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 Congresss 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 petitioners bankruptcy.

In this particular case, the father of petitioner Randy Bullock established an express trust that held a life insurance policy on the fathers 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 Bullocks father, a second was for the benefit of Bullocks 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 Bullocks brothers filed suit in a state court in Illinois. That court held no surprise to anybody whos 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 attorneys 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 Bullocks 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 terms 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.

Bullocks 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 Scalias recent book (with Bryan Garner) on Reading Law risky because of the likelihood the citations will irritate Justice Scalias 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.

Bullocks 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 debtors 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 Bullocks favor, and because the term defalcation is so inherently vague, the Court should construe the term in Bullocks 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 Bullocks 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 Bensingers. The most successful passage attacks Bullocks 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: Bullocks debt cannot be discharged.