Southern California Bankruptcy Law Blog

What Is Defalcation In Bankruptcy?

Posted in Chapter 11, Chapter 13, Chapter 7

In 2013 the U.S. Supreme Court handed down an opinion that shed light on the meaning of the word “defalcation” as it is used in the Bankruptcy Code’s list of nondischargeable debts.  The opinion disabuses of their error those who thought the word had something to do with a bathroom bodily function.  In this post we will look at the Supremes’ decision in the larger context of nondischargeability under 11 U.S.C. § 523(a)(4).

 

I.  Nondischargeable Debts In A Personal Bankruptcy:  Section 523(a)(4)

 

As readers of this blog know, 11 U.S.C. § 523(a) contains the exceptions to discharge in Chapter 7, 11, 12, and 11 U.S.C. § 1328(b) hardship discharge Chapter 13 bankruptcies.  Included in that list is the following:

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— . . . for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.

11 U.S.C. § 523(a)(4).

The list of debts that are nondischargeable in a completed Chapter 13 plan discharge ― found in 11 U.S.C. § 1328(a) ― is shorter than the list of exceptions to discharge found in 11 U.S.C. § 523(a).  However, § 1328(a) includes § 523(a)(4) by reference, so a debt incurred through “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny” is never dischargeable in any personal bankruptcy.

However, § 523(a)(4) is not self-executing.  According to 11 U.S.C. § 523(c)(1):

[T]he debtor shall be discharged from a debt of a kind specified in paragraph (2), (4), or (6) of subsection (a) of this section, unless, on request of the creditor to whom such debt is owed, and after notice and a hearing, the court determines such debt to be excepted from discharge under paragraph (2), (4), or (6), as the case may be, of subsection (a) of this section.

Thus, the creditor can only make the debt survive the bankruptcy discharge by successfully prosecuting a special kind of lawsuit in the Bankruptcy Court.  That kind of lawsuit is called an adversary proceeding.

The rules governing adversary proceedings are found in the Federal Rules of Bankruptcy Procedure 7001 – 7087.  The adversary process is very complicated, and should not be entered lightly.  An adversary proceeding can die in its incunabula if the rules aren’t followed precisely.  Therefore, a creditor should not initiate one without an attorney, and a debtor should not defend against one without an attorney.  In fact, there is a technical legal term for someone who enters an adversary proceeding without an attorney:  Idiot.

Since section 523(a)(4) has three parts:

(1)    fraud or defalcation while acting in a fiduciary capacity,

(2)    embezzlement, or

(3)    larceny,

we will break the discussion into three parts.  Note the “or,” which means that the plaintiff only has to prove one of them to succeed.

 

II.  Fraud Or Defalcation While Acting In A Fiduciary Capacity

 

Section 523(a)(2) also excludes from discharge debts incurred through fraud.  Is the Bankruptcy Code redundant here?  Or more precisely, was Congress (the opposite of Progress?) guilty of redundant statutory drafting when it included both § 523(a)(2) and (4) in the Code?  The clear answer is no.

Section 523(a)(4)’s “fraud and defalcation” clause has a very specific context:  the debtor incurred the debt while acting in a fiduciary capacity.  There is no fiduciary requirement in § 523(a)(2).

 

A.  The Meaning Of Fiduciary Duty

 

The Cornell University Law School’s Legal Information Institute’s website defines “fiduciary duty” as follows:

A fiduciary duty is a legal duty to act solely in another party’s interests.  Parties owing this duty are called fiduciaries.  The individuals to whom they owe a duty are called principals.  Fiduciaries may not profit from their relationship with their principals unless they have the principals’ express informed consent.  They also have a duty to avoid any conflicts of interest between themselves and their principals or between their principals and the fiduciaries’ other clients.  A fiduciary duty is the strictest duty of care recognized by the US legal system.  Examples of fiduciary relationships include those between a lawyer and her client, a guardian and her ward, and a director and her shareholders.

However, within the context of § 523(a)(4), courts have more stringent requirements for determining whether the debtor had a fiduciary duty to the injured creditor.  In particular, they have required that the offending debtor must have been the trustee of an actual trust, with a res in it, for there to have been a fiduciary duty that was breached.  For example, the Ninth Circuit held:

The broad, general definition of fiduciary — a relationship involving confidence, trust and good faith — is inapplicable in the dischargeability context.  See Angelle v. Reed (In re Angelle), 610 F.2d 1335, 1338-39 (5th Cir.1980).  The trust giving rise to the fiduciary relationship must be imposed prior to any wrongdoing; the debtor must have been a “trustee” before the wrong and without reference to it.  Davis, 293 U.S. at 333, 55 S. Ct. at 153-54; Pedrazzini, 644 F.2d at 758.  These requirements eliminate constructive, resulting or implied trusts.  Pedrazzini, 644 F.2d at 759.

Ragsdale v. Haller, 780 F. 2d 794, 796 (9th Cir. 1986).

Thus, there has to be a document called the trust instrument that was used to create the trust.  The trust instrument names the beneficiaries and trustees, lists the assets ― i.e., the res ― in the trust, and specifies the administration of the trust.  Thus, for example, just because the creditor trusted the debtor and lent him money, does not mean that the debtor had a fiduciary duty to the creditor.

