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* This disposition is not appropriate for publication. 

Although it may be cited for whatever persuasive value it may

have (see Fed. R. App. P. 32.1), it has no precedential value. 

See 9th Cir. BAP Rule 8013-1.

UNITED STATES BANKRUPTCY APPELLATE PANEL

OF THE NINTH CIRCUIT

In re: ) BAP No. CC-12-1430-TaPaMk

)

MARTIN PEMSTEIN and DIANA ) Bk. No. 2:12-bk-15900-RK

PEMSTEIN, )

 ) Adv. No. 2:12-ap-01291-RK

Debtors. )

______________________________)

HAROLD PEMSTEIN, )

)

Appellant, )

)

v. ) MEMORANDUM*

)

MARTIN PEMSTEIN; DIANA )

PEMSTEIN, )

)

Appellees. )

______________________________)

Argued and Submitted on May 16, 2013

at Pasadena, California

Filed - June 5, 2013

Appeal from the United States Bankruptcy Court

for the Central District of California

Honorable Robert N. Kwan, Bankruptcy Judge, Presiding __________________________________________

Appearances: Christopher L. Blank for Appellant Harold

Pemstein; Alan Wayne Forsley of Fredman Knupfer

Lieberman LLP for Appellees Martin Pemstein and

Diana Pemstein __________________________________________

Before: TAYLOR, PAPPAS, and MARKELL, Bankruptcy Judges.

FILED

JUN 05 2013

SUSAN M SPRAUL, CLERK

U.S. BKCY. APP. PANEL

OF THE NINTH CIRCUIT
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1

 Unless specified otherwise, all chapter and section

references are to the Bankruptcy Code, 11 U.S.C. §§ 101-1532, and

all “Rule” references are to the Federal Rules of Bankruptcy

Procedure, Rules 1001-9037.

2

 Section 523(a)(4) excepts from discharge any debt: “for

fraud or defalcation while acting in a fiduciary capacity,

embezzlement, or larceny.”

3

 As the parties bear the same family name, we will refer

to them herein by their given names. We intend no disrespect by

such informality.

4

 The bankruptcy court also held that Harold failed to

establish that Martin had committed fraud or larceny. On appeal,

Harold does not argue that this holding was erroneous. Our

(continued...)

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INTRODUCTION

This appeal presents the question whether defalcation under

§ 523(a)(4)1

 pertains solely to funds actually received by a

fiduciary.2

 The bankruptcy court interpreted Ninth Circuit

authority to so require. As a result, in plaintiff Harold

Pemstein’s nondischargeability action against debtor/defendant

Martin Pemstein,3 the bankruptcy court did not give preclusive

effect to Harold’s state court judgment against his business

partner Martin for damages for breach of Martin’s duty of care in

the collection of rents. And, it also found that Harold failed

otherwise to show that Martin committed defalcation because

Harold had not offered sufficient evidence that Martin actually

received rents for which he failed to account. We conclude that

the bankruptcy court defined defalcation too narrowly. We also

conclude that this error was not harmless, as we cannot otherwise

affirm the decision. We, therefore, REVERSE the bankruptcy

court’s narrow application of § 523(a)(4) defalcation, we VACATE

the denial of Harold’s § 523(a)(4) claim,4 and we REMAND for
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4(...continued)

conclusion here solely pertains to the bankruptcy court’s ruling

regarding defalcation.

5 The Supreme Court granted certiorari after the bankruptcy

court here rendered its decision, but while this appeal was

pending.

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further findings with respect to the applicability of issue

preclusion for defalcation under § 523(a)(4) consistent with this

Memorandum or, if the bankruptcy court does not enter a judgment

based on issue preclusion, for reconsideration by the bankruptcy

court of its conclusions after trial.

On remand, the bankruptcy court also should be mindful of

the Supreme Court’s recent decision in Bullock v. BankChampaign,

N.A., 2013 U.S. Lexis 3521 (U.S. May 13, 2013).5 In Bullock,

the Supreme Court resolved the split among the circuits regarding

the mental state that must accompany defalcation under

§ 523(a)(4) (in doing so, it considered and spoke to the meaning

of § 523(a)(4) “defalcation”). Although we reverse here based on

the bankruptcy court’s application of an incorrect legal

interpretation of defalcation, and not based on the scienter

standard articulated in Bullock, on remand the bankruptcy court

should consider reopening evidence regarding intent, given that

Bullock requires a heightened standard not previously required in

the Ninth Circuit.

