“Fraud Junior”: An Analysis of the Supreme Court’s Construction of Defalcation and Pension-Fund Trustee Decisions in Bankruptcy Law

Tara C. Pakrouh

Defalcation is a cause of action listed in a provision in the exceptions-to-discharge section of the Bankruptcy Code. Beneficiaries raise this claim when their expressly appointed debtor-trustee seeks to discharge his debts incurred from mismanaging the trust funds. Congress has neither defined defalcation nor indicated its intent with respect to the term’s meaning.

The Supreme Court recently heard Bullock v. BankChampaign to resolve the prolonged circuit split regarding whether defalcation requires a mental state. The Court held defalcation requires the fiduciary-trustee to have had knowledge of, or to have been grossly reckless with respect to, his improper fiduciary behavior.

The practical outcome of the Bullock decision is that litigators will aim solely to prove recklessness with respect to defalcation, because to prove “knowledge of” is akin to a showing of fraud. Further, the “knowledge of” requirement effectively becomes subsumed by fraud. This confluence of fraud and defalcation amounts to an impermissible surplusage problem—”fraud junior.” Another consequence of defalcation’s heightened mental state is that it allows trustees to take advantage of their roles by making needlessly riskier investments to the potential detriment of the beneficiaries.

The Bullock decision divorces defalcation from Congress’s intentional “fiduciary-capacity” connection and from the established principals of trustee-fiduciary duties. The solution this author proposes is to break embezzlement and larceny from “fraud or defalcation while acting in a fiduciary capacity” and to place the terms in a different provision of the code.

A court subsequently analyzing the issue will stress the importance of disaggregating defalcation from fraud and will focus on the actions, rather than the intent, of the debtor. Therefore, courts will view defalcation under an objectively reckless standard and engage in a two-step analysis: (1) whether the debtor was a fiduciary; and (2) whether a defalcation occurred.

This analysis charges fiduciaries with knowledge of the law and their duties, and it makes the unclear history of defalcation clear and consistent for future beneficiary-plaintiffs. Under this standard of review, beneficiaries can prevent trustee-debtors from discharging their debts and can recover their entrusted funds.