 

B.  The Meaning Of Fraud

 

The Bankruptcy Appellate Panel for the Ninth Circuit nicely summarized the meaning of fraud in the § 523(a)(4) context:

“Fraud” under § 523(a)(4) means actual fraud.  Roussos v. Michaelides (In re Roussos), 251 B.R. 86, 91 (9th Cir. B.A.P. 2000) (citing Bugna, 33 F.3d at 1057).  Actual fraud involves conscious misrepresentation, or concealment, or non-disclosure of a material fact which induces the innocent party to enter into a contract.  Cal. Civ. Code § 1572; Odorizzi v. Bloomfield School Dist., 246 Cal. App.2d 123, 54 Cal. Rptr. 533, 538 (1966).  To prove actual fraud the plaintiff must prove: 1) defendant made a misrepresentation, concealment, or non-disclosure of a material fact; 2) defendant had knowledge that what he was saying was false; 3) defendant intended to induce plaintiff’s reliance; 4) plaintiff justifiably relied; and 5) plaintiff suffered damage as a result.  Id.

In re Honkanen, 446 B.R. 373, 382-83 (B.A.P. 9th Cir. 2011) (emphasis added).

Suppose a creditor fails to prove all five of the fraud factors.  Does that end the fiduciary duty portion of the § 523(a)(4) show?  What about defalcation?  After all, the statute’s wording is “fraud or defalcation,” not “fraud and defalcation.”  This wording suggests that as far as Congress was concerned, “fraud” and “defalcation” are not the same thing.  The Supremes concluded as much in Bullock v. BankChampaign, N.A., 133 S. Ct. 1754 (2013).

 

C.  The Meaning Of Defalcation

 

The Court focused on the requisite frame of mind for defalcation and held:

[W]here 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. . . .  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.

Bullock v. BankChampaign, N.A., 133 S. Ct. at 1759-60 (internal quotes and citations omitted).

The Court noted that an important benefit to this definition is that it distinguishes defalcation from fraud, embezzlement, and larceny; making its inclusion in the statute more than just surplusage:

[T]his interpretation does not make the word identical to its statutory neighbors.  . . . As commonly used, “embezzlement” requires conversion, and “larceny” requires taking and carrying away another’s property.  . . .  “Fraud” typically requires a false statement or omission. . . .  “Defalcation,” as commonly used (hence as Congress might have understood it), can encompass a breach of fiduciary obligation that involves neither conversion, nor taking and carrying away another’s property, nor falsity.

Id. at 1760 (internal quotes and citations omitted).

Given the definition’s reliance on the frame of mind of the debtor at the time of the breach of the fiduciary duty, a creditor may have substantial difficulty proving defalcation.  Therefore, § 523(a)(4) actions will probably focus more on proving fraud, embezzlement, and larceny ― which are determined more by behavior than the debtor’s frame of mind ― than on defalcation.

 

III.  Embezzlement

 

The first thing to observe is that embezzlement under § 523(a)(4) does not require a fiduciary relationship, since the portion of § 523(a)(4) involving a fiduciary duty deals solely with fraud and defalcation:

Clearly, a debt can be nondischargeable for embezzlement under 523(a)(4) without the existence of a fiduciary relationship.

In re Littleton, 942 F. 2d 551, 555 (9th Cir. 1991).

The Cornell University Law School’s Legal Information Institute’s website defines “embezzlement” as:

Fraudulent taking of personal property by someone to whom it was entrusted.  Most often associated with the misappropriation of money.  Embezzlement can occur regardless of whether the defendant keeps the personal property or transfers it to a third party.

When the Supremes in Bullock stated:  “‘embezzlement’ requires conversion” (Bullock, at 1760) they meant converting the property of the rightful owner to someone else.  A common example is when an employee embezzles money from the employer’s till.  The employer has entrusted the money in the till to the employee, who then fraudulently takes it, perhaps to support a gambling addiction.

In Littleton the Ninth Circuit laid out the elements of an embezzlement nondischargeability action:

Under federal law, embezzlement in the context of nondischargeability has often been defined as the fraudulent appropriation of property by a person to whom such property has been entrusted or into whose hands it has lawfully come.   Embezzlement, thus, requires three elements: (1) property rightfully in the possession of a nonowner; (2) nonowner’s appropriation of the property to a use other than which it was entrusted; and (3) circumstances indicating fraud.

In re Littleton, 942 F. 2d at 555 (internal quotes and cites omitted).

The creditor must establish all three elements.  Otherwise the embezzlement action will fail.

 

IV.  Larceny

 

As with embezzlement, there is no requirement that there be a fiduciary duty for embezzlement to occur.  We turn again to the Ninth Circuit for guidance in understanding the meaning of “larceny”:

For purposes of section 523(a)(4), a bankruptcy court is not bound by the state law definition of larceny but, rather, may follow federal common law, which defines larceny as a “felonious taking of another’s personal property with intent to convert it or deprive the owner of the same.”

In re Ormsby, 591 F. 3d 1199, 1205 (9th Cir. 2010).

Since both embezzlement and larceny involve the taking of property, it is natural to ask how they are different:

“Larceny” differs from embezzlement in the fact that the original taking of property was unlawful, and without the consent of the injured person.

In re Dobbs, 115 B.R. 258, 265 (Bankr. D. Idaho 1990).

 

V.  Conclusions

 

Litigating nondischargeability actions is hard ― whether you are the debtor or the creditor ― and requires the services of a good bankruptcy attorney.  Even if you have a good case, if you fail to follow the correct procedures you can lose.  Therefore, if you’re in need of bankruptcy litigation counsel, contact an extremely knowledgeable and highly skilled bankruptcy attorney to guide you through the process.

 

Image courtesy of Flickr (Licensed) by elhombredenegro