Non-Dischargeability in Bankruptcy
January 17, 2023
In this Surety Today Blog post we will discuss Non-Dischargeability in Bankruptcy. But first, in order to understand “non-dischargeability,” you have to understand “dischargeability.” A fundamental goal of the Bankruptcy Code is to give debtors a financial fresh start, so to speak. The Supreme Court observed long ago that the purpose of the bankruptcy system was to “give the honest but unfortunate debtor a new opportunity in life and a clear field for future effort unhampered by the pressure and discouragement of pre-existing debt.” The various bankruptcy chapters, 7, 11 and 13 all provide for a discharge of the debtor.
Section 524 of the Bankruptcy Code addresses the effect of the discharge and generally provides a discharge of the debtor that releases the debtor from personal liability for pre-existing debt. Specifically, section 524 provides that discharge of the debtor voids any pre-bankruptcy judgments against the debtor and operates as a continuing and permanent injunction against any enforcement or collection efforts of any creditors of any debts that are the subject of the discharge. The discharge under 524 of the Bankruptcy Code operates automatically by operation of law. A violation of the discharge by a creditor would be void and any violator could be subject to sanctions or penalties.
Notwithstanding the fresh start and discharge goal of bankruptcy, the Bankruptcy Code does provide that certain types of debt are not subject to the discharge, and thus, they are non-dischargeable. When a debt is non-dischargeable, that means that even after the bankruptcy a creditor can pursue such debt against the debtor’s post-bankruptcy assets. Section 523 of the Bankruptcy Code provides for exceptions to discharge, and it identifies some 21 different types of debts that are non-dischargeable. When you look at these exceptions, they are very limited, specific and detailed and there are all kinds of different things in there, but basically, there are two broad categories of debts that the Code declares are exceptions to discharge.
The first category consists of those debts that are excluded for public policy reasons. So you have things in the Code like certain taxes, student loans and child support obligations. These types of debt are declared non-dischargeable. The second category of debts that are exceptions to the discharge under 523 are debts that were created as result of what you would call “bad behavior.” These are debts that were created by fraud, false pretense, intentional tort, etc. The courts have decided that all of these exceptions to discharge under 523 are to be narrowly construed in order to limit their affect and to broaden the scope of the fresh start. Further, the party seeking non-dischargeability under 523 will bear the burden of proving the requirements by a preponderance of the evidence.
Non-dischargeability can be important to a surety because it can establish that your debt is not discharged and you can continue to pursue collection post-bankruptcy. Maybe there are some assets that were not part of the bankruptcy that you could gain access to or you can use the threat of non-dischargeability as a negotiation tool either pre-bankruptcy or post-bankruptcy in order to improve the surety’s position. It has relevance and is something that I know a lot of surety people have dealt with.
In the Supreme Court case of Bullock v. BankChampaign, 133 S. Ct 1754 (2013), the Court addressed non-dischargeability in a context that has application to sureties. It relates to section 523(a)(4), which provides that an individual debtor is not discharged from any debt that was incurred by defalcation while acting in a fiduciary capacity. So, if a debtor, while acting as a fiduciary, incurred a debt or liability as a result of a defalcation of their fiduciary obligations, then that debt would be excluded from discharge. The keys to 523(a)(4) are whether there is a “fiduciary capacity” and whether “defalcation” occurred while the debtor was acting in that fiduciary capacity. Unfortunately, the Code does not define either fiduciary capacity or defalcation, so we are left with the Courts to figure it out. We will look at these two keys to Section 523(a)(4) and then get into the Bullock case. Of course, sureties run into this issue because most Indemnity Agreements, underlying bonded contracts and some state statutes create trusts for the bonded contract funds and the principal and/or its indemnitors become trustees of those trust funds and have fiduciary duties as a result.
“Fiduciary Capacity” Under Section 523(a)(4)
The first key is “fiduciary capacity.” There are a lot of relationships where parties may be described as a fiduciary in one sense or another. For example, agents and principals, bailees and bailors, brokers, factors, partners, have all been treated under various state laws as fiduciaries. For the purposes of section 523, those are not sufficient fiduciary capacities in order to trigger non-dischargeability. However, relationships such as the trustee of a trust, executors or administrators of an estate, guardians and those types of relationships are the kind of fiduciary relationships that section 523 is addressing. Not all trusts will satisfy section 523. Only express or technical trusts fall within the scope of 523. So, things like constructive trusts, resulting trusts, or implied trusts cannot create the necessary capacity under section 523. Further, the trust must exist prior to the bankruptcy and arise without reference to any wrongdoing. Constructive, resulting and implied trusts are all remedy-based trusts that only come into existence after or as a result of wrongdoing.
If you can establish the existence of the express trust and the debtor was the trustee, you will have that necessary fiduciary capacity required by section 523; you then need to establish defalcation.
“Defalcation” Under Section 523(a)(4)
As noted earlier, the Bankruptcy Code does not define the term “defalcation.” As a result, several definitions have arisen over the years. The 4th, 8th and 11th Circuits have all held that defalcation under section 523 could occur from a mere failure to meet a fiduciary obligation, whether through negligence or innocent mistake. Basically, if the trustee was supposed to have $100 in the trust account and they didn’t, the trustee as the fiduciary, was guilty of defalcation in those Circuits. The 5th, 6th and 7th Circuits developed a rule that defalcation under section 523 required more than just mere negligence. There had to be some sort of willful conduct, although short of fraud. You didn’t have to have the intent to deceive or the gross extreme recklessness, but you had to have more than just mere negligence in order to constitute defalcation. The third position was established by the 1st and 2nd Circuits, which held that defalcation required an intent to deceive, the scienter element of fraud, or extreme recklessness in order to satisfy the defalcation requirement of section 523. So, you’ve got this split among the Circuits with all of these different positions, and the Supreme Court finally, in the Bullock case, put to rest the split and came out with a pretty tough standard; adopting the most restrictive approach.
Non-Dischargeability in Section 523(a)(4) Under Bullock
The Bullock case itself was a typical self-dealing situation where the debtor was the trustee of the trust and he was basically taking loans out of the trust and self-dealing for his own personal benefit. The Court looked at that, looked at the history of defalcation, looked at the split among the Circuits, and ultimately held that defalcation under section 523 requires conduct that must include bad faith, moral turpitude or other immoral conduct or intentional wrongdoing. The Court clarified that “intentional wrongdoing” includes not only conduct that the fiduciary knows is improper, but also reckless conduct. It defined “reckless conduct” as a conscious disregard of a substantial and unjustifiable risk that the conduct will turn out to violate the fiduciary duty. Later in the decision, the Court defined it as a gross deviation from the standard of conduct that a law abiding person would observe. So, in the Bullock decision, the Court adopted the most restrictive approach to non-dischargeability for defalcation and has made section 523 relief a lot more difficult to obtain.
Because of the requirement to establish intent and willfulness, the surety will need to prove that the principal/indemnitors knew they were trustees, that there was a trust relationship and that they owed fiduciary duties. During the underwriting phase, the surety should point out the trust fund provision of the indemnity agreement, maybe in the cover letter and informing the indemnitors of their duties. When the first claim comes in, the surety claims handler should have their letter going to the indemnitors advising that they are trustees and that they have trust obligations. During the initial investigation, the claims handler should be looking for facts and information that are going to show the knowledge and show the intent to violate the trust obligation. The surety should make sure that it locates and preserves all of the documents that are out there; particularly electronic documents, emails and the like, which can be critical to show what the parties were thinking at the time and why they were doing what they were doing. The higher burden requires greater diligence in order to establish non-dischargeability.
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