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School of Law
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Robert A. Leflar Law Center
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University of Arkansas
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Phone: (479) 575-5601

Defalcation by a Fiduciary – A New Standard

By · August 10, 2014 · 2014 Ark. L. Notes 1634
In categories: Bankruptcy, Business Law, Debtor/Creditor, Financial Institutions Law, Post Types, Snapshot

I am a year late, but I hope this will still be interesting to you. Not surprisingly, I am writing about a bankruptcy case from the Supreme Court. This changes cases from the Eighth Circuit and this is why I am discussing it. The case is Bullock v. BankChampaign. 1 The issue concerns whether a debt is dischargeable when the debtor obtains a bankruptcy discharge. The phrase in the Bankruptcy Code is “defalcation by a fiduciary”. If the fiduciary has done this, the debt is not discharged. This issue does not come up frequently, but when it comes up, this is an important change. It applies when a person is in charge of money belonging to someone else. I am a trustee for my brother’s spendthrift trust. You as lawyers may well be in this position also. The Bullock case was an appeal from an Eleventh Circuit case. 2 In the court of appeal case, the court aligned itself with circuits that adopted an objectively reckless standard. 3 The court of appeal rejected the Eighth Circuit approach which along with some other circuit courts of appeal have adopted an innocent standard. 4 Under this standard, a trustee who innocently mishandles the trust money would have a nondischargeable debt. The Supreme Court reversed the Eleventh Circuit’s opinion saying the Court was establishing a higher standard. 5 This is the subject of this Law Notes article. Under either the court of appeal case or the Supreme Court’s test, the Eighth Circuit rule is changed.

This note focuses on what the Supreme Court is saying and what standard is now in place. The test in the Bankruptcy Code is “defalcation by a fiduciary”. 6 In the Bullock opinion, the Court was focusing just on the word “defalcation”. The Eleventh Circuit has held that even an insurance agent is a fiduciary. 7 This was not an issue before the Court.

The facts in the case are interesting. Debtor’s dad decided to create a trust and appointed debtor, one of his sons, to act as the trustee. The trust contained a life insurance policy on dad’s life set up in 1978. 8 Dad in 1981 told his son to borrow on the insurance policy to allow his dad’s wife, debtor’s mother, to pay off one of her debts to dad’s company and the son complied. Another loan on the trust was also used to buy a garage fabrication mill in 1984. 9 This loan was made after his mother requested the loan. The loan was put into CDs and then transferred to buy the mill. The debtor and his mother held the interest in the mill. A third loan from the trust bought some real estate in 1990. 10 This property was placed in the debtor’s and his mother’s names. 11 The trust instrument allowed the borrowing of the money in two situations. First was to pay costs of the life insurance premiums and second to satisfy a beneficiary’s request for withdrawal. 12 In fact, all three loans were paid back into the trust with six percent interest paid as well. 13 Bullock was a beneficiary of the trust as well as his four siblings. 14 (Emphasis supplied.)

When the other two sons found out about the borrowing, they sued their brother for breaching his trust duties. The Illinois court held that the debtor trustee breached his trust duties. The court found he should be liable for all the benefit he gained from the three loans. The court awarded the other sons $250,000 in damages and $35,000 in attorneys’ fees. 15 This caused Bullock to file for Chapter 7 bankruptcy. One of the more interesting facts in the case is BankChampaign was now trustee and they obtained a constructive trust lien put on the mill property. Bullock argued this was unfair because he could pay off the debt if he could sell the mill. The Illinois court’s judgment was in part based on the mill’s value. The bankruptcy court held this was defalcation by a fiduciary and the debt could not be discharged. This was affirmed by the District court but the court was troubled by the Bank’s unwillingness to sell the mill. The Eleventh Circuit affirmed. 16

The Supreme Court opinion is unanimous. 17 Recall that the Eleventh Circuit used the “objective reckless” standard. Early in the Bullock opinion the Court holds that defalcation must have a culpable state of mind as is required for the other terms included in (a)(4). 18 Later they say they are only ruling on the state of mind needed. 19 The Court holds “[w]e describe that state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.” 20 In explaining this they say:

[t]hus, where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term requires an intentional wrong. We include in intentional 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, we include reckless conduct of the kind set forth in the Model Penal Code. Where actual knowledge 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. 21

The Court is quoting the American Law Institute, Model Penal Code § 2.02(2) p. 226 (1985). “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, disregards a gross deviation from the standard of conduct that alaw-abiding person would observe in the actor’s situation.’ ” This also is quoting from the ALI Model Penal Code and Comments. 22 The Court even cites the language used in securities law which is “a mental state embracing intent to deceive, manipulate, or defraud.” 23

Section 2.02 of the ALI Model Penal Code is setting out the degrees of criminal culpability. The Court is quoting from both the section 2.02 language for knowing and recklessness and the comments. Comment 9 to this section also discusses “willful blindness” to a problem. You can see the Court added this phrase to their discussion of the test they are creating for defalcation. 24

The Court refers to this as a scienter requirement. Noting it should help “nonprofessional trustees, perhaps administering small family trusts potentially immersed in intrafamily arguments that are difficult to evaluate in terms of comparative fault.” (Emphasis supplied by the Court.) The Court reasons this standard will be relatively easy to apply since there is a large amount of securities case law examining the meaning of the terms. 25 This certainly describes the debtor in this case. Dad set up the trust. Was the son to disregard his dad’s and mother’s requests?

