By: Elizabeth Vanderlinde
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
The Bankruptcy Court for the Eastern District of Wisconsin in In re Mueller[1] recently concluded that a genuine issue of material fact existed as to whether the debtor had the requisite mental state required to commit defalcation under section 523(a)(4) of the Bankruptcy Code (the “Code”), and therefore summary judgment was inappropriate.[2] The debtor failed to make certain required fringe benefit contributions to the plaintiffs under certain collective bargaining agreements entered into in connection with three construction projects.[3] The plaintiffs claimed that the debtor's failure to make such contributions violated Wisconsin's theft by contract statute and supported a finding of defalcation.[4] By contrast, the debtor argued that his failure to pay was inadvertent and reflective of the problems arising in the contracted projects.[5]
Under section 523(a)(4), a debtor's discharge will not discharge it from any debt "for fraud or defalcation while acting in a fiduciary capacity.”[6] To prove defalcation under the Code, a party must establish a willful, knowing, or reckless breach of fiduciary duty.[7] In the Seventh Circuit, mere negligence is not sufficient to constitute defalcation.[8] Because the court determined that the debtor’s failure to make the required contributions resulted from the debtor’s mistaken belief that the contributions were to be paid through funds that the debtor believed the plaintiffs owed him,[9] the court found that the plaintiffs failed to show that the debtor’s failure to pay arose from more than mere negligence rendering summary judgment inappropriate.[10] The court also denied summary judgment on the claim that the violation of Wisconsin’s theft by contractor statute constituted per se defalcation.[11]
Circuit courts are split as to the level of culpability required to prove defalcation.[12] The Fourth, Eighth, and Ninth Circuits have concluded that an innocent mistake may justify a finding of defalcation and prevent a debtor from receiving a discharge of its debt.[13] In these circuits, a debtor commits defalcation if it did not fulfill an obligation to pay, regardless of the level of culpability.[14] The Fifth, Sixth, and Seventh Circuits conclude that mere negligence is insufficient and require proof of a reckless, willful, or knowing breach of a fiduciary duty.[15] The First and Second Circuits require proof of extreme recklessness or conscious misbehavior to constitute defalcation.[16] These circuits focus on the debtor’s intent requiring a degree of fault, similar to the level of fraud.[17] Finally, the Tenth Circuit follows a standard that is not entirely clear, but is understood to require some degree of fault.[18]
The court in Mueller adopted the Seventh Circuit’s approach,[19] which is in line with a central purpose of the Bankruptcy Code – providing the innocent debtor with a fresh start.[20] By limiting the defalcation exception to those claims that a debtor incurred through a willful, knowing, or reckless breach of fiduciary duty, a debtor may emerge from bankruptcy with a clean slate and without undue fear of liability based on an honest mistake.
[1] In re Mueller, No. 10–23917–skv, 2011 WL 2360122, at *1 (Bankr. E.D. Wis. June 8, 2011).
[2] Id. at *6.
[3] Id. at *1.
[4] Id.
[5] Id.
[6] Id.
[7] Id. at *3.
[8] Meyer v. Rigdon (In re Meyer) 36 F.3d 1375, 1384–85 (7th Cir. 1994); Collier on Bankruptcy, ¶ 523.10 (Alan N. Resnick & Henry J. Sommer eds., 16th ed. 2009) (defalcation under the Code refers to failure to produce funds entrusted to a fiduciary, but conduct need not necessarily amount to fraud, embezzlement, or misappropriation).
[9] In re Mueller, 2011 WL 2360122, at *4–5.
[10] Id. at *5.
[11] In re Rieck, 439 B.R. 698, 702 (Bankr. W.D. Wis. 2010).
[12] Compare Uwimana v. Uwimana (In re Uwimana) 274 F.3d 806, 811 (4th Cir. 2001) (stating that “negligence or even an innocent mistake which results in misappropriation or failure to account is sufficient” to a finding of defalcation), with Denton v. Hyman (In re Hyman) 502 F.3d 61, 68 (2d Cir. 2007) (holding that “defalcation under § 523(a)(4) requires a showing of conscious misbehavior or extreme recklessness), with In re Rieck 439 B.R. at 702 (stating that “innocent or unintentional defalcations may be discharged, and nondischargeability is premised upon a showing of something more than mere negligence, which need not rise to the level of fraud but still must be akin to a reckless, willful, or knowing breach of fiduciary responsibility.”).
[13] In re Mueller, 2011 WL 2360122, at *2.
[14] Lewis v. Scott (In re Lewis) 97 F.3d 1182, 1186 (9th Cir. 1996).
[15] In re Hyman, 502 F.3d at 68.
[16] Id.
[17] Id.
[18] Id.
[19] See In re Mueller, 2011 WL 2360122, at *6.
[20] Grogan v. Garner 498 U.S. 279, 286–87 (1991) (“[A] central purpose of the Code is to provide a procedure by which certain insolvent debtors can reorder their affairs, make peace with their creditors, and enjoy ‘a new opportunity in life with a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.’ But in the same breath that we have invoked this ‘fresh start’ policy, we have been careful to explain that the Act limits the opportunity for a completely unencumbered new beginning to the ‘honest but unfortunate debtor.’” (quoting Local Loan Co. v. Hunt 292 U.S. 234, 244 (1934))).
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