Michigan Bankruptcy Blog

U.S. Supreme Court Clarifies Requirements of Defalcation

In a recent decision, the United States Supreme Court provided guidance relating to the term “defalcation” of the Bankruptcy Code under Section 523(a)(4).¹ In a unanimous decision, the Supreme Court held that the term “defalcation” of 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.”

In Bullock v Bankchampaign, the debtor’s siblings had previously obtained a judgment against the debtor for breach of fiduciary duty while acting as the trustee of their father’s Trust. After the debtor filed for bankruptcy relief, the siblings opposed discharge of the debtor’s state-court imposed debts to the Trust pursuant to 11 U.S.C. § 523(a)(4). The issue before the Supreme Court was whether the term defalcation applied to the debtor while acting as the trustee (fiduciary) of his father’s Trust when there were no findings of ill intent or evidence of loss of Trust principal.

The Supreme Court noted that defalcation has been an exception to discharge in the bankruptcy statute since 1867, and legal authorities and lower courts have long disagreed about its meaning. The central question has always been whether defalcation includes a scienter requirement. The Court analyzed several previous definitions and interpretations of defalcation and ultimately concluded that where the conduct at issue does not involve bad faith, moral turpitude, or immoral conduct, defalcation requires an intentional wrong. The Court went on to state that an intentional wrong includes not only conduct that the fiduciary knew was improper at the time, but also reckless conduct similar to the kind criminal law often treats as the equivalent.

As a result, the Supreme Court held that the term defalcation includes a culpable state of mind requirement. The state of mind requirement is one that involves “knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.”

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¹ Bullock v. Bankchampaign, N.A., 133 S. Ct. 1754 (U.S. May 13, 2013).

Categories: U.S. Supreme Court