Welcome to the linguistic neighborhood: Defalcation after Bullock v. Bankchampaign, N.A.

In a unanimous decision released on May 13, 2013, in Bullock v. Bankchampaign, 569 U.S. ___ (2013), the United States Supreme Court answered the question as to the legal definition of “defalcation” in the context of non-dischargeability in bankruptcy cases. The decision is largely one of statutory construction that traces the use of the term “defalcation” from its historical roots to present day usage. The result of the case creates important factors to consider when evaluating the pursuit of an exception to discharge action under 11 U.S.C. §523(a)(4) of the Bankruptcy Code.

The individual Debtor was a four time loser in the underlying litigation, having suffered a judgment in both state court and the Bankruptcy Court, which was then affirmed on appeal by both the District Court and the 11th Circuit Court of Appeals. Bullock was appointed by his father in 1978 as the trustee of a family trust for the benefit of himself and his four siblings. Over the course of years, Bullock borrowed money from the trust three times for various business ventures related to the family business. These loans were made at the behest of Bullock’s father or mother. Each loan was fully repaid to the trust with interest. Bullock, however, did benefit from at least two of the loans in that he became a part owner in both a mill and real property with his mother. His remaining four siblings did not obtain any interest to those assets. In what became an ugly family affair, Bullock’s brothers sued him for a breach of fiduciary duty in the state court of Illinois which ruled that although Bullock did not appear to have any “malicious motive,” he nonetheless was involved in “self-dealing.” Bullock was removed as trustee and the state court imposed a constructive trust against the assets acquired by Bullock through the trust loans. Bullock next sought refuge in the Bankruptcy Court by filing a Chapter 7. Bankruptcy did not turn out to be the safe haven that Bullock had hoped for as the Bankruptcy Court entered a non-dischargeable judgment against him that was subsequently twice affirmed on the road to the Supreme Court.

In a rare unanimous decision authored by Justice Breyer, the Supreme Court reversed and remanded the case. In reaching its decision, the Court noted the wide disparity of definitions as to the meaning of defalcation, and set about the task of tracing the historical use of the term from as early as 1842 to the present. Prior usage of the term defalcation basically fell into two camps as to the trustee’s state of mind. One the one side, prior cases had held that defalcation may occur even when negligence or innocent mistake results in misappropriation. Meanwhile, other cases required a higher level of misconduct more consistent with fraud or embezzlement. The Court engaged in statutory construction to find that defalcation is the “linguistic neighbor” of fraud and larceny in its reading of §523(a)(4), and that consequently, some level of intent is required. Relying upon a decision from 1878 authored by Justice Harlan, the Supreme Court held that defalcation requires an “intentional wrong.” Neal v. Clark, 95 U.S. 704,709 (1878). That intentional wrong, however, includes reckless conduct where the fiduciary’s actions constitute a ‘“gross deviation from the standard of conduct that a law-abiding person would observe in the actor’s situation.’” Bullock, id., quoting, ALI, Model Penal Code §2.02(2), p. 226 (1985).

The result in Bullock dictates that care must be taken in evaluating whether a non-dischargeability action against a trustee or other fiduciary can be successfully maintained. It is remarkable that not only was the decision from a unanimous court, but also a reversal of all three courts below. Another item worth noting is that the Supreme Court made no analysis whatsoever of the res judicata effect of the prior state court judgment from Illinois. The solidarity of the Court in Bullock underscores the necessity of properly evaluating a potential non-dischargeability case. Where intentional wrongs can be demonstrated, the ability to pursue an exception to discharge is obvious. But, the Court’s holding that reckless conduct may also constitute defalcation opens a host of factual considerations and may include the necessity of providing expert testimony to establish the “standard of conduct” for a fiduciary as an element of proof at trial. Because of this heightened level of proof and the prospect that expert testimony may also be required to meet the burden of proof, a careful cost-benefit analysis is something the prudent practitioner and potential plaintiff must consider before making the decision to file suit to avoid a discharge.