FACTS

Harold and Martin are brothers and were partners in a

California general partnership, as well as directors of and

shareholders in a small, closely-held family corporation. The

partnership owned industrial real property that it leased to the
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6

 The gap in time between the 2005 Decision and the 2010

Judgment was, at least in part, attributable to intervening

bankruptcy petitions filed by both the corporation and the

partnership.

7 The bankruptcy court admitted the 2010 Judgment into

evidence at the trial as Plaintiff’s Trial Exhibit 2.

8

 The bankruptcy court admitted, at Martin’s request, a

copy of Plaintiff’s Second Amended Complaint in the State Court

Action dated December 1, 2001 (“State Court Complaint”). At

trial the parties agreed that the State Court Complaint was the

operative complaint on which the state court based the 2010

Judgment.

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corporation and from which the corporation ran the family

business. Harold filed lawsuits against Martin in state court

based on disputes that arose between them regarding the

corporation and the partnership (the “State Court Action”).

During the course of the litigation, the state court filed a

Statement of Decision and Judgment in the State Court Action on

June 30, 2005 (the “2005 Decision”). The 2005 Decision primarily

ordered dissolution of the corporation and the partnership. On

January 5, 2010,6 Harold obtained a money judgment in the State

Court Action against Martin in the amount of $696,218.03 (the

“2010 Judgment”).7 The state court did not issue a statement of

decision in connection with the 2010 Judgment, as neither party

requested it.8

 The 2010 Judgment states as follows:

The Court finds for the Plaintiff Harold

Pemstein against Martin Pemstein finding that

Martin Pemstein breached his duty of care to

Harold Pemstein in the collection of rent on

behalf of HMS Properties. The Court finds

that the breach caused Harold Pemstein

damages of $295,871.00 in principal and

$400,347.03 in interest.

The State Court Complaint, in particular the fifth cause of

action for breach of fiduciary duty against Martin as partner of
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9 Specifically, California Corporations Code § 16404(b).

10 Cal. Corp. Code § 16404(c).

11 At the trial before the bankruptcy court, Martin

testified that he filed bankruptcy because he was financially

unable to obtain an appellate bond.

12 Harold’s appeal from the 2010 Judgment is not directly

relevant to the issue on appeal here. Harold asserted that the

trial court erred by refusing to allow him to amend his complaint

to conform to evidence by adding a cause of action for breach of

fiduciary duty. As discussed later in this Memorandum, Martin

argues that the DCA Opinion confirms that the 2010 Judgment did

not include a finding that Martin breached any fiduciary duty. 

We disagree. The DCA Opinion addresses Harold’s attempt to add a

breach of fiduciary duty claim in connection with Harold’s

argument and alleged evidence proving that Martin had, at one

(continued...)

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the partnership, cited statutory authority that would support

findings that Martin had breached the duty of loyalty to Harold

in the management and winding up of the partnership.9

 It also

alleged facts that would support findings that Martin had

breached both the duty of loyalty and the duty of care owed to

Harold, although it did not include a citation to the statute

defining the duty of care.10 The 2010 Judgment was based on the

finding that Martin had breached his duty of care to Harold. 

Under California law, this finding necessarily means that the

state court found that Martin had engaged in “grossly negligent

or reckless conduct, intentional misconduct, or a knowing

violation of law” while acting as a trustee over partnership

assets. Cal. Corp. Code § 16404(c). And, as specifically stated

in the 2010 Judgment, that conduct related to the “collection of

rent on behalf of” the partnership. 

Harold, but apparently not Martin,11 appealed from the 2010

Judgment.12 The Court of Appeal resolved Harold’s appeal by
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12(...continued)

point in time, put the partnership into bankruptcy to avoid the

state court’s dissolution order and, by doing so without Harold’s

consent, had breached his fiduciary duty and harmed Harold. The

DCA Opinion does not address the state court’s finding that

Martin breached his duty of care to Harold, a fiduciary duty owed

by partners to one another in a California partnership. See, Cal. Corp. Code § 16404(a).

