined to those plainly expressed.'” Id . at 1760 (quoting Gleason v. Thaw , 236 U.S. 558, 562 (1915)). Alluding to Bullock's situation, the Court noted its decision would most likely preserve the bankruptcy discharge for non-professional trustees “perhaps administering small family trusts potentially immersed in intrafamily arguments that are difficult to evaluate in terms of comparative fault.” Id. at 1761. The Court remanded the case for application of “the heightened standard that we have set forth.” Id.

Observations

First, as a practical matter, Bullock is likely to limit the circumstances in which issue preclusion is available in exception to discharge proceedings premised on “defalcation” under ' 523(a)(4). Creditors that claim breach of fiduciary duty in an underlying civil action would be prudent to seek findings consistent with Bullock to foreclose a later bankruptcy discharge. The Court's intentional wrongdoing or gross recklessness standard will mean that the mere finding of breach of fiduciary duty in a prior civil action will not establish defalcation in bankruptcy. A prior civil action, instead, will need to include a finding of the culpable mental state required by Bullock. If there is no admission or finding of intentional wrongdoing by a fiduciary, then gross recklessness will need to be established by a finding in the prior action. And that gross recklessness finding will need to be consistent with willful blindness or conscious disregard of a “substantial and unjustifiable” risk, as specified in Bullock.

Second, pre-Bullock cases on defalcation's mental state requirement are no longer good law on that point. The Court selected a standard more restrictive than any of the three standards that had divided the circuit courts, but one adapted to the facts in Bullock. Although the Court cited with a “Cf.” the securities-law scienter standard imported by the First and Second Circuits (Denton v. Hyman (In re Hyman), 502 F.3d 61, 68 (2d Cir. 2007); Rutanen ex rel. Quevillon v. Baylis (In re Baylis), 313 F.3d 9, 20 (1st Cir. 2002)), in which “something close to a showing of extreme recklessness” can be a surrogate for fraudulent intent, the Court chose a somewhat more rigorous and better-established standard for recklessness, the definition found in section 2.02(2)(c) of the Model Penal Code.

Recklessness under the Model Penal Code entails an element of subjectivity, i.e., did the actor consciously disregard a substantial and unjustifiable risk and proceed in the face of it? The nature and purpose of the actor's conduct and the “circumstances known to him” must be evaluated in determining whether there is “a gross deviation from the standard of conduct that a law-abiding person would observe in the actor's situation.” A finding of “objective recklessness” will no longer be sufficient, as the Court expressly rejected the Eleventh Circuit standard.

Third, Bullock stands as a strong endorsement of a narrow construction of discharge exceptions. Although the Court again avoided stating in so many words that exceptions to discharge should be strictly or narrowly construed, the Court quoted the somewhat more elegant yet kindred statement from its 1915 Gleason v. Thaw decision that exceptions to discharge “should be confined to those plainly expressed.” Eschewing the phrase “strict construction” may have avoided friction with some members of the Court who might object to that freighted language. Along with Kawaauhau v. Geiger , 523 U.S. 57 (1998), however, Bullock demonstrates that the Court will be vigilant for infringements on bankruptcy's core “fresh start” policy that are not specified in the Code.

Thomas Byrne is a partner in Sutherland Asbill and Brennan LLP's Litigation Practice Group. His practice focuses on complex business litigation, primarily the defense of consumer and policyholder class actions and bankruptcy litigation. Mr. Byrne represented the petitioner in Bullock v. BankChampaign, N.A. and argued the case before the Supreme Court. He may be reached at [email protected].'

'

'