Defalcation, Defined: The U.S. Supreme Court Resolves Longstanding Circuit Split Concerning Scope Of Misconduct Contemplated By Section 523(A)(4) Defalcation

Section 523(a)(4) of the Bankruptcy Code prevents an individual debtor from obtaining a discharge from any debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." 11 U.S.C. § 523(a)(4). Of the terms contained in section 523(a)(4), "defalcation" has historically caused the most confusion amongst the circuits, despite having been an exception to discharge since 1867.

Until the U.S. Supreme Court's recent clarification of the term in Bullock v. BankChampaign, N.A., 133 S.Ct. 1754 (2013), various circuit courts of appeal struggled to define the mentalstate contemplated by "defalcation" as used in section 523(a)(4). Some circuits held thateven an innocent act by a fiduciary could constitute defalcation. In re Uwimana, 274 F.3d806 (4th Cir. 2001); In re Cochrane, 124 F.3d 978 (8th Cir. 1997); In re Sherman, 658 F.3d1009 (9th Cir. 2011). Others, including the Eleventh Circuit Court of Appeals in its Bullock decision that was the subject of the appeal to the U.S. Supreme Court, held that defalcationrequired a showing of recklessness or similar conduct. Bullock v. BankChampaign, N.A.,670 F.3d 1160 (11th Cir. 2012); In re Harwood, 637 F.3d 615 (5th Cir. 2011); In re Patel, 565F.3d 963 (6th Cir. 2009); In re Berman, 629 F.3d 761, 766 n.3 (7th Cir. 2011) (requiring"more than negligence or mistake, but less than fraud"). Still others held that defalcationrequired establishment of "extreme" recklessness. In re Baylis, 313 F.3d 9 (1st Cir. 2002); In re Hyman, 502 F.3d 61 (2nd Cir. 2007). Neither the Third Circuit Court of Appeals nor theTenth Circuit Court of Appeals has weighed in on the meaning of defalcation in a publishedopinion.

In May 2013, the U.S. Supreme Court held that where there is no bad faith, moral turpitude or other immoral conduct, defalcation as used in 11 U.S.C. § 523(a)(4) requires an "intentional wrong." Bullock, 133 S. Ct. at 1759. This includes 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," i.e., reckless conduct "of the kind found in the Model Penal Code." Id. Thus, where actual knowledge of wrongdoing is lacking, conduct will be considered sufficiently reckless to constitute defalcation where the fiduciary consciously disregards (or is willfully blind to) a substantial and unjustifiable risk that his/her conduct will turn out to violate a fiduciary duty. Id. That risk must be of such a...

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