Supreme Court Redefines “Defalcation”

If an individual is thinking about declaring chapter 7 bankruptcy it is most likely under the assumption that all their debts will be discharged. This is for the most part true. However, there are instances in which debts cannot be discharged. VA code precludes nineteen different types of debts from being discharged for various reasons. These types of debts are generally grouped into three categories. The first includes debts that cannot be discharged for policy reasons and may include items such as taxes or alimony payments. The second, for failing to follow certain bankruptcy rules such as notifying a creditor of chapter 7 bankruptcy. And the final category, for debtors which have debtor committed a wrongful act prior to filing bankruptcy.

The third category can be a complicated issue in bankruptcy cases. “Wrongful acts” can apply to any number of acts including but not limited to, “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” Until recently, the courts were split in their interpretation of defalcation. Previously, a “strict liability” statute was imposed meaning even minor or innocent errors as a fiduciary could result in non-dischargeable liability for defalcation. Other courts interpreted the definition differently requiring that defalcation only be declared if recklessness or negligence were found.

A recent case heard in the Supreme Court involved a debtor who had seemingly committed defalcation. Randy Bullock had previously been named the trustee for a trust set up by his father for the benefit of himself and his four siblings. The trust possessed a sole asset, a life insurance policy for Mr. Bullock’s father. The conditions of the trust permitted the trustee (Mr. Bullock) to borrow from the trust’s value at a rate of 6%. Subsequently, Mr. Bullock borrowed from the trust on three different occasions, each time at the predetermined rate of 6%. Each loan was repaid in full at the specified 6% rate.

Mr. Bullock was then lated sued by his brothers which resulted in Illonois courts declaring that Mr. Bullock had in fact “engaged in self-dealing and thus committed a breach of fiduciary duty”. This ruling resulted in a judgement requiring that all items purchased by Mr. Bullock with the funds from the trust (this included a mill and other real property) be placed in a constructive trust under BankChampaign N.A.

Following the judgement, Mr. Bullock (debtor) declared bankruptcy. The Bankruptcy court entered a summary which stated that the judgement had been found due to “defalcation in a fiduciary capacity”. Both the district and circuit courts affirmed this decision. Ultimately the case was brought before the Supreme court.

In the recent ruling of Bullock v. BankChampaign, the Supreme court ruled in favor of the Debtor stating that, “where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term [defalcation] requires an intentional wrong”. This ruling sets a new standard for the term defalcation and will now be considered in future cases that involve possible breaches of fiduciary duty.