Argument preview: Court to scour dictionaries to define “defalcation” in bankruptcy dispute

Next week the Court will hear oral arguments in its only bankruptcy case of the year, Bullock v. BankChampaign, N.A. The dispute involves an obscure 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 in Congress’s view should not be discharged.  The question in this case is whether the claim against petitioner falls within one of the exceptions; if it does, the claim would survive petitioner’s bankruptcy.

In this particular case, the father of petitioner Randy Bullock established an express trust that held a life insurance policy on the father’s life; Bullock was the trustee for the trust.  Subsequently, between 1981 and 1990 (when interest rates were much higher than they are now), Bullock (acting as trustee) agreed to a series of loans taken against the cash value of the life insurance policy.  One loan was for the benefit of Bullock’s father, a second was for the benefit of Bullock’s mother, a third was used for a business in which Bullock engaged with his mother.  All of the loans were repaid with interest at the rate of six percent.

In time, the family fell into dispute over these transactions.  Two of Bullock’s brothers filed suit in a state court in Illinois.  That court held – no surprise to anybody who’s been exposed to trust law – that Bullock violated his duty of loyalty by agreeing to loans from the trust to himself and his relatives.  The state court required him to pay $250,000 to the trust based on the profits he made from the loans, as well as $35,000 in attorney’s fees.  Bullock did not pay the judgment, but instead sought bankruptcy relief and attempted to discharge the obligation in that proceeding.

Respondent BankChampaign (which had succeeded Bullock as trustee of the trust) objected in the bankruptcy proceeding, arguing that the debt was not dischargeable because it resulted from “defalcation.”  All three courts (the bankruptcy court, the district court, and the Eighth Circuit) agreed that Bullock’s conduct amounted to defalcation; thus, the case comes to the Court with Bullock unable to discharge his obligation to turn over his profits to the trust.

The most surprising thing about this case is that the question has come up so frequently that there is a deep-seated conflict in the circuits, with three distinct interpretations of “defalcation.”  The parties agree that the term “defalcation” is an obscure legal term, so rarely used in common parlance as to provide limited guidance to the Court.  The obscurity of the term is underscored by the reluctance of either of the parties to explain the etymology of the term.  Essentially, the term’s core meaning  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.

Bullock’s counsel Thomas Byrne argues that “defalcation” must be limited to situations of conscious misbehavior, essentially the same as the standard for scienter under the securities laws.  His central point is that the term appears in Bankruptcy Code Section 523 in a passage that makes it parallel to the criminal offenses of “embezzlement” and “larceny.” Because those offenses require criminal intent, he argues defalcation should require the same level of intent.

This “noscitur a sociis” argument is presented replete with risky citations to the discussion of that topic in Justice Scalia’s recent book (with Bryan Garner) on Reading Law – risky because of the likelihood the citations will irritate Justice Scalia’s colleagues. All agree that Bullock did not have any actual intent to violate the requirements of trust law – the Illinois court quite plausibly concluded that as a layperson he had no familiarity with those rules.  Hence, Byrne argues, Bullock did not have the requisite intent for “defalcation.”

Bullock’s side of the case draws skillful support from Eric Brunstad, the most noted of Supreme Court bankruptcy advocates – he has argued, briefed, and won more bankruptcy cases in the Supreme Court than any other attorney in history.  Brunstad emphasizes two related canons of construction: first that the interest in the debtor’s “fresh start” calls for a broad interpretation of the discharge, and second that it has narrowly interpreted the exceptions to the discharge.  Because those canons apply strongly in Bullock’s favor, and because the term “defalcation” is so inherently vague, the Court should construe the term in Bullock’s favor.

On the other side of the case, BankChampaign, represented by Bill Bensinger, largely sidesteps the question of intent on which Bullock focuses.  Rather, he emphasizes Bullock’s violation of the duty of loyalty.  Because the duty of loyalty is such a foundational element of the duties of a trustee, Bensinger argues that even an unintentional violation of the duty of loyalty should be treated as defalcation.

Finally, the Solicitor General appears as an amicus on behalf of the bank, representing the Office of the United States Trustee (a component of the Department of Justice).  The Solicitor General presents an argument quite similar to Bensinger’s.  The most successful passage attacks Bullock’s noscitur a sociis argument.  Why, the government asks, is it so clear that the relevant common attribute of embezzlement and larceny is criminal intent?  “It might be said with at least equal force that the distinguishing feature of embezzlement or larceny is the acquisition of property to which one is not entitled.”  Against that point, the government argues that any violation of the duty of loyalty that includes an “unauthorized and self-dealing diversion of trust assets” must amount to defalcation.

The case will be an odd one for the Court, a relatively uncommon one in which (as far as I can tell) neither party has chosen to retain counsel with previous experience arguing before the Court.  My guess is that the appearance of the United States Trustee presages a loss for Bullock.  Although (as I frequently have written here in the past, most recently in my discussion last year of Hall v. United States) the Court often interprets the Bankruptcy Power narrowly, it has almost always accepted arguments from the Office of the United States Trustee. As in this case, those arguments generally have sought a broad scope for rules barring a discharge based on fraud.  The Court has ruled in favor of the Office in every case in which it has appeared for the last fifteen years (a total of six cases in a row).  Interestingly enough, the last time that the Court ruled for a broad discharge (by narrowing one of the exemptions) was its decision in Kawaauhau v. Geiger – the Office chose not to appear in that case. So although the textual arguments might be thought so obscure as to be evenly balanced, my guess is that the balance of the Justices will come down on the side of the trust: Bullock’s debt cannot be discharged.