US Supreme Court clarifies when trustees may lose their right to a discharge

By far, the right to a discharge of debts is the most valuable benefit of a bankruptcy filing. Discharge of particular debts can be denied under limited circumstances when the creditor files a timely suit in the bankruptcy court. One of the grounds for such non-dischargeability applies to debts for “defalcation while acting in a fiduciary capacity” [ie acting as a trustee].   The term defalcation generally means causing a loss or acting in violation of required standards of conduct. Fiduciaries are held to higher standard of conduct and trustworthiness than others, but not everyone who is placed in that position fully understands or appreciates the obligations that come with it. What was unclear until recently was whether a trustee acting without ill intent whose actions did not cause actual loss could be held liable and such liability could be made non dischargeable.

In Bullock v BankChampaign NA, the United States Supreme Court answered this question. There, the debtor had served as trustee of his father’s trust created for him and his four siblings. The trust had one asset, a life insurance policy with cash value. The trust allowed borrowing against the value of that policy. Three times, Mr. Bullock authorized such borrowings. In all cases, the borrowed money was repaid with interest. In two instances, the borrowed money was used to buy assets that Mr. Bullock and his mother jointly owned. Thus, Mr. Bullock personally benefitted from some of the borrowing, although no money was lost.

His brothers sued him in Illinois state court. Finding that he had violated his fiduciary duties by engaging in “self-dealing” that court entered  a judgment against him requiring him to repay the benefit he received along with costs and attorneys fees. BankChampaign was appointed the new trustee. After Mr. Bullock filed for bankruptcy, BankChampaign sought to have the unpaid judgment declared non-dischargeable. The lower courts all held that Mr. Bullock’s conduct was a sufficient violation of his duties that the debt should not be discharged, even though there was no actual loss and no proof of ill intent.

The Supreme Court reversed and sent the case back to apply the new standards it announced. To be non-dischargeable “defalcation” in the absence of actual loss, bad faith, moral turpitude or other immoral conduct, it held, there must be more. The trustee must have knowingly engaged in wrongful conduct, or else  recklessly disregarded  a “substantial and unjustifiable risk” that his conduct will turn out to violate a fiduciary duty. The risk, it held, “must be of such a nature anddegree that, considering the nature and purpose of the actor’s conduct and the circumstances known to him, its disregard involves a gross deviation fromthe standard of conduct that a law-abiind person would observe in the actor’s situation”

As noted above, many people take on fiduciary obligations without a proper understanding or appreciation of the high standards imposed on them. A common example is the family member acting as trustee for a parent’s estate. For such persons, this decision not only clarifies the limits of non-dischargeability, but also provides  needed relief  where innocent mistakes are made.  In proper circumstances, this decision will prevent the innocent technical violation from becoming a life-long liability.

That said, anyone serving as a guardian, trustee or executor should seek legal advice to avoid these types of problems from arising in the first place. With years of experience as fiduciaries or representing them, we can provide the needed help.

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