The Court remands the case instructing the lower court to use this new standard to analyze the facts. The bankruptcy court originally issued summary judgment against the debtor. 26

Since this case is changing Eight Circuit law,and In re Cochrane is the case cited by the court of appeal in the Bullock case, it is worth examining. 27 Mr. Cochrane was a lawyer hired by Tudor Oaks to work with Tudor Oaks and its partners in a bank foreclosure on a big condominium project in Canada. 28 From the court of appeal facts, Mr. Cochrane agreed to work for a flat fee and to keep for Tudor Oaks a 20% equity interest. 29 Cochrane assembled a group of investors who bid to own the property. Cochrane instead took the 20% interest for himself and never disclosed to Tudor Oaks that Cochrane was a part owner of the buy-out company, KSCS. A Minnesota court found that Cochrane and KSCS breached their fiduciary duty to Tudor Oaks. The state court originally assessed damages of $1.628 million against Cochrane and $3.520 million against KSCS. On appeal the case was remanded and the trial court awarded $1,722,025.52 in damages against both defendants jointly and severally. This caused Cochrane to file a Chapter 11 bankruptcy that was converted to Chapter 7 when Tudor Oaks filed a motion to make the judgment non dischargeable. One of the issues on appeal was what standard should apply for defalcation. The Eighth Circuit held that in their circuit even innocent or negligent actions were not dischargeable. 30 The court notes that Mr. Cochrane could probably not characterize his conduct as innocent or merely negligent so he easily met the innocent or negligent standard. The court holds when the fiduciary misappropriates trust funds and fails to properly account for such funds this is defalcation, even if doing so was entirely innocent. 31

Would Cochrane’s debt to Tudor Oaks be not discharged under the new Supreme Court test? In the state case the jury issued a special verdict finding, among other things, that Cochrane and KSCS conspired to breach fiduciary duties to Tudor Oaks and this resulted in damage to Tudor Oaks. I highlighted the above to focus on what this means. Remember Cochrane and KSCS took for themselves 20% of the value of the condominium project. This by contract between Tudor Oaks and Cochrane was supposed to go to Tudor Oaks. This looks like the intentional action that should be defalcation under the Bankruptcy Code. If Cochrane and KSCS conspired to keep the 20% ownership away from Tudor Oaks, this seems to qualify for defalcation under the Bullock test.

To me, there is a world or difference between the lawyer, Cochrane, and the son in the Bullock case. As the Supreme Court noted, these family trustees like the son need special protection. 32 Almost always they are doing it for the love of family and doing the work for free. Remember in the Bullock case, the first loan on the insurance policy was from a request of dad who of course had created the trust in the first place. What would you do if this request were made to you acting as a trustee in similar facts? I think the two other loans were made at his mother’s request. This was not the debtor trustee spending the money on himself. I say this knowing that the mill and the real estate were in both mom and the debtor’s names. All loans against the insurance policy were repaid. Mr. Cochrane, however, willfully took for himself the 20% he should have given to Tudor Oaks, his client. This looks a bit like stealing. In contrast are the Bullock facts. We do not know the training of the son who agreed to be the trustee of the trust. I suspect he never looked at the document creating the trust. I think a court would have mentioned if the son were a lawyer or a sophisticated businessman. After all, most children follow their parent’s requests. This is especially true when the parents were the ones who set up the trust.

I looked for a reported decision to see how the bankruptcy court was applying the new Supreme Court test. Unfortunately, I found nothing reported, at least so far.

Notes

  1. 133 S.Ct. 1754 (2013).
  2. In re Bullock, 670 F.3d 1160 (11th Cir. 2012).
  3. 133 Id. at 1166.
  4. In re Cochrane, 124 F.3d 978, 984 (8th Cir. 1997).
  5. 133 S.Ct. at 1757-58.
  6. This section can be found in 11 U.S.C.A. §523(a)(4) (2013). In toto it says “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny;”.
  7. Quaif v. Johnson, 4 F. 3d 950 (11th Cir. 1993).
  8. 133 S.Ct. at 1757.
  9. Id.
  10. Id.
  11. Id.
  12. In re Bullock, 670 F.3d 1160.
  13. 133 S.Ct. at 1757 Interestingly, the 6% interest rate was set by the insurance company. I assume this means that it was higher than the actual interest rate available elsewhere but I did not check.
  14. 133 .Ct. at 1757.
  15. Bullock, 670 F.3d at 1162.
  16. In re Bullock at 1163, 1166 .
  17. 133 S.Ct. at 1756. The Eleventh Circuit also was troubled by the bank’s refusal to sell the mill.
  18. Id. at 1157. (Noting that the word “fraud” has also been construed by the Court to include a bad state of mind.).
  19. Id. at 1759.
  20. Id. at 1757.
  21. Id. at 1759-60.
  22. The italicized portion was italicized by the Court. The quoted part comes from the ALI Model Penal Code § 2.02(2)(c) at 226. (Bullock 133 S.Ct. at 1759-60.)
  23. Bullock, 133 S.Ct. at 1760.
  24. American Law Institute, Model Penal Code and Commentaries, Part 1, §2.02 and comment 9 (1985).
  25. Bullock, 133 S.Ct. at 1761.
  26. Id.
  27. In re Cochrane, 124 F.3d 978, 984
  28. Id. at 981.
  29. Id.
  30. Id. at 984.
  31. Id.
  32. Bullock, 133 S.Ct. at 1761.
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