13 The record is silent as to if or when the bankruptcy

court granted relief from the stay to allow Harold’s appeal to go

forward post-petition. The bankruptcy court admitted a copy of

the DCA Opinion into evidence at trial and, thus, was apparently

aware of the prosecution of the appeal, at least after the fact.

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affirming the 2010 Judgment in an unpublished opinion on May 16,

2011 (“DCA Opinion”).13 

Martin and his wife Diana Pemstein filed their joint

petition under chapter 11 on April 28, 2010, and Harold filed his

complaint objecting to discharge and dischargeability thereafter

(“Adversary Complaint”). Pemstein v. Pemstein (In re Pemstein),

476 B.R. 254, 256 (Bankr. C.D. Cal. 2012). The Adversary

Complaint incorporated the 2010 Judgment. Pursuant to the first

cause of action, Harold sought an exception to discharge under

§ 523(a)(4), solely as to Martin, on multiple alleged factual

grounds. All such grounds were based on alleged breaches of

fiduciary duties Martin owed to Harold as his partner in the

partnership. The Adversary Complaint also asserted that Martin

was liable to Harold based on larceny and conversion of rental

income and based on fraud or defalcation by Martin’s violation of

his duty of loyalty and the duty of care owed to Harold as his

partner. At paragraphs 23 and 24 of the Adversary Complaint,

Harold virtually quoted, without citation, § 16404(b) & (c) of

the California Corporations Code: 
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14 Although Harold was represented by counsel when he filed

the Adversary Complaint and for all post-trial briefing and

argument, he presented his direct testimony at trial by

declaration filed pro se and participated in the trial in pro

per.

15 The record indicates that at least twice the bankruptcy

court stated or issued tentative rulings in Harold’s favor on the

§ 523(a)(4) defalcation cause of action.

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23. A partner’s duty of loyalty to the partnership and

the other partners includes all of the following:

(A) To account to the partnership and hold as

trustee for it any property, profit, or benefit derived

by the partner in the conduct and winding up of the

partnership business or derived from a use by the

partner of partnership property or information,

including the appropriation of a partnership

opportunity.

(B) To refrain from dealing with the partnership

in the conduct or winding up of the partnership

business as or on behalf of a party having an interest

adverse to the partnership.

(C) To refrain from competing with the

partnership in the conduct of the partnership business

before the dissolution of the partnership. 

24. A partner’s duty of care to the partnership and

the other partners in the conduct and winding up of the

partnership business is limited to refraining from

engaging in grossly negligent or reckless conduct,

intentional misconduct, or a knowing violation of law. 

The bankruptcy court conducted a trial on November 30,

2011.14 It requested or allowed three rounds of post-trial

briefs on specifically identified legal questions regarding

defalcation under § 523(a)(4).15 The bankruptcy court twice

heard post-trial oral arguments. Thereafter, it issued its

Memorandum Decision denying all claims under the Adversary

Complaint and entered judgment in favor of both Debtors on

August 2, 2012. Harold timely filed his notice of appeal. 

Harold appeals only from the bankruptcy court’s denial of his
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16 In Harold’s Notice of Appeal he appealed broadly from

all orders and rulings adverse to him, including denial of his

motion for summary judgment (“MSJ”), and all adverse evidentiary

rulings made in connection with the MSJ and at trial. Harold’s

Statement of Issues on Appeal identified thirteen issues that

pertain to rulings on the MSJ or at or after trial regarding

§ 523(a)(4) and § 523(a)(6), but no issues regarding the § 727

rulings. In Harold’s Opening Brief here, he further reduces the

issues and now appeals only trial rulings on his § 523(a)(4)

claim. On appeal, both parties address only the bankruptcy

court’s rulings regarding defalcation by a fiduciary. We

therefore consider all other issues identified in the Notice of

Appeal and the Statement of Issues on Appeal as waived by Harold. 

Padgett v. Wright, 587 F.3d 983, 986 n.2 (9th Cir. 2009)(per

curium)(appellate courts “will not ordinarily consider matters on

appeal that are not specifically and distinctly raised and argued

in appellant's opening brief.”).

