DEFALCATION is an act of misappropriating funds that were entrusted to a person. The person who is entrusted with the funds is called the fiduciary. For instance, your friend wins $2.0 million in the lottery. He gives you the money and asks you to manage the money for him for one year. You give him a cyanide smoothie when it’s time for you to return the money to him. The smoothie kills him. Instead of managing the money for him, you gambled the money away at Las Vegas. His relatives file a lawsuit against you to collect the $2.0 million plus damages of $500,000. You file for Chapter 7 relief because you cannot pay the $2.5 million they are asking for. The relatives file an adversary complaint objecting to the discharge of the $2.5 million arguing that you defalcated as a fiduciary; therefore the debt is not dischargeable. Are they correct? Well, this question is really irrelevant because you are going to jail for the rest of your life for murder. Remember the cyanide smoothie?
Section 523(a)(4) of the bankruptcy code states that debts arising from “fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny” are not dischargeable.
The US Supreme Court on October 29, 2012 granted certiorari in a non-dischargeability case, Bullock v. BankChampaign. The 11th Circuit Court of Appeals held in the decision below, In re Bullock, that “defalcation” within the meaning of Section 423(a)(4) requires a showing of recklessness by the fiduciary. The question before the Supreme Court is, “What degree of misconduct by a trustee constitutes ‘defalcation’ under Section 523(a)(4) of the bankruptcy code that disqualifies the errant trustee’s resulting debt from a bankruptcy discharge-and does it include actions that result in no loss of trust property?” The trustee in the question refers to the debtor, who was the trustee of his father’s trust. The sole asset of the trust was a life insurance policy. The trust had borrowing restrictions which the debtor disregarded when he borrowed from the trust on three occasions. And even though he repaid the loans in full, the debtor’s siblings and fellow beneficiaries under the trust sued him because of his self-dealing. “What self-dealing are you talking about? My financial consultant, Mr. Bernie Madoff, has advised me that there was nothing morally and legally wrong with what I did…” the debtor said.
The state court found that the debtor did not have a malicious motive (everyone wants a new house in Malibu) but nevertheless granted the siblings summary judgment and awarded them damages based on the benefit that the debtor received due to the self-dealing. The debtor filed for Chapter 7 relief, and BankChampaign (now the trustee of the father’s trust), filed a non-dischargeability complaint. The bankruptcy court, and the 11th Circuit agreed that the judgment debt was a debt for “defalcation while acting in a fiduciary capacity” within the meaning of Section 523(a)(4). The 11th Circuit held that defalcation under Section 523(a)(4) requires more than mere negligence. Defalcation requires a known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless.
The 11th Circuit said that there are four groups on the issue:
1. Even an innocent act by a fiduciary duty can be a defalcation. This is the position adopted in California In re Sherman 658 F.3d 1009, 2011)
2. Defalcation requires a showing of recklessness. 11th, 5th, 6th and 7th Circuits.
3. Extreme recklessness must be established for a finding of defalcation. 2nd Circuit.
4. No position. 3rd Circuit.
How will the Supreme Court decide, will it adopt any of the foregoing or fashion its own position? If you are a fiduciary, the best course of action for you is to adopt the better part of caution and avoid any kind of self-dealing because it is very likely that any debt arising out of your defalcation in a fiduciary capacity will not be dischargeable. Investing trust money in a cockfight is defalcation in California where even an innocent act is defalcation.
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Lawrence Bautista Yang specializes in bankruptcy, business, real estate and civil litigation and has successfully represented more than five thousand clients in California. Please call Angie, Barbara or Jess at (626) 284-1142 for an appointment at 1000 S Fremont Ave Bldg A-1 Suite 1125 Unit 58 Alhambra, CA 91803.
