Under the United States Bankruptcy Code (the “Code”), if a debtor, acting as a fiduciary, incurred a debt through defalcation, the debt is non-dischargeable in bankruptcy.  The problem is that the Code does not define defalcation, and, perhaps naturally, courts have historically disagreed on its meaning.  Last year, the Supreme Court attempted to settle the disagreement in the case of Bullock v. BankChampaign, NA, 133 S. Ct. 1754, 185 L. Ed. 2d 922 (2013).  Black’s Law Dictionary defines defalcation as “embezzlement” or “the failure to meet an obligation; a nonfraudulent default.”  The historical disagreement on the term’s definition centered on whether defalcation required an intent by the debtor to deceive (scienter) or whether, as Black’s suggests, mere negligence is sufficient.

In Bullock, the debtor was a trustee of his father’s trust and misused the trust proceeds.  The other trust beneficiaries sued the debtor and obtained a judgment.  The court ordered the debtor to repay damages to the trust and appointed BankChampaign, N.A. as trustee over certain of his assets.  When the debtor was unable to repay the trust, he filed for bankruptcy protection.  The bank objected to the discharge of the debtor’s judgment debt, arguing that the debt arose from the debtor’s defalcation committed while he was acting in a fiduciary capacity.  Although the bankruptcy court found the debtor had no ill will or intent to deceive, he had committed defalcation while acting in a fiduciary capacity and held the debt to the trust non-dischargeable.  On appeal, the district court and subsequently the Eleventh Circuit Court of Appeals affirmed.

The Supreme Court reviewed the historical disagreements on the definition of defalcation.  It noted that as far back as 1934, the Second Circuit hinted, but did not hold, that an innocent (i.e., non-fraudulent) default may be sufficient to commit defalcation.  The Court recognized that the circuit courts of appeal have, since 1934, utilized three different standards, each with their own requirements.  At one end of the spectrum, some circuits, such as the Fourth, Eighth, Ninth and Eleventh Circuits, agreed with Black’s that a mere non-fraudulent failure to meet an obligation is sufficient.  At the other end of the spectrum, the First and Second Circuits required a specific intent to deceive or extreme recklessness.  Treading a middle path between the two, the Fifth, Sixth and Seventh Circuits required something more than an innocent default, but they stopped short of requiring an intent to deceive or gross negligence.

Citing an 1878 case interpreting the Code’s term “fraud,” the Supreme Court largely sided with the First and Second Circuits, holding that the term defalcation includes “bad faith, moral turpitude, or other immoral conduct.”  However, where such conduct is lacking, defalcation then requires “an intentional wrong.”  “Intentional” includes “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.”  Thus, where actual knowledge is not present, recklessness may also suffice, “if the fiduciary ‘consciously disregards’ (or is willfully blind to) ‘a substantial and unjustifiable risk’ that his conduct will turn out to violate a fiduciary duty.”  This “risk,” the Court concluded, “must be of such a nature and degree that, considering the nature and purpose of the actor’s conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor’s situation.”  133 S. Ct. at 1760.  The Court concluded by remanding the case back to determine whether additional fact finding was required in light of this heightened standard.

The Bullock holding is important because it establishes a uniform, nationwide standard for proving defalcation.  A creditor’s attorney seeking to prove defalcation should therefore take early steps to lay the factual and procedural groundwork to meet this new heightened standard.  This is especially important when a creditor, such as a surety, a bank, a credit union or other such entity, is seeking to obtain a judgment that the creditor suspects the debtor may seek to discharge in bankruptcy.  In such a situation, the creditor’s attorney should set forth allegations in the pleadings that allege conduct that meets the new Bullock standard.  The attorney should also take advantage of whatever discovery mechanisms are available to try and prove the debtor’s subjective state of mind, or prove facts that meet the heightened recklessness standard.  Finally, following a bankruptcy filing, the creditor should utilize bankruptcy procedures, such as the initial §341 meeting of creditors, to add additional facts that supplement those developed in the pursuit of the underlying judgment.  Although Bullock announced a new, heightened nationwide standard for defalcation objections to discharge, it can still be powerful tool in the creditor’s attorney’s arsenal.