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When Good Fiduciaries Go Bad

Section 523(a)(4) of the Bankruptcy Code, 11 USC 523(a)(4) makes debts arising from “fraud or defalcation while acting in a fiduciary capacity” nondischargeable.  You know what that means, right? If you answered “Yes,” then you’ve overcome a gulf that several Federal Courts of Appeal could not.

In fact it was not until the decision in Bullock v. Bankchampaign (October term 2012 decided May 13, 2013 slip opinion 11-1518) that the Supreme Court addressed that Circuit split and determined once and for all that “defalcation” requires a showing that the actor had the requisite state of mind or scienter. In short, to have a debt excepted from discharge based on breach of a fiduciary duty, a Debtor must have known that what they were doing was wrong, or must have acted with a gross neglect of whether that was true.

So why did the Supreme Court rule on this relatively abstruse point? It turns out that the Courts of Appeal couldn’t even agree on whether there was a scienter component to defalcation, much less what defalcation should mean. The Supreme Court had to clarify the issue for good.

The Court started its analysis by looking at an old case that discussed requirements for the fraud exception to discharge.  In Neal v. Clark, 95 U.S. 704 (1878) the Court declared that Bankruptcy fraud must be “positive fraud, fraud in fact, involving moral turpitude or intentional wrong” rather than merely implied fraud or fraud in law. The key to Bankruptcy fraud, it seemed, was intentional action and moral turpitude. Certainly moral terpitude seemed a necessity for fraud to exempt a debt from discharge. After all, what good would Bankruptcy be if it did not absolve most all forms of debt? It seemed logical to draw the line at bad actions by bad actors.

Using this logic the Supreme Court concluded that intentional acts, bad faith, and moral turpitude, were prerequisites for a finding of nondischargeability due to a breach of fiduciary duty; while the necessary state of mind could only be shown by demonstrating acts that were intentional or had been taken with reckless disregard as to their propriety.

The Model Penal Code was pressed into service to support the idea that only actual knowledge of wrongdoing or “conscious disregard” of “a substantial and unjustifiable risk” could demonstrate the necessary state of mind to support this discharge exception. Whether the conduct also violated a fiduciary duty was another question. What was certain however, was that the “risk” must have been so obvious “that its disregard would involve gross deviation from the standard a law-abiding person would observe.” (citing Model Penal Code).

Likewise, the Court emphasized that exceptions to discharge “should be confined to those plainly expressed.” Kawaauhau v. Geiger, 523 U. S. 57, 62 (1998). In this case, the Trustee wasn’t a professional: simply a son in charge of his father’s trust. The Court noted this and observed that when there was no apparent fault or intent there was no policy reason for excepting the debt from discharge.

The takeaway here is that the discharge exception in Sec. 523(a)(4) of the Code requires a showing of intent or reckless disregard. It is also important to note the distinction between professional and nonprofessional trustees.

Questions? Concerns? Contact M. Hedayat & Associates, PC for a confidential consultation.

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