U.S. Supreme Court Remands Bankruptcy Defalcation Case, Says Higher Standard Needed

 WASHINGTON, D.C. - (Mealey's) The U.S. Supreme Court on May 13 unanimously vacated and remanded a case involving a bank's claim that a debtor who had acted as trustee for his father's insurance trust was guilty of defalcation for making loans to himself during the time he had control of the trust, ruling that the 11th Circuit U.S. Court of Appeals needed to review the case to determine if it should apply the higher standard of "defalcation" outlined by the high court (Randy Curtis Bullock v. BankChampaign, No. 11-1518, Chapter 7, U.S. Sup.) (lexis.com subscribers may access Supreme Court briefs and the opinion for this case).

Bankruptcy, Trust

Randy Curtis Bullock filed for Chapter 7 bankruptcy in the U.S. Bankruptcy Court for the Northern District of Alabama.
 
Prior to his bankruptcy, Bullock had been appointed the trustee of his father's life insurance trust, and during the time he held that position, Bullock took out three loans from the trust. Despite the fact that the loans were all repaid with interest, Bullock's two brothers - two of the five beneficiaries of the trust - sued Bullock in the Vermilion County, Ill., Circuit Court, alleging breach of fiduciary duty.

The Circuit Court did not find that Bullock committed a knowing or deliberate breach of fiduciary duty, but it granted summary judgment in favor of Bullock's brothers because the fully repaid loans were deemed self-dealing transactions and, thus, breaches of fiduciary duty under Illinois law.

11 U.S. Code Section 523

Bullock filed his bankruptcy petition shortly after that ruling, and BankChampaign, as successor trustee, filed an adversary proceeding in the Bankruptcy Court, seeking a ruling that Bullock's obligations under the Illinois judgment were nondischargeable under 11 U.S. Code Section 523(a)(4).

The Bankruptcy Court granted BankChampaign's motion for summary judgment dismissal, and Bullock appealed to the U.S. District Court for the Northern District of Alabama, which affirmed. Bullock appealed to the 11th Circuit U.S. Court of Appeals, which affirmed yet conceded that among the circuit courts, there is a split regarding the definition of "defalcation."

Bullock appealed to the Supreme Court, arguing that the high court needs to rule on the case to resolve the split among the federal appellate courts.

'Defalcation'

Bullock's attorney, Thomas M. Byrne, had argued at the Supreme Court that the case at hand "presents one of the most confounding questions of bankruptcy law" and contended that "defalcation" is an undefined term in the Bankruptcy Code, which contains more than 100 defined terms, without a plan or contemporary meaning.

Arguing for BankChampaign, Ben D. Bensinger had told the Supreme Court that Bullock's actions constituted self-dealing that was a reckless breach of his fiduciary duty of loyalty and, therefore, it was a defalcation.

Justice Stephen G. Breyer, writing for a unanimous U.S. Supreme Court, said that the term "defalcation" in the Bankruptcy Code includes a culpa­ble state of mind requirement involving knowledge of, or gross reck­lessness in respect to, the improper nature of the fiduciary behavior. Moreover, while "defalcation" has been an exception to discharge in a bankruptcy statute since 1867, legal authorities have long disagreed about its meaning, the Supreme Court said.

Meaning Debated

The panel said that Congress first included the term "defalcation" as an exception to discharge in a federal bankruptcy statute in 1867 and that legal authorities have disagreed about its meaning "almost ever since."  Similarly, courts of appeals have long disagreed about the mental state that must accompany the bankruptcy­ related definition of "defalcation," the Supreme Court added.

"In resolving these differences, we note that this long­standing disagreement concerns state of mind, not whether 'defalcation' can cover a trustee's failure (as here) to make a trust more than whole," the Supreme Court concluded. "We consequently shall assume without deciding that the statutory term is broad enough to cover the latter type of conduct and answer only the 'state of mind' question."

The Supreme Court held that "where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term 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 the equivalent."

Fiduciary Duty

The Supreme Court added said it included "reck­less conduct of the kind set forth in the Model Penal Code."  Furthermore, where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary "consciously disregards a substantial and unjustifiable risk" that his conduct will turn out to violate a fiduciary duty, the panel said.

In this case, the 11th Circuit applied a standard of "objectiv[e] reckless[ness]" to facts presented at summary judgment, the Supreme Court said. "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."

Byrne is with Sutherland Asbill & Brennan in Atlanta. Bensinger is with Baker Donelson Bearman Caldwell & Berkowitz in Birmingham, Ala.

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