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§ 523(a)(4) claim;16 he primarily challenges the bankruptcy

court’s interpretation and application of the standard for

defalcation, its refusal to apply issue preclusion, and its

conclusion that Harold failed to carry his burden of proof at

trial.

JURISDICTION

The bankruptcy court had jurisdiction pursuant to 28 U.S.C.

§§ 1334 and 157(b)(2)(I) & (J). We have jurisdiction under

28 U.S.C. § 158.

ISSUES

Did the bankruptcy court err in determining that Harold’s

§ 523(a)(4) defalcation claim fails because neither the 2010

Judgment nor evidence admitted at trial established that Martin

actually received rents for which he failed to account?

STANDARD OF REVIEW

In reviewing a bankruptcy court’s dischargeability

determination, we review its findings of fact for clear error and

its conclusions of law de novo. Oney v. Weinberg
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17 Harold also argues on appeal that the bankruptcy court

denied him due process by ruling that he could not re-try facts

from the State Court Action. Nothing in the record indicates

that the bankruptcy court made such a ruling. Nor did Harold

present any argument directed to his due process issue. We,

thus, consider the issue waived.

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(In re Weinberg), 410 B.R. 19, 28 (9th Cir. BAP 2009). The

availability of issue preclusion is a question of law, which we

review de novo. Wolfe v. Jacobson (In re Jacobson), 676 F.3d

1193, 1198 (9th Cir. 2012). If issue preclusion is available,

the decision to apply it is reviewed for abuse of discretion. 

Lopez v. Emergency Serv. Restoration, Inc. (In re Lopez),

367 B.R. 99, 103 (9th Cir. BAP 2007). A bankruptcy court abuses

its discretion if it bases a decision on an incorrect legal rule,

or if its application of the law was illogical, implausible, or

without support in inferences that may be drawn from the facts in

the record. United States v. Hinkson, 585 F.3d 1247, 1261-62 &

n.21 (9th Cir. 2009) (en banc).

DISCUSSION

A creditor objecting to the dischargeability of its claim

bears the burden of proving, by a preponderance of the evidence,

that the particular debt falls within one of the exceptions to

discharge enumerated in section 523(a). Grogan v. Garner,

498 U.S. 279, 286-91 (1991). The bankruptcy court here correctly

allocated to Harold the burden to prove that Martin was acting in

a fiduciary capacity and that, while doing so, he committed

defalcation. In re Pemstein, 476 B.R. at 257. 

Harold cites as error the bankruptcy court’s placement of

the burden of proof on him at trial.17 Harold’s argument on this

point consists entirely of quotations from case authority with no
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discussion. As confirmed during oral argument, Harold argues

that the burden of proof should have shifted to Martin at some

point to show that he had properly accounted. See Otto v. Niles

(In re Niles), 106 F.3d 1456, 1462 (9th Cir. 1997) (burden is

placed on the fiduciary to render an accounting, “once the

principal has shown that funds have been entrusted to the

fiduciary and not paid over or otherwise accounted for”). The

burden never shifted here because the bankruptcy court too

narrowly defined defalcation.

Harold also bears the burden of proof for application of

issue preclusion. Honkanen v. Hopper (In re Honkanen), 446 B.R.

373, 382 (9th Cir. BAP 2011). To meet this burden, Harold was

required to pinpoint “the exact issues litigated in the prior

action and introduce[] a record revealing the controlling facts.” 

Id. As a pro se litigant at trial, Harold provided the 2005

Decision, the 2010 Judgment, and his direct testimony by

declaration. Martin offered the State Court Complaint and the

DCA Opinion, as well as his direct testimony by declaration. 

Harold testified that the dispute between Martin and him in the

state court concerned how much rent was due him from Martin for

the period of time Martin was in sole possession of partnership

properties. In effect, the bankruptcy court found that Harold

did not meet this burden. The bankruptcy court, however, did not

perform a complete issue preclusion analysis, given its view of

defalcation. 

Issue preclusion.

