The term “defalcation” has been an exception to discharge in bankruptcy statutes since 1867. However, courts have disagreed as to what mental state must accompany a “defalcation.”
After a century and a half, the United States Supreme Court addressed what the term “defalcation” meant in the context of an exception to discharge. Specifically, 11 U.S.C. section 523(a)(4) provides that a debt for “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny” is not dischargeable.
In this case, the Mr. Bullock (“Debtor”), filed for bankruptcy relief and sought to discharge a debt concerning money he owed for his role in overseeing his father’s life insurance trust. He used the money from the trust to make investments for himself and other family members. He eventually paid the money back to the life insurance trust with interest, but the question before the Court was whether Debtor’s actions, which did not deprive the trustee of any money, fit within the legal description of “defalcation.”
The Supreme Court noted that in a prior decision, Neal v. Clark, 95 U.S. 704 (1878), the Court interpreted the term “fraud” for the purpose of nondischargeability to mean “positive fraud, or fraud in fact, involving moral turpitude or intentional wrong, as does embezzlement; and not implied fraud, or fraud in law, which may exist without the imputation of bad faith or immorality.” The Court concluded that the term “defalcation” should be treated similarly. Consequently, where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, “defalcation” requires an intentional wrong. The Court concluded that an intentional wrong included 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 words of the Court, a “culpable state of mind requirement involving knowledge of, or gross recklessness in respect to, the improper nature of the fiduciary duty.”
The Court determined that this interpretation is consistent with the longstanding principle that exceptions to discharge should be confined to those plainly expressed and the intent of Congress in normally confining to circumstances where strong, special policy considerations, such as the presence of fault, argue for denying the dischargeability of the debt. Thus, this would generally exclude the honest but unfortunate debtor from the threat of denying the dischargeability of a specific debt.
– Robert Lantz