[authors: Rudolph J. Di Massa Jr. and Aaron J. Margolis]
November 16, 2012 - The Legal Intelligencer
In a corporate system based in part on the separation of ownership and control, the relationship between principals and agents is riddled with agency problems: Among them are potential conflicts of interest where agents may abuse their fiduciary position for their own benefit as opposed to the benefit of the principals to whom they are obligated. Delineating the agents' fiduciary duties is thus a central focus of corporate law, and the dereliction of those duties often comes under scrutiny in the bankruptcy context.
Agents who incur debts through wrongdoing sometimes seek refuge in bankruptcy, hoping to avail themselves of the Bankruptcy Code's provisions for discharge. To mitigate this potential abuse, Congress passed Section 523(a) of the Bankruptcy Code. That section excludes from bankruptcy discharge, inter alia, debts arising from certain breaches of fiduciary duty. However, the degree of culpability required to trigger nondischargeability of a debt is not defined in the statute, and thus has been left to the courts to construct. This lack of definition has led to a three-way circuit split regarding the types of behavior — specifically the degree of wrongful intent — that will result in a denial of discharge.
In Bullock v. BankChampaign, 670 F.3d 1160 (11th Cir. 2012), the U.S. Court of Appeals for the Eleventh Circuit examined the meaning of "defalcation" by a fiduciary, which is one type of wrongdoing that triggers nondischargeability under Section 523(a)(4). In denying the debtor's discharge, the court maintained its alignment with the group of circuit courts that defines the state of mind for "defalcation" as "objective recklessness," which lies somewhere between negligence and extreme recklessness. On October 29, the U.S. Supreme Court granted certiorari in Bullock in order to resolve the circuit split. Although the issues addressed in Bullock bear directly on the scope of exceptions to bankruptcy discharge, they have broader implications for the concepts comprising fiduciary duty under federal law.
Source of the Circuit Split
One of the fundamental purposes of bankruptcy is to provide for a discharge of prepetition debt, thereby giving debtors a fresh start upon their emergence from bankruptcy. This principle is balanced against that of safeguarding the rights of creditors, one such safeguard being to deny discharge to dishonest debtors. While certain debts are excepted from discharge for policy purposes, e.g., taxes, domestic support obligations, educational loans, etc., Section 523 also seeks to prevent abuse of the bankruptcy process by delineating certain exceptions to discharge in the case of a debtor's wrongdoing. To that end, Section 523(a)(4) provides that the code's discharge provisions shall not discharge an individual debtor from any debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." "Defalcation" is defined as "a failure to produce funds entrusted to a fiduciary and applies to conduct that does not necessarily reach the level of fraud, embezzlement or misappropriation." As noted above, the phrase "defalcation while acting in a fiduciary capacity" is not defined in the statute, and there is little guidance provided by the statute's legislative history. Consequently, courts of appeals have struggled with the level of culpability required for Section 523(a)(4) purposes, and the three-way circuit split, mentioned above, has emerged.
The harshest standard for defalcation from a fiduciary-turned-debtor's standpoint exists in the Fourth, Eighth and Ninth circuits, where mere negligence — or even an innocent mistake — may be enough to prevent an individual from being granted a discharge. At the other end of the spectrum, the First and Second circuits borrow from other areas of federal law such as securities fraud, which requires scienter, or "extreme recklessness." Somewhere in between, the Sixth, Seventh and Eleventh circuits apply an "objectively reckless" standard, which requires a finding that the fiduciary has committed a known breach of fiduciary duty. In Bullock, the Eleventh Circuit applied this standard of "objective recklessness" in denying the debtor his discharge — but did so in a factual context that apparently involved no malfeasance on the part of the debtor when he was serving as a fiduciary, and resulted in no material harm to his counterparties. Against this factual and legal backdrop, the Supreme Court granted certiorari to resolve the circuit split over the meaning of "defalcation" for purposes of nondischargeability under Section 523(a)(4).
The Eleventh Circuit's Bullock Decision
Chris Bullock was appointed by his father, Curt Bullock, to serve as the trustee of the Curt Bullock Trust No. 2 (the trust), the sole asset of which was Curt Bullock's life insurance policy featuring a $1 million death benefit and accumulated cash value. A few years after the trust was created in 1978, Curt Bullock convinced his son to make a loan in the amount of $117,545 to Chris Bullock's mother, Imogene Bullock, so that Imogene Bullock could repay a debt to the family construction business. The following year, Chris Bullock used an additional $80,257 from the trust to make a loan to himself and his mother for an investment in a fabrication mill. Several years later, Bullock made another loan from the trust to himself and his mother in the amount of $66,223, the proceeds of which were used to fund a commercial real estate transaction. The total amount of $264,026 was timely repaid to the trust over respective terms of 15 years at an interest rate of 6 percent, the same interest rate the trust earned from the insurance company.
In 1998, Bullock resigned as trustee at the urging of certain trust beneficiaries, and was replaced by BankChampaign. The next year, two of these beneficiaries, Bullock's brothers, filed a state court action against Bullock and certain businesses in which Bullock held an interest. The suit alleged breaches of fiduciary duty, and sought the imposition of a constructive trust on profits earned as a result of the three loans. While the court found that Bullock did "not appear to have had a malicious motive in borrowing funds from the trust," and made no finding to contradict the fact that the funds had been fully repaid, it nonetheless held the defendants liable for breach of fiduciary duty because the transactions were deemed to constitute self-dealing. Accordingly, the court awarded damages in the amount of $250,000, plus $35,000 in attorney fees, and imposed a constructive trust on the assets of Bullock and his businesses. In effect, the constructive trust placed the assets in the control of BankChampaign, which then refused to allow Bullock to liquidate these assets in order to pay the judgment debt.
