Opinion ID: 1236577
Heading Depth: 2
Heading Rank: 3

Heading: Whether Defalcation Was Necessarily Decided

Text: While the Code generally allows for the discharge of debts, significant exceptions exist. DeTrano, 326 F.3d at 322. Among them is § 523(a)(4) excepting from discharge any debt for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny. 11 U.S.C. § 523(a)(4). As previously noted, this exception, like most, must be narrowly construed. Kawaauhau v. Geiger, 523 U.S. 57, 62, 118 S.Ct. 974, 140 L.Ed.2d 90 (1998) (observing that exceptions to discharge `should be confined to those plainly expressed') (quoting Gleason v. Thaw, 236 U.S. 558, 562, 35 S.Ct. 287, 59 L.Ed. 717 (1915)); Renshaw, 222 F.3d at 86. There has been much debate among the Circuits over whether a defalcation under § 523(a)(4) includes all misappropriations or failures to account or only those that evince some wrongful conduct. [1] See Zohlman v. Zoldan, 226 B.R. 767, 775 (S.D.N.Y.1998) (discussing the circuit split). This Circuit, although previously having suggested that some portion of misconduct may be required to establish a defalcation under § 523(a)(4), has yet to squarely address this issue. Cent. Hanover Bank & Trust Co. v. Herbst, 93 F.2d 510, 512 (2d Cir.1937); see Hayes, 183 F.3d at 172 (assuming that defalcation demands some portion of misconduct, in finding that the debtor committed a defalcation). In Herbst, 93 F.2d at 511-12, Judge Learned Hand wrestled with this problem without resolving it. He wrote: Colloquially perhaps the word, defalcation, ordinarily implies some moral dereliction, but in this context [the first reference to defalcation in the Bankruptcy Code] it may have included innocent defaults, so as to include all fiduciaries who for any reason were short in their accounts. It must be remembered that the fiduciary capacity was limited to special or technical fiduciaries. . . . . Whatever was the original meaning of defalcation, it must here [in the Bankruptcy Act of 1867] have covered other defaults than deliberate malversations, else it added nothing to the words, fraud or embezzlement. [2] . . . . We must give the words different meanings so far as we can, especially when a contrary interpretation would wrest defalcation, if not from its original meaning, at least from that which it must have had in the Act of 1867. . . . . We do not hold that no possible deficiency in a fiduciary's accounts is dischargeable; in [In] Re Bernard, 87 F.2d 705, 707 [(2d Cir.1937)], we said that the misappropriation must be due to a known breach of the duty, and not to mere negligence or mistake. Although that word probably carries a larger implication of misconduct than defalcation, defalcation may demand some portion of misconduct; we will assume arguendo that it does. Denton relies on In re Hammond, 98 F.2d 703, 704 (2d Cir.1938), for the proposition that no actual intent is necessary to establish a defalcation. Hammond involved our determination of whether the unlawful appropriation of a corporate contract constituted a misappropriation under the previous version of § 523(a)(4), absent any finding by the lower court of a conscious wrongdoing or purpose to defraud. Id. at 704, 705. Hammond does not stand for the proposition that a misappropriation under this provision can be found absent a wrongful intent. In Hammond, we held that a wrongful or evil intent, if required by the provision, could be inferred based on the debtor's intentional unlawful act and by finding the debtor chargeable with the knowledge that his actions violated the law. Id. at 705. The Fourth, Eighth, and Ninth Circuits hold that an innocent mistake can constitute a defalcation. In re Uwimana, 274 F.3d 806, 811 (4th Cir.2001) ([N]egligence or even an innocent mistake which results in misappropriation or failure to account is sufficient.); In re Hemmeter, 242 F.3d 1186, 1190 (9th Cir.2001) (Even innocent acts of failure to fully account for money received in trust will be held as non-dischargeable defalcations.); In re Cochrane, 124 F.3d 978, 984 (8th Cir.1997) (Defalcation includes the innocent default of a fiduciary who fails to account fully for money received.). [3] The majority of the Circuits addressing this issue, however, require some level of wrongful conduct in order to find a defalcation under § 523(a)(4). The Fifth, Sixth, and Seventh Circuits require a level of fault greater than mere negligence. In re Schwager, 121 F.3d 177, 185 (5th Cir.1997) (While defalcation may not require actual intent, it does require some level of mental culpability. It is clear in the Fifth Circuit that a `willful neglect' of fiduciary duty constitutes a defalcation  essentially a recklessness standard.); Meyer v. Rigdon, 36 F.3d 1375, 1384-85 (7th Cir.1994) ([A] mere negligent breach of a fiduciary duty is not a `defalcation' under section 523(a)(11).); In re Johnson, 691 F.2d 249, 257 (6th Cir.1982) (ruling that while subjective intent to violate a known fiduciary duty or bad faith is irrelevant, the misuse of monies as the result of negligence or a mistake of fact does not constitute defalcation). The Tenth Circuit's standard is not entirely clear but at least requires some portion of misconduct. Compare In re Storie, 216 B.R. 283, 288 (B.A.P. 10th Cir. 1997) (announcing a standard requiring that includes intentional, wilful, reckless or negligent breaches of fiduciary duty), with In re Millikan, 188 Fed.Appx. 699, 702 (10th Cir.2006) (unpublished) (declining to identify a specific standard but requiring some portion of misconduct