How inclusive is the term defalcation? 11th Circuit clarifies

On behalf of Bankruptcy Law Firm of Clare Casas on Friday, May 17, 2013.

Under a Chapter 7 bankruptcy, the bankruptcy trustee will determine which debts are eligible to be discharged. In some cases, there are ones that may be excluded under certain rules in the bankruptcy code. For example, student loans are generally not able to be discharged. In some cases, the definitions, well, leave room for interpretation.

For example, there is a clause in the code that prohibits debts from being discharged where an individual under a fiduciary duty commits "fraud or defalcation." However, the term defalcation has remained a little unclear, but the U.S. Supreme Court provided some necessary clarity in a bankruptcy case from the 11th Circuit.

The term 'defalcation' was first written into the bankruptcy code in 1841. The meaning of the word could technically include anything from accidental misuse of funds by a trustee under a fiduciary duty to criminal embezzlement. That is a wide range that could have a real effect on a number of personal bankruptcy cases.

In the ruling issued on Monday, May 14 by the U.S. Supreme Court, Justice Stephen Breyer wrote that the definition requires specific knowledge and extreme conduct. Specifically, he wrote that the definition include "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 this case, one of three brothers was named as the trustee for a life insurance trust set up by his father. The brother used money from the account to help with his private finances and paid every penny back plus interest so that the trust value was where it should be. However, his brothers filed suit and received a judgment to be paid to the trust on top of the money that had been replaced.

It was this judgment that the brother wanted to discharge in his bankruptcy proceedings. The lower court ruled that the debt could not be discharged, and the 11th Circuit upheld that ruling. The U.S. Supreme Court remanded the case back to the trial court under the narrower definition.

Source: News & Insight, "Justices finally say what 'defalcation' means," Lawrence Hurley, May 14, 2013