Bullock filed for Chapter 7 bankruptcy protection in the U.S. Bankruptcy Court for the Northern District of Alabama, seeking to discharge his debts. BankChampaign responded by filing an adversary proceeding to render the debts arising from the Illinois judgment ineligible for discharge. The bankruptcy court found that Bullock was collaterally estopped from attacking the Illinois judgment, adopted the Illinois court's determination that the three loans constituted "defalcation," and held that Bullock's debt was nondischargeable under Section 523(a)(4).
Bullock appealed to the U.S. District Court for the Northern District of Alabama. The district court sympathized with Bullock's predicament, and even chastised BankChampaign for abusing its position as trustee and preventing liquidation of the assets needed to pay the judgment debt. Nonetheless, the court concluded that the bank's malfeasance as trustee should be addressed in a separate cause of action, and in the instant case it affirmed the bankruptcy court's determination that the judgment debt was nondischargeable.
The question was thus presented to the Eleventh Circuit: whether the bankruptcy court correctly characterized Bullock's conduct in making the three loans from the trust as fraud or defalcation under Section 523(a)(4). The court determined that "a defalcation under § 523(a)(4) does not have to rise to the level of fraud, embezzlement, or misappropriation," but at the same time a level of culpability greater than mere negligence was required. Accordingly, the court maintained its alignment with the Fifth, Sixth and Seventh circuits in finding that "defalcation requires a known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless." Applying this standard, the court reasoned that "because Bullock 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, his conduct can be characterized as objectively reckless, and as such, it rises to the level of a defalcation under § 523(a)(4)." As a result, the court held the judgment debt to be nondischargeable.
Analysis of the Issue Before the Supreme Court
The Supreme Court has not yet addressed the degree of culpability for defalcation under Section 523(a)(4). The divergence of opinion among the circuits, coupled with the broader implications for the concepts comprising fiduciary duty under federal law, makes this issue ripe for determination. The case having yet to be briefed or argued, it is not clear how the parties will approach the issue or how the justices will respond. However, a few preliminary observations are warranted.
First, Supreme Court precedent favors a narrow reading of the exceptions to discharge. As the court explained in Kawaauhau v. Geiger, 523 U.S. 57, 62 (1998) (quoting Gleason v. Thaw, 236 U.S. 558, 562 (1915)), exceptions to discharge "should be confined to those plainly expressed."
Second, the statutory structure implies the higher degree of culpability associated with scienter. Section 523(a)(4) renders nondischargeable any debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." The grammar of that subsection does imply that the specific intent crimes of embezzlement and larceny apply to all debtors regardless of their role, whereas fraud and defalcation apply only to debtors serving in a fiduciary capacity. This distinction apparently manifests Congress' intent to impose a greater burden on the fiduciary, consistent with the higher expectations of fidelity associated with that role. Nonetheless, the common thread running through the subsection is the wrongfulness of the acts. Interpreting "defalcation" through a standard of negligence or objective recklessness would arguably expand the category to capture acts involving no illicit motive on the part of the actor. To do so would violate the "commonsense canon of noscitur a sociis — which counsels that a word is given more precise content by the neighboring words with which it is associated." (See Freeman v. Quicken Loans, ___ U.S. ___, No. 10-1042, 2012 WL 1868063, at *6 (May 24, 2012) (quoting United States v. Williams, 553 U.S. 285, 294 (2008)).)
Third, giving the term "defalcation" a lower quantum of culpability in the Bankruptcy Code than in other areas of federal law such as securities fraud, where the term is construed to involve scienter, inexplicably ignores guidance from other areas of federal law and creates unnecessary inconsistency. (See, e.g., Howard Delivery Service v. Zurich American Insurance, 547 U.S. 651, 652 (2006) (limiting courts' application of ERISA in bankruptcy cases, but allowing such application in certain limited circumstances, where it is "helpful").) A unified definition of "defalcation" across all areas of federal law would certainly promote consistency and greater predictability.
Section 523(a)(4) is geared toward preventing an agent from incurring debts through wrongdoing, and then using bankruptcy discharge as a weapon in furtherance of illegality. Where, as in Bullock's case, there appears to be neither illicit motive on the part of the agent nor harm suffered by the principal, application of Section 523(a)(4) to deny discharge would amount to a broadening of 523(a)(4)'s basic goal. While it is impossible to know at this early stage how the justices will adjudicate the issue, it does appear that one of the three approaches to the quantum of culpability implicit in "defalcation" will emerge from Bullock as the law of the land. Whatever the outcome, it is advisable for attorneys counseling agents serving in fiduciary capacities (or principals to whom fiduciary duties are owed) to keep abreast of this important development in the ongoing evolution of fiduciary duty.
Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights.
Aaron J. Margolis is an associate with the firm's business reorganization and financial restructuring department. He attended Washington University in St. Louis, graduating in 2010 with a J.D./M.B.A.
This article originally appeared in The Legal Intelligencer and is republished here with permission from law.com.