Section 523(a)(4) of the Bankruptcy Code excepts from discharge any debt “for fraud or defalcation, while acting in a fiduciary capacity, embezzlement, or larceny.” While at first glance interpreting this section of the Code might appear straightforward, the current state of the law appears to contradict this notion. Some of this confusion may stem from the fact that the Bankruptcy Code does not define the terms fraud, defalcation or fiduciary capacity. Rather, these terms have been subject to judicial interpretation. This article highlights the circuit court level split of opinion regarding the degree of culpability required to meet the defalcation standard imposed by §523(a)(4) of the Bankruptcy Code as recently addressed by the Second Circuit Court of Appeals in In re Hyman, 2007 WL 2492789 (2d Cir. 2007).
As noted above, the Bankruptcy Code does not define the term defalcation. Courts have defined defalcation within the context of §523(a)(4) as the misappropriation of trust funds or money held in any fiduciary capacity or the failure to properly account for such funds. Tudor Oaks Ltd. Partnership v. Cochrane (In re Cochrane), 124 F.3d 978, 984 (8th Cir. 1997). Courts, however, have struggled with the degree of fault or required intent, if any, necessary for a party to be found to have committed a defalcation. Three schools of thought have emerged regarding this issue. Some courts require evidence of reckless conduct by the fiduciary. See, In re Wells, 368 B.R. 506, 513 (Bankr. M.D. La. 2006) (judging defalcation by a reckless standard); In re Baylis, 313 F.3d 9, 20 (1st Cir. 2002) (requiring something close to a showing of extreme recklessness). Other courts employ a negligence standard. See, In re Goodwin, 355 B.R. 337, 345 (Bankr. M.D. Fla. 2006) (holding that negligence may constitute defalcation). Finally, a third line of cases holds that an innocent mistake can constitute defalcation. See, In re Davis, 371 B.R. 127, 136 (Bankr. E.D.N.C. 2007) (concluding that even an innocent mistake can constitute defalcation).
With this background, the Second Circuit in In Re Hyman, 2007 WL 2492789 (2nd Cir. 2007) addressed for the first time in the Second Circuit whether there is a misconduct element in the term “defalcation” as well as the degree of culpability required to render a debt nondischargeable. The facts of the case are as follows. Andrew Hyman (debtor) and George W. Denton incurred $1.6 million in debt, guaranteed jointly and severally, in order to form an insurance agency (the original agency) and two related pension administration companies, NPS and NPA. The original agency was the exclusive authorized agent for Guardian Life Insurance Company of America. Thirteen months after forming the business, and with the $1.6 million start-up debt still outstanding, Denton died and the agency relationship between the original agency and Guardian automatically terminated. The debtor formed a new insurance agency (the new agency) to serve as agent to Guardian and continued to operate NPS and NPA. Over the course of the next five years, the debtor repaid in full the $1.6 million debt, with the consent of Denton’s estate, using the assets of the original agency and the new agency. Additionally, the debtor engaged in lengthy, albeit unsuccessful, negotiations with the executor of Denton’s estate for the purchase of Denton’s 50 percent interest in the original agency, NPA and NPA.
When Guardian terminated its agency relationship with the new agency, the executor filed suit against the debtor, asserting a derivative claim on behalf of the original agency, seeking to recover profits earned by the debtor and new agency, which the executor believed belonged to Denton’s estate. The state court entered a $2.7 million dollar judgment in favor of the executor, finding that the debtor had breached his fiduciary duty by (i) co-opting the assets of the original agency, NPS and NPA for the benefit of the new agency and for his own personal enrichment; (ii) using furniture and fixtures of the original agency, NPS and NPA without compensation and (iii) using the original agency overrides to subsidize NPS and NPA and to satisfy the new agency’s debt to Guardian.
