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For most debtors filing for personal bankruptcy under Chapter 7 or Chapter 13, a primary goal is obtaining a discharge of debt at the end of the case. Federal bankruptcy law sets limits on what debts may be subject to discharge, in part to protect creditors who are owed money because of fraud, theft, or other dishonest acts. The Bankruptcy Code prohibits discharge of debts incurred by “defalcation,” although the statute does not provide a specific definition. Some jurisdictions, including California and the Ninth Circuit, have defined “defalcation” broadly, but in May 2013 the U.S. Supreme Court applied a narrow definition. For California debtors who have pending appeals in cases involving alleged defalcation, this has resulted in remands to the bankruptcy court to reconsider the case. With a narrower definition of “defalcation,” this could result in new orders discharging debts previously found nondischargeable.

Federal law prohibits the discharge of debts that resulted from “fraud or defalcation while acting in a fiduciary capacity.” 11 U.S.C. § 523(a)(4). A creditor challenging the discharge of a debt must prove by a preponderance of evidence that the debt falls under one of the exceptions in § 523. Courts have come to different conclusions regarding the meaning of “defalcation.” The Ninth Circuit has defined it as misappropriation of money held in trust or in another fiduciary capacity, as well as a failure to provide a full accounting of such funds—a definition taken directly from Black’s Law Dictionary. In re Lewis, 97 F.3d 1182, 1186 (9th Cir. 1996). This definition does not require proof of any specific mental state on the debtor’s part. The Supreme Court recently ruled, however, that “defalcation” requires proof of “knowledge of, or gross recklessness in respect to,” the misappropriation or failure to account. Bullock v. BankChampaign, N.A., 133 S. Ct. 1754, 1757 (2013).

A Sacramento federal district court remanded a Chapter 13 appeal to the bankruptcy court in August citing the Bullock decision. The debtors in In re Scott were appealing a partial summary judgment order finding that a debt totaling more than $898,000 was not dischargeable under the defalcation exception. While the appeal was pending, the Supreme Court ruled in Bullock. The debtors moved the district court to remand the case to the bankruptcy court. The district court granted the motion over the creditors’ objection, noting that Bullock changed the factual requirements for a finding of defalcation.

The district court in Scott cited two cases remanded by the Bankruptcy Appellate Panel (BAP) for the Ninth Circuit after Bullock. In one case, In re Pemstein, the BAP found that, while the creditor had proven that the debtor breached a fiduciary duty under California corporate law, the evidence did not meet the standard for defalcation established by Bullock. In the other case, In re Borsos, the BAP noted that the bankruptcy court made no findings regarding the debtor’s mental state when it ruled that he had committed defalcation. It remanded both cases for reconsideration under Bullock’s narrower definition.

Individuals who do not have enough income to pay their debts may be able to obtain relief through the bankruptcy system. Bankruptcy allows debtors to develop a plan for repaying their bills, and in some cases discharge their remaining debts in their entirety. Bankruptcy attorney Devin Sawdayi has helped countless clients in the Los Angeles area through the process of personal bankruptcy since 1997. To schedule a free and confidential consultation, contact us today online or at (310) 475-9399.

More Blog Posts:

Court Addresses Dischargeability of Debts Resulting from “Willful and Malicious Injury” by the Debtor, Los Angeles Bankruptcy Lawyer Blawg, October 3, 2013

California Bankruptcy Court Rules on Discharge of Debt Allegedly Incurred Through Fraud, Los Angeles Bankruptcy Lawyer Blawg, September 7, 2013

Supreme Court Rules on Meaning of “Defalcation” in Statutory Provision for Nondischargeable Debts in Bankruptcy, Los Angeles Bankruptcy Lawyer Blawg, July 30, 2013