Federal courts must give "full faith and credit" to

judgments of state courts. 28 U.S.C. § 1738. As a matter of
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full faith and credit, the federal court must apply the forum

state's law of issue preclusion. Bugna v. McArthur

(In re Bugna), 33 F.3d 1054, 1057 (9th Cir. 1994). These

principles of issue preclusion apply equally in § 523(a)

proceedings. Grogan v. Garner, 498 U.S. at 286-291. 

California courts will apply issue preclusion only if

certain threshold requirements are met, and then only if

application of preclusion furthers the public policies underlying

the doctrine. There are five threshold requirements: 

First, the issue sought to be precluded from

relitigation must be identical to that decided in a

former proceeding. Second, this issue must have been

actually litigated in the former proceeding. Third, it

must have been necessarily decided in the former

proceeding. Fourth, the decision in the former

proceeding must be final and on the merits. Finally,

the party against whom preclusion is sought must be the

same as, or in privity with, the party to the former

proceeding. 

Id. (internal citations omitted).

Here, the bankruptcy court decided it could not apply issue

preclusion in connection with the defalcation claim because it

determined that the issue decided in the State Court Action was

not identical to the question of whether Martin committed

defalcation while acting in a fiduciary capacity. Pemstein,

476 B.R. at 258. In making this determination, the bankruptcy

court utilized an inappropriately narrow definition of

defalcation.

Section 523(a)(4) defalcation by a fiduciary.

As relevant here, section 523(a)(4) excepts from discharge

debts incurred by fiduciaries as a result of their defalcations. 

It also excepts debts incurred through embezzlement, or larceny
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regardless of who embezzled or committed larceny. Case law makes

clear that the broad, general definition of fiduciary — a

relationship involving confidence, trust and good faith — is

inapplicable in the dischargeability context. Ragsdale v.

Haller, 780 F.2d 794, 796 (9th Cir. 1986). Instead, § 523(a)(4)

nondischargeability results only where, among other things, the

fiduciary relationship between the debtor and the creditor arises

in relation to an express or technical trust that pre-dates the

alleged defalcation. Lewis v. Scott (In re Lewis), 97 F.3d 1182,

1185 (9th Cir. 1996); Runnion v. Pedrazzini (In re Pedrazzini),

644 F.2d 756, 758 (9th Cir. 1981). In short, under

section 523(a)(4), it "is not enough that, by the very act of

wrongdoing out of which the contested debt arose, the bankrupt

has become chargeable as a trustee ex maleficio." Davis v. Aetna

Acceptance Co., 293 U.S. 328, 333 (1934); In re Honkanen,

446 B.R. at 378-379. Thus, section 523(a)(4) does not render a

claim nondischargeable when the fiduciary duty pre-dates the

defalcation, and the only trust is a constructive, resulting, or

implied trust that arises only after the defalcation. Blyler v.

Hemmeter (In re Hemmeter), 242 F.3d 1186, 1189-90 (9th Cir.

2001). Whether the debtor was acting in a fiduciary capacity

within the meaning of § 523(a)(4) is a question of federal law. 

Lewis, 97 F.3d at 1185. State law, however, determines whether

the requisite trust relationship exists. Id.

Under California law, “all partners [are] trustees over the

assets of the partnership.” Ragsdale, 780 F.2d at 796; and see

Cal. Corp. Code § 16404(b)(1) (partner has a duty to hold as

trustee any “property, profit, or benefit derived” from
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partnership business or use of partnership property). And

accordingly, “California partners are fiduciaries within the

meaning of § 523(a)(4).” Ragsdale 780 F.2d at 796-97. The

bankruptcy court here found “no factual dispute that Martin was

acting in a fiduciary capacity as a partner of Harold in

HMS Properties, a family business.” In re Pemstein, 476 B.R. at

257. And for purposes of issue preclusion, on its face the 2010

Judgment was based on Martin’s breach of his duty of care to

Harold in Martin’s actions in connection with partnership

business. 

The critical question here is whether the 2010 Judgment was

based on Martin’s defalcation. The bankruptcy court based its

negative answer to this question on the omission from the 2010

Judgment of any statement that “Martin had failed to account for

rents he received.” Id. (emphasis in original). Our analysis of

existing court decisions, supported by the Supreme Court’s

discussion in the recent Bullock decision, leads us to conclude

that actual receipt of funds subject to a trust is not necessary

to establish defalcation. 

