E-Alert Case Updates

Supreme Court Holds that a Culpable State of Mind is Required for “Defalcation”

Bullock v. BankChampaign
Case No. 11- 1518 (U.S. Supreme Court)
by Joel M. Celso, Summer Associate
Semmes, Bowen & Semmes (www.semmes.com)

In this recently issued opinion from the U.S. Supreme Court, authored by Justice Breyer, the U.S. Supreme Court was asked to decide whether a fiduciary must have a culpable state of mind to incur debts for “defalcation,” which occurs when a fiduciary borrows improperly for his or her own gain. Under Federal Bankruptcy Code, a fiduciary cannot discharge debts incurred for “defalcation” in a bankruptcy proceeding. See 11 U.S.C. § 523(a)(4). In answering in the affirmative, the Supreme Court vacated the decision of the Court of Appeals and remanded the case to be decided accordingly.

This suit arose out of a father’s effort to provide for his children’s financial well-being. In 1978, Defendant Randy Bullock’s (“Mr. Bullock”) father established a trust naming his five (5) children as beneficiaries. The father conferred a life insurance policy to the trust as its only asset. He made Mr. Bullock the trustee and permitted him to borrow funds from the insurer against the value of the policy. In 1981, Mr. Bullock borrowed money from the trust at his father’s request, so his mother could repay a debt. Later in 1984, Mr. Bullock borrowed money of his own initiative to purchase a mill with his mother. Again in 1990, Mr. Bullock borrowed money to buy real property.

Although Mr. Bullock repaid all of the borrowed funds to the trust, his brothers and sisters sued him in Illinois State Court in 1999. The state court found that Mr. Bullock had committed a breach of fiduciary duty, albeit without any malicious motive. The court ordered Mr. Bullock to pay the benefits from the breach back to the trust, and imposed a constructive trust on Mr. Bullock’s interests in both the original trust and the mill, to secure payment of its judgment. Plaintiff BankChampaign was named as the trustee for all of the trusts. Following the action, Mr. Bullock experienced financial difficulties and filed for bankruptcy in federal court.

BankChampaign argued in bankruptcy court that Mr. Bullock should not be allowed to discharge his debts to the trust which had been imposed by state court. The bankruptcy court agreed and held that the debts were for “defalcation,” while Mr. Bullock acted as a fiduciary, and could not be discharged under the Federal Bankruptcy Code. See 11 U.S.C. § 523(a)(4). Mr. Bullock appealed to the district court, which affirmed. He then appealed to the U.S. Court of Appeals, which stated that “defalcation” requires a knowing breach of fiduciary duties, and affirmed upon determining that Mr. Bullock’s conduct met the standard.

On certiorari, Mr. Bullock argued to the U.S. Supreme Court that his debts to the trust were eligible for discharge because “defalcation” did not apply in the absence of any ill intent. In speaking for the Court, Justice Breyer acknowledged that lower courts had long disagreed about whether “defalcation” contained a scienter requirement or what that requirement might be. The Court then examined the dictionary definition, which failed to resolve the issue. Ultimately, the Court relied on its own precedent from an 1878 decisions authored by Justice Harlan, holding that the term “fraud” in the Bankruptcy Code’s exceptions to discharge required moral turpitude or intentional wrong. See Neal v. Clark, 95 U.S. 704, 708 (1878).

The Court stated that “defalcation” should be treated similarly. Therefore, the Court held that “defalcation” has a scienter requirement. Where a fiduciary’s conduct does not involve bad faith, there must be an intentional wrong. An intentional wrong includes actual knowledge of, or reckless disregard with respect to, the fiduciary’s improper conduct. The Court decided to vacate the appellate court’s decision and remand the case to determine if Mr. Bullock’s behavior met the heightened standard established in the decision.