Category Archives: Section 523(a)(4) and Defalcation While Acting in a Fiduciary Capacity

What Mental State is Required for Defalcation While Acting in a Fiduciary Capacity?

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It has long been understood that under 11 U.S.C. §523(a)(4), you would not be able to receive a discharge of your debts in bankruptcy if those debts were incurred due to a fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny. On May 13, 2013, the Supreme Court described the scienter (state of mind) necessary to be considered “defalcation” in the case of Bullock v. BankChampaign, N.A., 569 U.S. _____ (2013).

In Bullock, Bullock’s dad made him the trustee in a trust that was established for Bullock and his four other siblings. Bullock borrowed money from the trust but he made sure the trust was repaid with interest every time he borrowed money. Bullock’s siblings sued him for a breach of fiduciary duty in state court and won. The state court imposed constructive trusts for the judgment and BankChampaign served as the trustee for the trusts. Bullock had to file bankruptcy because he was not able to liquidate his assets to pay for the judgment. BankChampaign opposed the discharge of the debt because it claimed the debt was for defalcation while acting in a fiduciary duty. After the bankruptcy court, federal court, and court of appeals all affirmed that the debt was not dischargeable, Bullock sought certiorari to decide whether defalcation applied even if there was no ill intent.

The Supreme Court concluded that defalcation 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 equivalent…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.” Bullock v. BankChampaign, N.A., 569 U.S. _____ (2013).

The Supreme Court decided to hear this case because there were different rulings throughout the country on whether a mental state was necessary to determine if there was defalcation. In the Ninth Circuit a bankruptcy lawyer only had to prove an innocent mistake took place by a fiduciary. Some circuits considered an act to be defalcation if the person did or fail to do something they were required to do in their fiduciary capacity. Whether the person knew the act or failure to act was wrong or not did not matter. Then there were some circuits that required a showing of extreme recklessness. The Supreme Court wanted to be sure that all the circuits applied the same standards and their ruling are more consistent. This also means that creditors objecting to the discharge of certain debts due to defalcation have more to prove. Their bankruptcy attorney cannot just claim that there was a wrongdoing, but now must prove actual intent to harm or recklessness. Did the debtor act in a way that a law abiding person would in the same circumstances? There are many questions that remain to be answered regarding this new defalcation requirement.