The bankruptcy court relied on a definition of defalcation

articulated by the Ninth Circuit, quoting Black’s Law Dictionary, 

in In re Lewis: “Defalcation is defined as the ‘misappropriation

of trust funds or money held in any fiduciary capacity; [t]he

failure to properly account for such funds.’” 97 F.3d at 1186

(citation omitted). From this definition, the bankruptcy court

focused largely on the words “misappropriation” and “funds.”

In effect, the bankruptcy court’s focus negates any

difference between defalcation and embezzlement under
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§ 523(a)(4). Embezzlement, however, is nondischargeable under

§ 523(a)(4) whether or not committed by someone acting in a

fiduciary capacity. To equate defalcation with embezzlement,

thus, would improperly render part of § 523(a)(4) mere

surplusage. See Bullock v. BankChampaign, N.A., 2013 U.S. Lexis

3521 at *14. Moreover, defalcation does not require conversion,

whereas embezzlement does. Id. (“‘Defalcation,’ as commonly used

(hence as Congress might have understood it), can encompass a

breach of fiduciary obligation that involves neither conversion,

nor taking and carrying away another’s property [i.e. larceny],

nor falsity [i.e. fraud]”).

And, the bankruptcy court missed the broader meaning of

defalcation actually applied in Lewis, where the Ninth Circuit

held that the debtors’ failure to “provide a complete accounting

of the funds [plaintiff] invested in the partnership, or of the

partnerships [sic] assets generally, and commingl[ing] [of] his

investment with their other funds” fit within the legal

definition of defalcation. Id. at 1187 (emphasis added). 

Defalcation, therefore, is broader than the misappropriation of

funds or mere bookkeeping malfeasance. Defalcation includes the

failure by a fiduciary to account for money or property that has

been entrusted to him. Woodworking Enter., Inc. v Baird

(In re Baird), 114 B.R. 198, 204 (9th Cir. BAP 1990); and see

In re Hemmeter, 242 F.3d at 1191 (the Ninth Circuit has “as yet

not fully defined the contours of defalcation under

§ 523(a)(4)”); In re Niles, 106 F.3d at 1462 (an agent who comes

into possession of money or other thing for the principal must

account for it).
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18 At trial, the bankruptcy court admitted into evidence

the State Court Complaint (Defendant’s Trial Ex. B), the 2005

Decision (Plaintiff’s Trial Ex. 1), the 2010 Judgment

(Plaintiff’s Trial Ex. 2), and the DCA Opinion (Defendant’s Trial

Ex. A). See Hr’g Tr. (November 30, 2011) at iii.

19 See Brown v. Kenney (In re Kenney), 2012 Bankr. LEXIS

4127 *11-12 (Bankr. N.D. Cal. 2012) (use of the term

“defalcation” is not required for issue preclusion purposes,

“[i]t is necessary only that the prior decision establish facts

necessary to except the debt from discharge under section 523”)

(emphasis in original).

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Whether the 2010 Judgment was based on Martin’s receipt of

rents and a failure to account for those rents or was based on

rents from partnership property that he should have received but

failed to collect, the state court determined that Martin caused

his partner, Harold, damages of $295,871.00 in principal and

$400,347.03 in interest. Based on our review of the record,18 we

can infer, at a minimum, that the state court found that Martin

breached a fiduciary duty to Harold that negatively impacted

Harold’s right to receive rents from the partnership’s property. 

The right to receive rents was part of the bundle of rights in

the real property owned by the partnership. See Black’s Law

Dictionary 1335 (9th ed. 2009)(property is the “right to possess,

use, and enjoy a determinate thing. . .; the right of ownership

. . . . Also termed bundle of rights.”) This breach of fiduciary

duty may constitute defalcation under § 523(a)(4).19 

The 2010 Judgment specifically states the finding that

Martin “breached his duty of care to Harold Pemstein in the

collection of rent on behalf of HMS Properties.” We may infer

that in making this finding, the state court necessarily decided

against Martin on the fifth cause of action in the operative

complaint, the only claim in the State Court Complaint against
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Martin for breach of fiduciary duty as Harold’s partner. The

wrongful conduct alleged there includes failing to account to the

partnership and to “hold as trustee the properties, profits, and

benefits” derived therefrom (State Court Complaint at 12-13,

para. f); dealing with partnership properties in a manner adverse

to Harold (Id. at 13, para. g); and “refusing to set market

rents” for partnership properties rented to the family

corporation, from which Harold had been excluded (Id. at 13.

para. k).

