Adversary proceedings contesting the dischargeability of debt in a bankruptcy case are rare, but they do happen.  There are various types of nondischargeability actions that a bankruptcy debtor can face under 11 U.S.C. 523.  One of these is an adversary proceeding under Sect. 523(a)(4) for “fraud” or “defalcation” while “acting in a fiduciary capacity.”  This type of action is often brought as an additional count in an adversary petition along with other Section 523 claims, such as claims under 523(a)(2).  They seem to be appearing more often than in the past, as creditors increasingly seek to have commercial debts classfied as “trusts” or “trust fund proceeds.”

We have noted 523(a)(4) actions in an increasingly wide variety of scenarios, from money order debts issued by convenience stores, to actions under the Perishable Agricultural Commodities Act (PACA), to “floor plan” types of commercial loans for used automobile dealerships.  By seeking to have their debts considered trust fund debts, creditors can also make an end-run around the doctrine of equal treatment of similarly-situated creditors, and have their debts considered as priority or superpriority status.

A key issue in actions under 523(a)(4) is:  what is the precise definition of defalcation?  A recent Supreme Court case has finally clarified the definition.  The case is Bullock v. BankChampaign N.A. (No. 11-1518, May 13, 2013).  The issue faced by the Supreme Court in Bullock was what mental state would be required under Bankruptcy Code section 523(a)(4) for a debt owed by an individual debtor to be excepted from discharge because of the debtor’s “defalcation while acting in a fiduciary capacity.”  (Section 523(a)(4) in its entirety excepts from discharge any debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.”)

The Court’s consideration of the case came as something of a relief.  The Court granted certiorari because the cases interpreting this statutory provision were split regarding where on the spectrum from negligence to actual intent one’s state of mind must fall so that the debt arising from defalcation of one’s fiduciary duty should be nondischargeable in bankruptcy.  For example, the First and Second Circuits required a minimum of “extreme recklessness.”  The Fifth, Sixth, and Seventh Circuits required a minimum of “objective recklessness.”  Mere negligence or innocent mistake was sufficient for the Fourth, Eighth, and Ninth Circuits.

The Court ultimately sided with the First and Second Circuits and adopted a mental state that embraces an “extreme recklessness” standard.  The Court agreed with the Second Circuit that adopting this mental standard “has the virtue of ease of application since the courts and litigants have reference to a robust body of securities law examining what these terms mean.”  The Court also held that a fiduciary’s conduct in handling the trust “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.”

So, the rule now is that the mental state required for “defalcation” by a fiduciary under Code section 523(a)(4) is basically equivalent to other fraudulent or felonious intentions characteristic of its statutory neighbors “fraud,” “embezzlement,” and “larceny”.  The Court cited the Model Penal Code in its decision, and basically heightened the level of culpability required for a creditor to meet its burden in a 523(a)(4) action.  No longer will a debtor’s mere mistake or simple recklessness as a trust fiduciary be enough for a creditor to win a 523(a)(4) judgment.  Now, a creditor/plaintiff will have to show a higher standard of “extreme recklessness.”  The distinction is critical.  And it will make a creditor’s job in a 523(a)(4) action much harder.

A key concept of bankruptcy dischargeability actions is that exceptions to discharge should be narrowly construed.  Applying a heightened intent standard for a debtor/defendant’s defalcation was consistent with the legislative intent of Congress in its formation of 11 U.S.C. 523, the Court said.  Summing up its philosophy, the Court noted, “In the absence of fault, it is difficult to find strong policy reasons for favoring a broader exception [to discharge] here…”

The Bullock decision finally removes some of the varying standards and interpretations in judicial circuits surrounding the meaning of “defalcation.”  As a practical matter in litigating 523(a)(4) actions, the creditor/plaintiff’s job has now become that much harder.  If you are facing an adversary proceeding in bankruptcy court, you need an experienced attorney.

Read More:  What Is An Adversary Proceeding?