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Supreme Court finally defines 1841 bankruptcy term 'defalcation'

Did you know that you can be prohibited from filing for bankruptcy if you're found to have committed defalcation? It's true -- although the term had never actually been defined until now. On Monday, the U.S. Supreme Court took up the issue and defined the term in a unanimous ruling.

According to Reuters, the term "defalcation" was first used in bankruptcy law in 1841. It currently appears in four sections of the U.S. Bankruptcy Code, one of which is 11 USC ยง 523 "exceptions to discharge," which lists debts that aren't eligible for discharge in bankruptcy. But "defalcation" is always used in the phrase "fraud of defalcation," so bankruptcy courts have typically just used the part about fraud.

Generally, the law has meant that you can't discharge debts in bankruptcy if there is evidence of financial fraud in your recent past -- particularly if you commit a fraud that results in the debt, or if you commit fraud in the bankruptcy process.

We now know that defalcation involves breach of fiduciary duty. When you act as a fiduciary, essentially you have the duty to act in the best interest of the person or organization you’re a fiduciary for. Common fiduciaries include trustees, conservators, guardians and, in some cases, attorneys and members of boards of directors. Defalcation is apparently fraud in the course of acting as a fiduciary -- plus a little more.

Justice Stephen Breyer wrote the court’s unanimous opinion and said that courts should basically treat the word “defalcation” as if it meant “fraud.” However, he also clarified that defalcation is different from breach of fiduciary duty in that it 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.”

The issue came up in the bankruptcy case of an Illinois man who wanted to discharge debts he built up while managing his father’s life insurance trust. Apparently, while he was trustee he used some of that money to make loans, some of which he benefitted from personally. However, there was no fraud involved, the loans were paid back, and the trust lost no money. So, when his bankruptcy was threatened by allegations of defalcation, he took the case to court -- and it eventually landed in the U.S. Supreme Court.

As it turns out, the high court did not answer the question of whether the Illinois man’s actions constituted defalcation. Instead, the court sent the case back to the bankruptcy court to rule on the question now that the word has been defined.

Source: Thomson Reuters News & Insight, “Justices finally say what 'defalcation' means,” Lawrence Hurley, May 14, 2013

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