This inference is supported by our review of the

DCA Opinion. In the DCA Opinion, the Court of Appeal recited the

history of the litigation between these parties, and in summary

stated that after the 2005 Decision, “[t]he only issue remaining

was the equitable accounting for rents Harold claimed Martin owed

him.” DCA Opinion at 3. It then quoted the state court’s minute

order dated December 14, 2009, wherein the state court prefaced

its oral ruling after the multi-day trial on the State Court

Complaint by stating that the only issue then remaining was

“Harold’s . . . equitable claims for RENT between himself and

Martin . . . regarding Martin[‘s] stewardship of HMS on behalf of

the partnership . . ..” Id. at 3-4. Thus, as the 2010 Judgment

was the result of Martin’s failure to account for partnership

property entrusted to him, the bankruptcy court utilized an

incorrect legal rule when it denied the 2010 Judgment issue

preclusive effect, based on the assumption that defalcation

resulted only when the fiduciary fails to account for cash

actually received.
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Section 523(a)(4)’s scienter requirement.

In its decision, the bankruptcy court opined that the 2010

Judgment may have been based on a finding of “negligence,” which

the bankruptcy court thought insufficient to establish

defalcation. In re Pemstein, 476 B.R. at 259. We find no

support in the record for a finding of simple negligence. The

State Court Complaint contained no negligence cause of action. 

And, at the time the bankruptcy court rendered its decision, at

least in the Ninth Circuit, “the term ‘defalcation’ include[d]

innocent, as well as intentional or negligent defaults.” 

In re Lewis, 97 F.3d at 1186 (citation omitted). Thus, the

bankruptcy court’s concern that Martin may have been found only

negligent, even if true, did not support the bankruptcy court’s

ruling under the standard in effect at that time in the Ninth

Circuit. 

We acknowledge, however, that the Bullock decision abrogates

the Ninth Circuit’s previous standard that omitted a scienter

element for § 523(a)(4) defalcation, and the bankruptcy court’s

analysis on remand must reflect the change. In brief, Bullock

instructs us that the necessary state of mind for § 532(a)(4)

defalcation is “one involving knowledge of, or gross recklessness

in respect to, the improper nature of the relevant fiduciary

behavior.” Bullock v. BankChampaign, N.A., 2013 U.S. Lexis 3521,

*5.

In the 2010 Judgment, the term “duty of care” applies to one

of the two statutory fiduciary duties of partners to one another

and the partnership as enunciated in the California Corporations

Code. See Cal. Corp. Code § 16404(c). This duty required Martin
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to refrain from “engaging in grossly negligent or reckless

conduct, intentional misconduct, or a knowing violation of law”

in the conduct and winding up of the partnership business. Thus,

in light of this statutory provision, the state court necessarily

found that Martin’s collection of rents was no less than “grossly

negligent or reckless conduct,” “intentional misconduct,” or “a

knowing violation of law.” Id. Whether such findings, made in

the context of the civil litigation and tort concepts that were

before the state court, satisfy the heightened standard

established in Bullock is not for this Panel to determine for the

first time as a reviewing court and must be determined by the

bankruptcy court on remand.

CONCLUSION

Based on the foregoing, we conclude that the bankruptcy

court erred when it ruled that Harold’s § 523(a)(4) claim failed

because Harold did not prove that Martin actually received funds

for which he failed to account. We determine that this error was

not harmless. We, therefore, REVERSE the bankruptcy court’s

narrow application of § 523(a)(4) defalcation, we VACATE the

denial of Harold’s § 523(a)(4) claim, and we REMAND for further

findings regarding issue preclusion or, if found to be otherwise

not applicable, for determinations of the sufficiency of evidence

at trial in light of our conclusions herein, or for further

consideration of evidence as the bankruptcy court deems necessary

in light of the intervening Supreme Court decision in Bullock.