U.S. Supreme Court Defines ‘Defalcation’

05/15/13

On Monday, for the first time in almost one and a half century, the U.S. Supreme Court clarified the meaning of the term ‘defalcation’ which is generally used in bankruptcy code to indicate both embezzlement and misuse of funds. Under the federal law, a person in the position of a fiduciary cannot seek bankruptcy relief to discharge debts if his action is tainted by “fraud or defalcation.”


Though the term ‘defalcation’ was introduced in bankruptcy law in 1841, and its relation to discharge of debt was mentioned in the law in 1867, this is the first time the Supreme Court determined the precise meaning of “defalcation.”

In its unanimous decision, the Supreme Court held in the matter of Bullock v. BankChampaign, U.S. Supreme Court, No. 11-1518, that if a court were to make a defalcation finding about a trustee, it must be proved that the person so accused was acting either with gross negligence, or with some knowledge of the impropriety of his actions.

Writing for the court, Justice Stephen Breyer observed that the term “defalcation” should be treated in bankruptcy law in the same fashion as the term “fraud.” The decision observed that the definition of ‘defalcation’ includes “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.”

In the instant case, one Randy Bullock tried to discharge his debts by seeking bankruptcy protection. However, Randy Bullock was the sole trustee of his father’s life insurance, which featured a $1 million benefit upon the death of the policy holder upon Bullock and four of his siblings. In his capacity as a trustee of the life insurance for 20 years, on three occasions, Bullock used the trust funds to issue loans. He financially benefited from two of them.

Though Bullock paid back the money with interest to the trust, two of his brothers sued him for breaching his duty as a trustee, and a state court ordered him to pay $250,000 to the trust plus a fine of $35,000, attorney’s fees and other costs.

Bullock sought bankruptcy and asked a federal bankruptcy court in Alabama to discharge the debt to the trust, which is currently supervised by BankChampaign. The federal government also intervened in the matter in support of the bank.

Bullock, being unsuccessful in discharging his debts to the trust created by order of the state court, appealed. The 11th U.S. Circuit Court of Appeals ruled in favor of the bank.

Bullock appealed again placing the question before the U.S. Supreme Court whether his actions, which did not deprive the trust of any money whatsoever, fell into the legal definition of “defalcation,” which was used to refuse his attempt to discharge his debts.

Though the Supreme Court did not decide whether Bullock’s actions fitted the definition of “defalcation,” it clarified what the term meant and remanded the case back to the district court. The district court is now expected to judge Bullock’s actions armed with the latest definition of “defalcation.”