In February 2003, the debtor filed for bankruptcy protection. The executor sought to declare the judgment nondischargeable under §523(a)(4) of the Bankruptcy Code based solely on the collateral estoppel effect of the state court proceedings. Although the bankruptcy court found the judgment valid and enforceable, it refused to hold that the claim was nondischargeable pursuant to §523(a)(4) of the Bankruptcy Code. The bankruptcy court found that the §523(a)(4) of the Bankruptcy Code is narrower than the concept of misappropriation under state law and that this section requires some portion of misconduct. The bankruptcy court emphasized that the executor had failed to identify any specific conduct that could be characterized as wrongful, illegal or morally reprehensible. The district court affirmed the decision, finding that the debtor’s offer to buy out the estate’s interest, the long negotiations over a purchase price and the satisfaction of the $1.6 million dollar debt did not necessarily demonstrate the level of misconduct necessary to trigger the application of §523(a)(4) of the Bankruptcy Code.
In affirming the district court, the Second Circuit first addressed the question of whether a defalcation within the meaning of §523(a)(4) is identical to the factual and legal determinations necessarily decided in the state court proceedings. The Second Circuit noted that there has been much debate among the other circuit courts over whether a defalcation under §523(a)(4) includes all misappropriations or failures to account, or only those that are accompanied by some wrongful conduct. The Second Circuit pointed out that its previous opinions suggested that there was a misconduct element in the word defalcation but that it had not squarely addressed the issue.
As part of its analysis, the Second Circuit cited decisions from the Fourth, Eighth, and Ninth Circuits holding that an innocent mistake can constitute a defalcation. The Second Circuit then noted that a majority of the circuits addressing this issue require some level of wrongful conduct in order to find a defalcation under this section. By way of example, the opinion points out that the Fifth, Sixth and Seventh Circuits require a level of fault greater than mere negligence and that, while the Tenth Circuit’s standard is not entirely clear, it at least requires “some portion of misconduct.” According to the Second Circuit, the First Circuit sets the highest bar by requiring a showing of extreme recklessness akin to the level of recklessness required for scienter in securities law.
In “light of this persistent confusion,” the Second Circuit aligned itself with the First Circuit in holding that “defalcation under §523(a)(4) of the Bankruptcy Code requires a showing of conscious misbehavior or extreme recklessness—a showing akin to the showing required for scienter in the securities law context.” This standard, according to the Second Circuit, ensures that the term “defalcation” complements, but does not dilute, the other terms of the provision—“fraud,” “embezzlement” and “larceny”—all of which require a showing of actual wrongful intent. By requiring the courts to make appropriate findings of conscious misbehavior or recklessness in the course of dischargeability litigation, this standard ensures that the harsh sanction of nondischargeability is reserved for those who exhibit “some portion of misconduct.” The standard does not reach fiduciaries that may have failed to account for funds or property for which they were responsible only as a consequence of negligence, inadvertence or similar conduct not shown to be sufficiently culpable. It also has the virtue of ease of application since there is a robust body of case law in the securities law context examining what these terms mean.
Applying this standard, it was clear that the executor could not rest his case on the state court’s determination. The state court had made no express findings with regard to the debtor’s state of mind, nor was it required to do so under state law in order to find a breach of a fiduciary duty. The state court had neither the ability nor the incentive to apply this announced standard. Moreover, the record contained evidence of the debtor’s good faith in using proceeds of the new agency to pay off debts for which the estate and debtor were jointly liable and in attempting for years to try to reach a buyout with the executor of Denton’s interest in the original agency, NPS and NPA under mutually acceptable terms. Thus, the identical issue was not necessarily decided by the state court, nor did the debtor have a full and fair opportunity to contest his state of mind. Because (i) the state of the law was murky, (ii) exceptions to discharge are to be construed narrowly and (iii) an exception to discharge carries serious consequences for the debtor, the Second Circuit held that collateral estoppel did not apply and affirmed the District Court’s judgment.
The Second Circuit’s decision to adopt the “conscious misbehavior or extreme recklessness” standard appears to be based upon the belief that this standard is easily applied based on the large body of case law interpreting this standard in the securities laws context. Whether or not the Second Circuit’s prediction is accurate remains to be seen. Either way, with the split of authority on the standard to be applied, it appears that this issue is ripe for consideration by the Supreme Court.