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Adjunct Professor of Law, NYU School of Law

Section 523(a)(4) of the Bankruptcy Code provides that an individual’s discharge in bankruptcy does not discharge any debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” 11 U.S.C. § 523(a)(4). In Bullock v. BankChampaign,

N.A., 569 U.S. __, 133 S. Ct. 1754 (2013), the Supreme Court addressed the question of what

degree of misconduct by a debtor constitutes “defalcation” under section 523(a)(4) sufficient to disqualify the debt from discharge. The Court analyzed the term’s statutory context, its history, and the principle that exceptions to discharge should be construed narrowly in holding that “defalcation” “includes a culpable state of mind requirement.”

A. Factual Background

Petitioner Randy Bullock was named trustee of a trust established by his father, Curt Bullock, in 1978. Bullock, 133. S. Ct. at 1757. The trust, which was for the benefit of Curt Bullock’s children (including Randy), had as its sole asset an insurance policy on Curt Bullock’s life. Id. The trust allowed Randy Bullock, as trustee, to borrow funds against the insurance policy’s value. Id.

Bullock borrowed against the insurance policy three times during his tenure as trustee.

Id. First, in 1981, at the direction of his father, he borrowed money to give to his mother, which

she used to repay a debt to Curt Bullock’s company. Id. Three years later, Bullock borrowed from the trust to invest in a business run by himself and his mother. Id. Finally, in 1990, Bullock borrowed additional funds to buy some real property for his business. Id.

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Bullock repaid all of the borrowed funds, with 6% interest. Id. Nonetheless, in 1999, Bullock’s brothers sued him in Illinois state court for breach of fiduciary duty. Id. The Illinois court held that Bullock had, indeed, breached his fiduciary duty by engaging in self-dealing transactions with trust assets, but noted that Bullock “d[id] not appear to have a malicious motive in borrowing the funds.” Id. (internal quotation marks omitted). The state court ordered Bullock to pay the trust “the benefits received from his breaches.” Id. (internal quotation marks omitted). The court also imposed constructive trusts over Bullock’s interest in the assets he had purchased with funds borrowed from the trust. Id.

When Bullock was unable to liquidate his interests in those assets to repay the judgment, he filed for bankruptcy in federal court. Id. BankChampaign, the successor trustee of Curt Bullock’s trust and the trustee of the constructive trusts on Bullock’s assets, opposed Bullock’s attempt to obtain a discharge of his debts to the trust. Id. The bankruptcy court granted summary judgment for BankChampaign, holding that Bullock’s debt fell within section 523(a)(4)’s exception “as a debt for defalcation while acting in a fiduciary capacity” and was therefore not dischargeable. Id. at 1758 (internal quotation marks omitted).

On appeal, the district court affirmed the bankruptcy court’s determination, despite the fact it was “convinced” that BankChampaign was “abusing its position of trust by failing to liquidate the assets.” Id. (internal quotation marks omitted). The court of appeals subsequently affirmed the district court, reasoning that “defalcation requires a known breach of fiduciary duty, such that the conduct can be characterized as objectively reckless” and that Bullock’s conduct met that standard. Id. (internal quotation marks omitted). Bullock sought review of that decision in the Supreme Court, which granted certiorari to resolve the profound disagreement among

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lower courts “about whether ‘defalcation’ includes a scienter requirement and, if so, what kind of scienter it requires.” Id.

B. Analysis

Justice Breyer, writing for a unanimous Court in Bullock, began his analysis by acknowledging that “legal authorities have disagreed about” the meaning of “defalcation” almost ever since the term was first included in a federal bankruptcy statute in 1867. Id. Because dictionary definitions of the term generally contain “broad definitional language” of an equivocal nature, the Court noted they “are not particularly helpful” in deciphering the term’s meaning. Id. Moreover, the Court observed that the courts of appeals and lower courts have “long disagreed about the mental state that must accompany the bankruptcy-related definition of ‘defalcation.’”

Id. at 1759.

In light of the equivocal dictionary definitions and lower court interpretations of “defalcation,” the Court searched deeper into the term’s meaning, including the Court’s own analysis in Neal v. Clark, 95 U.S. 704, 709 (1878). Id. In Neal, the Court interpreted the term “fraud” as used in the statutory predecessor to section 523(a)(4) to “mean[] positive fraud, or fraud in fact, involving moral turpitude or intentional wrong . . . and not implied, fraud, or fraud in law, which may exist without the imputation of bad faith or immorality.” Id. (quoting Neal, 95 U.S. at 709). As the Neal Court did with “fraud,” the Court in Bullock looked to defalcation’s statutory context in deriving its meaning. Specifically, the Court applied the canon noscitur a

sociis—“a word is known by the company it keeps”—concluding that this militated in favor of

interpreting defalcation as requiring a type of scienter similar to the other terms used in the statutory provision. Id. at 1760. Because the other statutory terms surrounding “defalcation”—

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fraud, larceny, and embezzlement—all require a showing of wrongful intent, the Court reasoned, so too must “defalcation.” Id.

Seeking to differentiate the term “defalcation” to avoid rendering any of the terms in section 523(a)(4) superfluous, the Court further chose a meaning of the term that “does not make the word identical to its statutory neighbors.” Id. The Court held that an interpretation of “defalcation” including a scienter requirement “can encompass a breach of fiduciary duty that involves neither conversion [embezzlement], nor taking and carrying away another’s property [larceny], nor falsity [fraud].” Id.

Interpreting “defalcation” to include a showing of wrongful intent (or extreme recklessness), the Court noted, is also “consistent with the long-standing principle that exceptions to discharge should be confined to those plainly expressed.” Id. (internal quotation marks omitted). The Court observed that, because the Bankruptcy Code evinces a strong preference for granting debtors a “fresh start,” Congress has confined the exceptions to discharge to “circumstances where strong, special policy considerations, such as the presence of fault, argue for preserving the debt.” Id. at 1761. Here, the Court noted, where a scienter requirement would most likely help nonprofessional trustees (like Bullock), “it is difficult to find strong policy reasons favoring a broader exception.” Id.

Finally, the Court emphasized the importance of having a uniform interpretation of federal law, and noted the fact that some Circuits had used its interpretation of “defalcation” without encountering administrative or other practical difficulties. Id. Accordingly, the Court held that the term “defalcation” in section 523(a)(4) of the Bankruptcy Code “includes a culpable state of mind requirement akin to that which accompanies application of the other terms in the same statutory phrase.” Id. at 1757. Specifically, that state of mind is “one involving knowledge

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of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.”

Id.

C. Import of the Bullock Decision

Bullock squarely holds that avoiding discharge of a debt for defalcation under section

523(a)(4) requires a showing of knowledge of, or gross recklessness with respect to, the improper nature of the relevant behavior. Accordingly, a negligent breach of fiduciary duty is insufficient to make any resulting debts susceptible to the exception. In reaching that conclusion, the Court reiterated its position that, consistent with the Bankruptcy Code’s preference for granting debtors a “fresh start,” the exceptions to bankruptcy discharge are to be construed narrowly. This has obviously broader implications in the larger discharge context.

Crucially, however, Bullock should only be read as addressing the ability of a bankruptcy trustee to discharge a debt resulting from “defalcation” while acting in a fiduciary capacity. The Court addressed only “the scope of the term ‘defalcation’” in § 523(a)(4). Bullock does not implicate a fiduciary’s underlying liability for defalcation with respect to a fiduciary relationship; rather, it only addresses the circumstances in which a debt resulting from that breach is properly subject to discharge under the Code. Consequently, Bullock does not affect the duties owed by a fiduciary or the culpability required to make him liable for a breach.