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The U.S. bankruptcy code has prohibited discharging debts that arise from a consumer’s “defalcation” since 1867. However, the precise meaning of defalcation for the purposes of the bankruptcy code has never been clarified. Some courts interpret it to mean embezzlement, while others construe it as meaning a general misuse of money. The U.S. Supreme Court issued an opinion in May 2013 that offered some clarity regarding the meaning of defalcation in bankruptcy.

Bankruptcy case before the Court

The issue before the Court arose after a man filed Chapter 7 bankruptcy when he could not repay profits from loans that he took out against his father’s life insurance policy funds. The man’s father had made him trustee of the life insurance trust that the father set up in 1978. The terms of the trust allowed the trustee to borrow against the trust assets. The man took out three loans, one for his mother and two for himself, during his time as trustee. He repaid all three loans with interest.

Two of his brothers, trust beneficiaries, alleged that he was breaching his fiduciary duties and filed a lawsuit demanding payments of the profits that the man had earned on the investments he had made with the loaned funds. The court agreed with the brothers and ordered the man to pay. However, the man could not afford to pay and filed bankruptcy.

The trustee in the man’s bankruptcy case filed a motion to exempt the judgment from the general discharge under a provision of the bankruptcy code that prohibits discharge of debts due to “fraud or defalcation in a fiduciary capacity, larceny and embezzlement.” The bankruptcy court, the district court and the appellate court all agreed that the man had breached his fiduciary duty and therefore the debt was not dischargeable. The appellate court noted, however, that there was a split among the courts as to the definition of defalcation. The man appealed to the U.S. Supreme Court to settle the split.

Reckless conduct

The U.S. Supreme Court issued a unanimous opinion stating that defalcation requires that a person have knowledge of, or a reckless disregard for the possibility of, violation of fiduciary duty. The Court acknowledged that the meaning of defalcation has been debated since the time it was introduced in the bankruptcy code, specifically the state of mind that the trustee needs to demonstrate to prove defalcation. The Court restricted its focus to the state of mind issue, not whether defalcation can include failure to make a trust more than whole, which occurred in the case before the Court.

The Court stated that when there was no evidence of bad faith or immoral actions, the fiduciary must be intentional in violating fiduciary duties. Intentionality requires the fiduciary know or consciously disregard the risk of violating fiduciary duties. The Court remanded the case so that the lower court could apply the standard the Court established for defalcation.

Speak with an attorney

Filing bankruptcy can be a complex process. Some creditors may challenge discharge of debts for a variety of reasons. Those seeking bankruptcy protection may not believe that they can afford the assistance of an attorney and try to manage the process themselves. However, people should consult skilled bankruptcy lawyers when filing bankruptcy due to the intricacies of bankruptcy laws.

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