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Supreme Court Makes it Harder for Trust Beneficiaries to Prove “Defalcation” by Fiduciary in Bankruptcy

Financial Institutions Law Update Christopher Combest

The U.S. Supreme Court, in Bullock v. BankChampaign, N.A., has arguably made it harder for damaged beneficiaries to prevent a negligent or self-interested trustee from filing a bankruptcy case and escaping debts owed to the trust's beneficiaries. Individual debtors file bankruptcy cases to obtain a discharge of their debts. However, creditors may block the discharge of certain debts - and continue to pursue a debtor for those debts, even after bankruptcy - if the individual incurred the debts as a result of various kinds of bad acts, among them, in the language of federal bankruptcy law, "defalcation while acting in a fiduciary capacity." Courts have long disagreed, however, about what exactly that word means: Does a trustee's ordinary negligence or mistake amount to "defalcation," or must the trustee have had a more culpable state of mind, an intention to commit a wrong - a much stricter standard for a damaged beneficiary to satisfy?

In Bullock, the Supreme Court opted for that stricter standard. Randy Bullock was the non-professional trustee of a trust set up by his father, for the benefit of Bullock and his siblings. Bullock twice borrowed money from the trust, to purchase real estate and shares in a business, and repaid it, with interest. His siblings nonetheless sued him, and a state court found that Bullock had engaged in self-dealing and breached his fiduciary duty. Bullock had made the trust whole after each borrowing, and the state court found no ill motive on his part. Nevertheless, the state court required him to pay the trust the value of the interests he had purchased with the trust's money. When Bullock could not do so, he filed a bankruptcy case.

The bankruptcy court held that Bullock's state court judgment debts should not be discharged, because they arose from Bullock's "defalcation" as a fiduciary. At the Supreme Court, Bullock argued, among other things, that he could not be guilty of defalcation, because he had had no malicious motive and no intent to breach his duties.

The Supreme Court agreed with Bullock, holding that, to be guilty of defalcation, a fiduciary either (a) must have engaged in actions involving "bad faith, moral turpitude, or other immoral conduct;" or (b) if no such actions are proven, must have had actual knowledge that his actions were wrong or must have acted with conscious disregard of the risk that his conduct would violate his fiduciary duties. The Supreme Court sent the case back to the lower courts to determine whether Bullock had violated this heightened standard.

The Supreme Court in Bullock made a policy choice to favor individual debtor-trustees who may have done harm, without meaning to do so, over injured beneficiaries. The court suggests that most such individual fiduciaries will be, like Randy Bullock, non-professional trustees of small family trusts. However, while the holding arises in the context of an individual's chapter 7 bankruptcy case, it remains to be seen whether the court's definition of "defalcation" - a term with no fixed, authoritative meaning before Bullock - will be applied more broadly, to protect institutional, as well as individual, fiduciaries.

If you have questions concerning these issues, please contact Christopher Combest at (312) 715-5091 / [email protected], or your Quarles & Brady attorney.

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