The court recently issued the published decision In re Hyman (Denton v. Hyman), 502 F. 3d 61 (2d Cir. 2007) in which the court construed the standards under Bankruptcy Code §523(a)(4) for determining whether a debt for defalcation while acting in a fiduciary capacity may be declared non-dischargeable. The court addressed a split among seven of the circuits, which have published decisions on the issue. It allied itself with those courts that hold an element of “conscious misbehavior or recklessness” in the breach of fiduciary duty to be demonstrated in order for the debt to be held non-dischargeable under the Bankruptcy Code.

Case Background
The case arose out of litigation between the debtor, Hyman, and the estate of his deceased business partner, Denton. Hyman and Denton owned an insurance agency and two pension administration companies. The companies incurred substantial debt, which was personally guaranteed by Hyman and Denton, jointly and severally. After Denton died, Hyman formed another insurance company that obtained referrals from the other companies and the profits from which Hyman used to payoff the debts of the three Denton/Hyman companies.

The estate of Denton subsequently sued Hyman for misappropriation and breach of fiduciary duty in connection with Hyman’s use of the referrals from the Denton/Hyman companies to operate his own company. Denton was granted a multimillion dollar judgment against Hyman by the New York state court under New York state law even though Hyman’s efforts resulted in a satisfaction of Denton’s liability on the corporate debt, among other things. In response to the judgment, Hyman filed bankruptcy. Denton sued Hyman to declare the debt under the judgment to be non-dischargeable.

The Non-Dischargeability Claim — What Is Defalcation Under the Bankruptcy Code?
Denton’s estate sued Hyman in bankruptcy court to obtain a declaration that the debt reflected in the New York state judgment was non-dischargeable under Bankruptcy Code §523(a)(4), as a debt incurred through “fraud, defalcation while acting in a fiduciary capacity, embezzlement or larceny.” The Denton estate specifically alleged that the judgment for misappropriation of funds and breach of fiduciary duty constituted a debt for “defalcation while acting in a fiduciary capacity” under the Bankruptcy Code. The claimant also tried to rely on the judgment alone as being a binding determination of the issue of whether the debt was a debt for “defalcation while acting in a fiduciary capacity” under the Bankruptcy Code, so as to compel entry of a non-dischargeable judgment in the bankruptcy court.

The bankruptcy court ruled that the state court judgment was only binding to determine that Denton held a claim against Hyman in the bankruptcy estate, but not on the issues required to be determined regarding whether the debt was non-dischargeable. The Denton estate chose to rely exclusively on the state court judgment as the basis for its contention that the debt was non-dischargeable and to abide by the bankruptcy court’s determination of the effect of that judgment.

The bankruptcy court ruled in favor of Hyman, and concluded that the state court had made no findings of fact regarding any intent or recklessness on Hyman’s part in connection with the misappropriation and breach of fiduciary duty judgment, and that as a result, the judgment did not support a declaration that the debt was non-dischargeable. The Denton estate appealed, and the District Court affirmed. The Denton estate then appealed to the Second Circuit Court of Appeals.

The Issue of Intent and the Split Among the Circuits
The issue squarely presented for determination by the Second Circuit was whether §523(a)(4) of the Bankruptcy Code requires proof of conduct by the debtor beyond the misappropriation or breach of fiduciary duty in order for the debt to be declared non-dischargeable. The Second Circuit cited reported decisions in three circuits, including the Fourth, Eighth and Ninth Circuits, that no proof of a particular mental state on the part of the debtor is required in order for the debt to be deemed non-dischargeable. Those courts hold that even an innocent or negligent act that constitutes a violation of the debtor’s duties as a fiduciary is sufficient for the debt to constitute “defalcation while acting in a fiduciary capacity” under §523(a)(4). See In re Uwimana, 274 F. 3d 806, 811 (4th Cir. 2001); In re Hemmeter, 242 F. 3d 1186, 1190 (9th Cir. 2001); In re Cochrane, 124 F. 3d 978,984 (8th Cir. 1997).

The Second Circuit also pointed to a number of other reported circuit court decisions that take a contrary view of the meaning of “defalcation while acting in a fiduciary capacity” under §523(a)(4). Those other circuits hold that “some level of wrongful conduct” is required to meet the non-dischargeability standard of 523(a)(4), including intentional misconduct or recklessness, before the debt will be deemed a defalcation giving rise to a non-dischargeable judgment. See In re Schwager, 121 F. 3d 177, 185 (5th Cir. 1997); Meyer v. Rigalon, 36 F. 3d 1375,1384-85 (7th Cir. 1994); In re Johnson, 691 F. 2d 249, 257 (6th Cir, 1982); In re Bayliss, 313 F. 3d 9, 20 (1st Cir. 2002). See also In re Storie, 216 B.R. 283, 288 (B.A.P. 10th Cir. 1997).

The Second Circuit ultimately sided with the First Circuit’s analysis of the issue in the Bayliss decision, and joined the majority of circuits in holding that proof of conduct beyond an innocent mistake or negligence is required in order for a debt to be non-dischargeable under §523(a)(4). In reaching this conclusion, the Second Circuit cited the policies underlying the Bankruptcy Code in general and the non-dischargeability statutes in particular. The court commented on the fundamental purpose of the Bankruptcy Code as being to give debtors a “fresh start” and because a determination that a debt is non-dischargeable impairs the debtor’s fresh start, the ground for declaring debts to be non-dischargeable must be narrowly construed.

The Second Circuit also construed the “defalcation while acting in a fiduciary capacity” language in the context of the list of other grounds enumerated in §523(a)(4), namely fraud, embezzlement and larceny, all of which require proof of intentional, reckless or other similar conduct rather than imposing liability based on negligent or innocent conduct. The factual context in which the case arose also may have had an influence on the Second Circuit’s decision; the court seemed to question the harm the Denton estate claimed to have suffered from Hyman’s misappropriation of assets and noted the substantial benefit Hyman conferred on the Denton estate through his satisfaction of the corporate debts with the use of those assets.

Implications for Creditors
The split among the circuits regarding the proper interpretation of this ground for declaring debts non-dischargeable cries out for legislative or judicial resolution. As a result of the split in the circuits, in some cases a breach of the trust imposed in a flooring financing agreement may give rise to a non-dischargeable debt while in others such a potentially innocent or negligent breach of the “technical” trust imposed in the loan and security documents will not; it all depends upon the circuit governing the bankruptcy court in which the debtor’s case is filed.

What constitutes a “defalcation” and the type of “fiduciary capacity” that meet the Bankruptcy Code’s standard for declaring a debt to be non-dischargeable should not be dependent upon the circuit in which a debtor files for bankruptcy protection. Creditors may expect to see the United States Supreme Court step into this debate to resolve the conflict.

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Lesley Anne Hawes is a partner with McKenna Long & Aldridge, LLP, a full-service law firm of 400 lawyers and public policy advisors with offices in Atlanta, Brussels, Denver, Los Angeles, Philadelphia, San Diego, San Francisco and Washington, DC. The firm provides business solutions in the areas of corporate law, government contracts, intellectual property and technology, complex litigation, public policy and regulatory affairs, international law, real estate, environmental, energy and finance as well as bankruptcy and creditor’s rights. To learn more about the firm and its services, visit www.mckennalong.com.