Supreme Court To Address Circuit Split Over 'Defalcation' Meaning

In a corporate system based in part on the separation of ownership and control, the relationship between principals and agents is riddled with agency problems: Among them are potential conflicts of interest where agents may abuse their fiduciary position for their own benefit as opposed to the benefit of the principals to whom they are obligated. Delineating the agents' fiduciary duties is thus a central focus of corporate law, and the dereliction of those duties often comes under scrutiny in the bankruptcy context.

Agents who incur debts through wrongdoing sometimes seek refuge in bankruptcy, hoping to avail themselves of the Bankruptcy Code's provisions for discharge. To mitigate this potential abuse, Congress passed Section 523(a) of the Bankruptcy Code. That section excludes from bankruptcy discharge, inter alia, debts arising from certain breaches of fiduciary duty. However, the degree of culpability required to trigger nondischargeability of a debt is not defined in the statute, and thus has been left to the courts to construct. This lack of definition has led to a three-way circuit split regarding the types of behavior — specifically the degree of wrongful intent — that will result in a denial of discharge.

In Bullock v. BankChampaign, 670 F.3d 1160 (11th Cir. 2012), the U.S. Court of Appeals for the Eleventh Circuit examined the meaning of "defalcation" by a fiduciary, which is one type of wrongdoing that triggers nondischargeability under Section 523(a)(4). In denying the debtor's discharge, the court maintained its alignment with the group of circuit courts that defines the state of mind for "defalcation" as "objective recklessness," which lies somewhere between negligence and extreme recklessness. On October 29, the U.S. Supreme Court granted certiorari in Bullock in order to resolve the circuit split. Although the issues addressed in Bullock bear directly on the scope of exceptions to bankruptcy discharge, they have broader implications for the concepts comprising fiduciary duty under federal law.

Source of the Circuit Split

One of the fundamental purposes of bankruptcy is to provide for a discharge of prepetition debt, thereby giving debtors a fresh start upon their emergence from bankruptcy. This principle is balanced against that of safeguarding the rights of creditors, one such safeguard being to deny discharge to dishonest debtors. While certain debts are excepted from discharge for policy purposes, e.g., taxes, domestic support obligations, educational loans, etc., Section 523 also seeks to prevent abuse of the bankruptcy process by delineating certain exceptions to discharge in the case of a debtor's wrongdoing. To that end, Section 523(a)(4) provides that the code's discharge provisions shall not discharge an individual debtor from any debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." "Defalcation" is defined as "a failure to produce funds entrusted to a fiduciary and applies to conduct that does not necessarily reach the level of fraud...