Argument analysis: Bankruptcy dispute finds Justices dubious about innocence of trustee self-dealing

Counsel got an earful of the Justices’ own views yesterday when the Court heard oral arguments in its only bankruptcy case of the Term, Bullock v. BankChampaign, N.A. The dispute involves an exception to the bankruptcy discharge for debts incurred through “defalcation.” The general rule is that an individual who obtains bankruptcy relief is discharged from any future obligation with respect to all preexisting debts.  The discharge is subject, however, to exceptions for a variety of debts that involve specified forms of misconduct.  The question in this case is whether the claim against petitioner falls within one of those exceptions; if it does, the claim would survive petitioner’s bankruptcy.

All agree on the basic facts: that petitioner Randy Bullock borrowed funds from a trust for which he was trustee, that he invested the funds for his own benefit, that he repaid the funds with interest, and that he earned (and retained) considerable (more than $250,000) in profits from the investments.  The lower courts concluded that his retention of those profits amounted to “defalcation,” and thus refused to permit him to use the bankruptcy process to discharge his obligation to repay them.

In their briefs, the parties (and the Solicitor General, appearing in support of the trust, on behalf of the Office of the United States Trustee) debated whether defalcation must be “intentional” or “reckless.”  All agree that Bullock did not in fact know that it violated trust law to borrow from the trust for his personal use; if “defalcation” requires that level of knowledge, then the lower courts would have erred.

From the moment Thomas Byrne rose on Bullock’s behalf, it was clear that a group of Justices found his position utterly meritless.  To that group of Justices, the only relevant intent was whether Bullock intended to borrow the funds.  Because he plainly intended to borrow the funds, his actions were wrongful and his ignorance of the law was no excuse.  Thus, Justice Ginsburg interrupted Byrne moments into his presentation, asking (with apparent puzzlement) “what else [would be required for defalcation] other than that [the borrowing] was not authorized and it was self-dealing?”

Justice Breyer was particularly emphatic. Referring to the crimes of embezzlement and larceny (which appear in the relevant statute in a list parallel to “defalcation”), he commented:

[I]f I look at the accompanying things – embezzlement, larceny, fraud in the trust – I don’t think any of them require a knowledge that what you’re doing is unlawful. So . . . you can be convicted of embezzlement while misunderstanding the law of embezzlement.  You can be convicted of larceny.  And as far as I know, a person to commit fraud lies, knows it’s material, . . . but he doesn’t have to know there’s a law against it.

Similarly, Justice Sotomayor repeatedly emphasized her sense that the case was a plain victory for the trust: “Why should you be discharged if you . . . knowingly did an act, the actus reus, with its concomitant mental state.  You intended to take the money.”

Strangely, when Bill Bensinger rose on behalf of the trust, he chose not to embrace the widespread sympathy for his side of the case, but instead started in repeating the argument from his brief that Bullock’s conduct was “reckless.”  Predictably enough, this led to a largely futile discussion about the precise extent of Bullock’s “recklessness” and why it should matter.

Still, the core group of the most engaged Justices remained focused on their idea that the relevant intent should apply only to the act of taking the money. The only apparent support for Bullock arose from a topic that neither the parties nor the Solicitor General addressed in their briefs. Strangely enough, although all the principal briefs suggested the term was obscure, none discussed the Latin source of the term.  As discussed earlier on this blog, the core etymological meaning of the term is “appropriation,” deriving from a medieval Latin verb (“defalcare“) that means “to lop off,” the verb deriving in turn from the “falx,” a particular type of scythe in common use in farming.

At least one of the Justices (apparently Justice Scalia) appears to have noticed this definition before the argument and developed the idea that the concept of “lopping off” requires that the trust actually lose money.  Thus, Justice Scalia suggested that the term’s original meaning of “a cutting off” required “a failure to turn over money that was due.”  Justice Breyer went so far as to chide Assistant to the Solicitor General Curtis Gannon for his failure to discuss the Latin definition in his brief. Gannon recovered well, however, arguing (accurately, to my mind) that the Oxford English Dictionary establishes that the concept of lopping off was archaic by the early nineteenth century, when Congress incorporated the term into bankruptcy law.

Despite that response, the Justices continued for some time debating (largely among themselves) whether the trust incurred a “loss” if the trust instrument required investment only in the life insurance policy, which could produce no more than the six-percent return that Bullock paid.  When Byrnes during his rebuttal agreed with Justice Sotomayor’s suggestion that this was an incorrect reading of the trust instrument, she flatly concluded that “you may be losing this case.” Apparently, she assumed that the Court would find that Bullock’s discretion over investments of the trust’s assets carried with it a concomitant obligation to account to the trust for the profits from those investments.

I suggested in my first entry about this case that the Court has exhibited a strong propensity for following the lead of the Office of the United States Trustee when the Office seeks to narrow the discharge by aggressive reading of the exceptions to discharge for bad acts.  If anything, the argument suggests this will be another case following that pattern.