A Strong Offense
A Stronger Defense
Last week, the United States Supreme Court issued its opinion in Bullock v. BankChampaign, N.A., which addressed the circumstances in which a breach of fiduciary duty judgment can be discharged in bankruptcy proceedings. Specifically, the Court resolved a deeply fractured Circuit split on the scope of the term “defalcation” within Section 523(a)(4) of the Federal Bankruptcy Code. That Section of the Bankruptcy Code provides that an individual cannot obtain bankruptcy discharge “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” For years, the lower courts had struggled with what, exactly, “defalcation” means. Wonder no longer because the Supreme Court has defined it.
Curt Bullock appointed his son, Chris Bullock, as trustee of the Curt Bullock Trust No. 2. Chris and his siblings were the only beneficiaries of the trust. The trust was a common life insurance trust with the only asset being Curt’s life insurance policy. The terms of the trust prevented the trustee from borrowing from the trust except to pay life insurance premiums or to satisfy a withdrawal request from another trustee. Nevertheless, Curt convinced Chris to make a loan to Chris’s mother, Imogene, so she could repay a debt to the family business. Chris made two more improper loans from the trust. He loaned money to himself and Imogene to invest in a mill. A few years later he made another loan to his mother and himself to purchase some real estate. Each of these three loans was repaid in full at an interest rate of 6 percent – the same rate the trust was earning from the insurance company.
Breach of Fiduciary Duty Judgment
Chris’s brothers ended up suing him for breach of fiduciary duty on the grounds that the loans constituted improper self-dealing. The brothers moved for summary judgment and the Illinois state trial court granted it. Under Illinois state law, in order for a trustee to self-deal, the trust instrument must provide for, not prohibit against, it. The trust instrument here did not specifically prohibit self-dealing, but it did not permit it either. In its initial summary judgment order, the trial court indicated there was a material issue of fact on whether Chris acted in good faith in making the prohibited transactions, and in its final order awarding damages the trial court noted that Chris did not appear to have “malicious motive” in making the prohibited transactions. Indeed, there was no finding in the state court as to Chris’s mental intent – only that Chris engaged in impermissible self-dealing, which created a conflict of interest between him and the trust beneficiaries. Nevertheless, the Illinois court ordered Chris to pay $250,000 in damages which represented the improper benefits he received from the trust, ordered Chris to pay $35,000 in his brothers’ attorney’s fees, and placed the mill Chris purchased with trust funds in a constructive trust controlled by BankChampaign. BankChampaign also replaced Chris as the trustee of Curt’s life insurance trust.
Chapter 7 Bankruptcy Proceeding
BankChampaign allegedly blocked Chris’s efforts to sell the mill to satisfy the judgment, so Chris filed for Chapter 7 bankruptcy protection in the U.S. Bankruptcy Court for the Northern District of Alabama and sought to discharge his debt from the Illinois state court judgment. BankChampaign started an adversary proceeding in bankruptcy court and argued that the debt was non-dischargeable because it arose out of Chris’s fraud. According to the bank, Chris’s conduct that garnered the state court judgment constituted defalcation which is non-dischargeable under Section 523(a)(4) of the Bankruptcy Code. The bankruptcy court agreed, and the U.S. District Court for the Northern District of Alabama and the 11th Circuit Court of Appeals did, too.
Meaning of “Defalcation” and Implications
The Supreme Court, however, disagreed. It held that “defalcation” is a state of mind “as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.” That isn’t all that helpful, so the Court explained:
[W]here 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 treats as the equivalent. . . . Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent 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. That risk “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.”
In reaching its decision, the Court recognized that the scienter requirement it adopted “will most likely help” nonprofessional trustees administering family trusts which are difficult to evaluate in terms of comparative fault. While a fiduciary may still be found liable for a breach of fiduciary duty where the applicable state law imposes a simple negligence standard of care, that judgment may be dischargeable in bankruptcy unless the fiduciary acted with bad faith, intentional wrong, or gross recklessness.