to prove defalcation). The First Circuit set the highest bar, requiring a showing of extreme recklessness, akin to the level of recklessness required for scienter [in securities law]. In re Baylis, 313 F.3d 9, 20 (1st Cir.2002). In so ruling, the First Circuit interpreted defalcation as requiring a degree of fault, closer to fraud, without the necessity of meeting a strict specific intent requirement. [4] Id. at 18-19. In light of this persistent confusion, we now align ourselves with the First Circuit, see Baylis, 313 F.3d at 20, in holding that defalcation under § 523(a)(4) requires a showing of conscious misbehavior or extreme recklessness  a showing akin to the showing required for scienter in the securities law context. See Ganino v. Citizens Utils. Co., 228 F.3d 154, 168 (2d Cir.2000); Novak v. Kasaks, 216 F.3d 300, 308 (2d Cir.2000); Press v. Chemical Inv. Servs. Corp., 166 F.3d 529, 538 (2d Cir.1999). We believe that these concepts  well understood and commonly applied in the securities law context  strike the proper balance under § 523(a)(4). This standard ensures that the term defalcation complements but does not dilute the other terms of the provision  fraud, embezzlement, and larceny  all of which require a showing of actual wrongful intent. See In re Stern, 231 B.R. 25, 26 (S.D.N.Y.1999) (noting that larceny under § 523(a)(4) requires a showing of fraudulent intent to convert another's property to debtor's own use); In re Caulfield, 192 B.R. 808, 818 (Bankr. E.D.N.Y.1996) (requiring a showing of fraudulent intent for larceny and embezzlement); see also In re Zois, 269 B.R. 89, 101 (Bankr.S.D.N.Y.1999) (requiring a showing of intentional deceit to establish fraud under this section); 4 Collier on Bankruptcy § 523.10(1)(a) (15th ed. rev. 2007) (`Fraud' for purposes of this exception has generally been interpreted as involving intentional deceit, rather than implied or constructive fraud.). By requiring the courts to make appropriate findings of conscious misbehavior or recklessness in the course of dischargeability litigation, the standard we adopt today insures that the harsh sanction of non-dischargeability is reserved for those who exhibit some portion of misconduct. Herbst, 93 F.2d at 512. The standard does not reach fiduciaries who may have failed to account for funds or property for which they were responsible only as a consequence of negligence, inadvertence or similar conduct not shown to be sufficiently culpable. This standard, we believe, also has the virtue of ease of application since the courts and litigants have reference to a robust body of securities law examining what these terms mean. In finding that Hyman breached his fiduciary duty by misappropriating and co-opting assets of the jointly-owned companies for his personal benefit, the Surrogate's Court made no express findings with regard to Hyman's state of mind. We assume that the Surrogate concluded that under New York law such findings were not necessary, since misappropriation and breach of fiduciary duties apparently do not, under New York law, consistently require proof of a culpable mental state. See Strough v. Bd. of Supervisors, 3 N.Y.S. 110, 112 (N.Y. Gen. Term 1888), modified on other grounds and aff'd, 119 N.Y. 212, 23 N.E. 552 (1890) (holding defendant liable for illegal, though innocent in intent, misappropriation); Matter of Happy Time Fashions, 7 B.R. 665, 670 (Bankr. S.D.N.Y.1980) (noting that good faith or innocent motives are no defense to a corporate officer's breach of fiduciary duties). [5] Having clarified the standard under § 523(a)(4) and given the unique circumstances of this case, we decline to mechanically apply collateral estoppel. See Jeffreys, 1 N.Y.3d at 41, 769 N.Y.S.2d 184, 801 N.E.2d 404; People v. Roselle, 84 N.Y.2d 350, 357, 618 N.Y.S.2d 753, 643 N.E.2d 72 (1994) ([C]ollateral estoppel, a flexible doctrine, should not be mechanically applied just because some of its formal prerequisites, like identity of the parties, identity of issues, a final and valid prior judgment and a full and fair opportunity to litigate the prior determination, may be present.); Halyalkar v. Bd. of Regents, 72 N.Y.2d 261, 269, 532 N.Y.S.2d 85, 527 N.E.2d 1222 (1988) (declining to give an administrative consent order preclusive effect and noting that the doctrine of collateral estoppel should never be rigidly or mechanically applied). The Surrogate had neither the ability nor the incentive to apply the standard we announce. Moreover, the record contains evidence of Hyman's good faith in using the proceeds of the new Agency to pay off the debts for which both he and the Denton estate were liable, and in attempting for years to negotiate a buy-out with the Denton estate [6]  all of which could militate against the required showing of recklessness or conscious misbehavior. As noted above, the Surrogate's Court was not required to take such considerations into account when reaching its conclusions concerning misappropriation and breach of fiduciary duty. In view of these complexities, we are loath to conclude that an identical issue was necessarily decided or that Hyman had a full and fair opportunity to contest his state of mind. In addition to the murkiness of the law, the harsh consequences that follow a finding of nondischargeability and the requirement that exceptions be narrowly construed both counsel against precluding a plenary trial in Bankruptcy Court, had the estate not voluntarily agreed to forego one here. Accordingly, we conclude that collateral estoppel does not attach.