Supreme Court Says Bankruptcy Defalcation Must Be More Than Merely Reckless

May 13, 2013

On the heels of the Great Recession, disputes involving discharge in bankruptcy have taken on greater importance -- particularly amid allegations of fraud in incurring the subject debt or bad faith involving the effort to discharge the debt.  The United States Supreme Court tackled one such seminal case with mixed results in Bullock v. BankChampaign. In reviewing the conduct of a debtor seeking a discharge, the Court suggests that mere reckless conduct may not rise to the level of non-dischargeable fraud -- the standard set by the Court is more in keeping with the criminal law definitions of more wilful misconduct involving intentional wrongs.

The Bullock Trust

In 1978, Randy Bullock's father had established a trust for the benefit of his five children, and the single asset of the trust was an insurance policy on the father's life. The father made Randy the trustee, who under the terms of the trust instrument was permitted to borrow funds from the insurer against the policy's value
 in only two situations: 
  1. to pay the life insurance premiums, and
  2. to satisfy a beneficiary's request for withdrawal.
Three Borrowings

In 1981, at his father's request, Randy borrowed from the trust $117,545.96 and paid those funds to his mother, who used them to repay a debt to the father's business. 

In 1984, again, Randy borrowed $80,257.04 from the trust to pay for certificates of deposit, which he and his mother used to buy a mill. 

In 1990, once again, Randy borrowed $66,223.96 to buy real property for himself and his mother. 

As to the three above borrowings, Randy saw that all of the borrowed funds were repaid to the trust along with 6% interest.

Internecine Litigation

In 1999, Randy's brothers sued him in Illinois state court, where he was found to have breached his fiduciary duty to the trust because of self-dealing but without "a malicious motive." The state court ordered Randy to repay the trust the benefits that he had received from his breaches plus costs and $35,000 in attorneys' fees. The state court determined that the benefits from self-dealing amounted to $250,000. Also, the court put the mill under a constructive trust to secure it as collateral for the $285,000 judgment amount. Further, the court placed another constructive trust on Bullock's beneficial interest in his father's trust as an additional source of collateral for the judgment. BankChampaign was named as trustee for all of the trusts. 

Seeking Discharge

After Randy failed to liquidate his interests in the mill and other constructive trust assets in order to satisfy the court-ordered repayments, in 2009 he filed for Chapter 7 bankruptcy in federal court seeking to discharge the Illinois judgment debt. BankChampaign initiated an
adversary proceeding to oppose the dischargeability. 

The Bankruptcy Court granted BankChampaign summary judgment, holding that the subject debts were not dischargeable because they constituted a debt for defalcation while acting in a fiduciary capacity.

Federal Appeals

On appeal, the federal District Court affirmed the Bankruptcy Court's decision but, oddly, noted that BankChampaign was "abusing its position of trust by failing to liquidate the assets." 

On further appeal, 11th Circuit Court of Appeals affirmed the District Court by finding that "defalcation requires a known breach of a fiduciary duty, such that the conduct can be characterized as objectively reckless;" and the Appeals Court found that Petitioner's conduct satisfied this standard.  Specifically, the 11th Circuit noted that it had agreed with the Distrcit Court's discomfort with BankChampaign's actions:

The district court affirmed the bankruptcy court's decision, but it sympathized with Bullock's predicament-he had a judgment debt that he could satisfy only by selling the underlying collateral, but the Bank persisted in preventing the sale. The district court stated that it questioned the propriety of the Bank's actions and noted that holding collateral hostage in perpetuity is impermissible. . .

Page 5 of the Circuit Court Opinion

On appeal to the United States Supreme Court, Petitioner Randy Bullock sought certiorari from the 11th Circuit and asked the Court to decide whether the bankruptcy term "defalcation" applies "in the absence of any specific finding of ill intent or evidence of an ultimate loss of trust principal." 

The Supreme Court

The Supreme Court noted that Congress first included the term "defalcation" as an exception to discharge in a federal bankruptcy statute in 1867 but that legal authorities have since disagreed as to the meaning of that exception. The Court stated that where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, defalcation requires proof of an intentional wrong, which was defined as not only conduct that the fiduciary knows is improper but also reckless (as consistent with such a finding in criminal law).  In conclusion, the Court noted:

In this case the Court of Appeals applied a standard of "objectiv[e] reckless[ness]" to facts presented at summary judgment. 670 F. 3d, at 1166. We consequently remand the case to permit the court to determine whether further proceedings are needed and, if so, to apply the heightened standard that we have set forth. For these reasons we vacate the judgment of the Court of Appeals and remand the case for further proceedings consistent with this opinion.