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Self Study Examinations for CLE Credit: The Bar Association of San Francisco

February 2014 Self Study Examination


Earn one hour of MCLE credit by taking the monthly self-evaluation exam. Read the monthly article below and answer the accompanying test questions. When you’re done, return the answer form (at the bottom) and a $25 check for processing.


 

Discharging Trust-Related Claims in Bankruptcy

By Reno F.R. Fernandez III

"Finance is the art of passing money from hand to hand until it finally disappears."
- Robert W. Sarnoff

When a person enters bankruptcy, creditors may be surprised to learn that the debtor does not have money set aside, earmarked and safeguarded for them as if on deposit with a bank.  In other words, creditors may (correctly or mistakenly) believe that their assets were held in trust.  Accordingly, a creditor may attempt to prove that the debtor held assets in trust for the purpose of rendering a claim nondischargeable under Title 11 of the United States Code (“Bankruptcy Code”) Section 523(a)(4), but it is not easy.  In fact, the Supreme Court recently raised the applicable standard of intent in Bullock v. BankChampaign, N.A., 133 S.Ct. 1754 (2013).  This article analyzes cases decided after Bullock under a variety of circumstances, specifically:  (1) real estate investments; (2) pension funds; and (3) marriage.

The Basics

Section 523(a)(4) provides that a debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny” is nondischargeable.  Section 523(a)(4) applies only to individual debtors, not corporations or limited liability companies.  The exception from discharge is not automatic; the creditor must bring a lawsuit against the debtor in bankruptcy court, which is called an adversary proceeding.

The phrase “while acting in a fiduciary capacity” has long been interpreted to require an express trust (arising by agreement) or technical trust (arising by statute or by law).  Chapman v. Forsyth, 43 U.S. 202, 208 (1844).  Section 523(a)(4) does not apply to trusts imposed after the fact, such as constructive, resulting or implied trusts, or other trusts arising ex maleficio (as a result of wrongdoing).  Ragsdale v. Haller, 780 F.2d 794, 796 (9th Cir. 1986).  General fiduciary duties, such as those owed by an agent to his or her principal, do not satisfy Section 523(a)(4).  Cal-Micro, Inc. v. Cantrell, 329 F.3d 1119, 1126 (9th Cir. 2003).  To summarize, the statute is commonly understood to bar discharge of a claim for the return of assets of a trust that were taken out of trust in a concrete sense.  This common understanding has been repeatedly tested.

Sea Change

The United States Court of Appeals for the Ninth Circuit has interpreted the term “defalcation” to include “even innocent acts of failure to fully account for money received in trust….”  In re Sherman, 658 F.3d 1009, 1017 (9th Cir. 2011).  Virtually any default, whether intentional or unintentional, was included.  However, the Supreme Court recently ruled that that “defalcation” includes “a culpable state of mind requirement akin to that which accompanies application of the other terms in the same statutory phrase.”  Bullock, 133 S.Ct. at 1757.  These are “fraud,” “embezzlement” and “larceny.”  “We describe that state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.”  Id.  For the Ninth Circuit, this is a dramatic change.

The Partnership That Never Existed

In Utnehmer v. Crull (In re Utnehmer), 499 B.R. 705 (9th Cir. BAP 2013), the Ninth Circuit’s Bankruptcy Appellate Panel (“BAP”) ruled that Section 523(a)(4) did not apply to render a debt nondischargeable in relation to a partnership that was never formed.  Specifically, an offering memorandum providing for profit-sharing was conditional upon events that did not occur.

William Utnehmer participated in a general partnership for real estate development.  In connection with the development of a luxury residence, Utnehmer provided the investor plaintiffs with an offering memorandum and other documents providing that the plaintiffs would make a loan secured by a lien against the property.  Conditional upon the drafting and execution of a formal operating agreement, $50,000 of the loan would be re-characterized as an equity contribution.  The agreements were executed, and the loan was funded, but the operating agreement was never prepared.  

Utnehmer defaulted.  After certain settlement efforts failed as a result of Utnehmer’s apparent failure to perform, the plaintiffs brought an action and obtained a default judgment for $213,645.17.  Thereafter, Utnehmer and his spouse jointly filed a chapter 7 bankruptcy case, and the plaintiffs brought an adversary proceeding to render the debt nondischargeable.  The plaintiffs prevailed under Section 523(a)(4), which was first raised at trial and not challenged as untimely.

The bankruptcy court appliedpre-Bullock authorities in finding that there was a defalcation, without determining whether there was evidence of “knowledge… or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.”  Bullock, 133 S.Ct. at 1757.  The BAP could have reversed and remanded on this basis alone.  However, the BAP reversed on additional grounds.

The bankruptcy court concluded that the debtor and the plaintiff were partners based upon the loan agreement’s terms providing for a re characterization of debt as equity.  California law provides that that partners hold partnership assets in trust.  Ragsdale780 F.2d 794.  The BAP, however, found that the loan agreement was insufficient to establish a partnership.  Specifically, the agreement plainly stated that the loan would be partially re-characterized as equity only upon the execution of an operating agreement for an entity to be formed in the future.  An agreement to be partners in the future does not establish a partnership until that time arrives.  Solomont v. Polk Dev. Co., 245 Cal.App.2d 488, 496 (1966).

Moreover, the BAP noted that there is no opinion applying the rule in Ragsdale to a limited liability company, leaving open the possibility that they will be treated like corporations. California law provides that officers and directors of a corporation do not hold company assets in trust within the meaning of  Section 523(a)(4)Cantrell, 329 F.3d 1119. However, California’s limited liability company statute was overhauled effective January 1, 204, and Cal. Corp. Code § 17704.09(b)(1) now provides that a member of a member-managed limited liability company owes a duty:  “To account to a limited liability company and hold as trustee for it any property, profit, or benefit derived by the member in the conduct and winding up of the activities of a limited liability company or derived from a use by the member of a limited liability company property, including the appropriation of a limited liability company opportunity.”

Pension?  What Pension?

In Carpenters Pension Trust Fund for Northern California v. Moxley, 734 F.3d 864 (9th Cir. 2013), the Ninth Circuit affirmed a bankruptcy court’s ruling that a construction contractor's withdrawal liability for an underfunded pension is dischargeable in bankruptcy notwithstanding Section 523(a)(4).

Contractors who stop working under collective bargaining agreements but stay in business must continue to fund the amount necessary to ensure payment to vested pension beneficiaries under the Employee Retirement Income Security Act (“ERISA”).  29 U.S.C. §§ 1381, 1391.  In this case, Michael Moxley's obligations under a collective bargaining agreement lapsed (he made all required contributions up to that point), but he continued in business without funding the pension to a level necessary to satisfy vested benefits.  He filed bankruptcy owing more than more than $170,000 to the Carpenters Pension Trust Fund for Northern California (the “Pension Fund”).

The Pension Fund brought an action to except its claim from discharge under Section 523(a)(4), and Moxley prevailed.  On appeal, the Ninth Circuit acknowledged that the Pension Fund is arguably a trust, Moxley is arguably a trustee and pension contributions arguably constitute assets of the trust.  However, the Ninth Circuit ruled that Moxley’s withdrawal liability, which arose after his obligation to fund pension contributions terminated, was an independent obligation not related to any asset of the trust.  “In sum, withdrawal liability is imposed by ERISA to account for the pension fund's needs going forward, and therefore is distinct from the contributions required to be made by the plan agreements.”  Moxley, 734 F.3d at 870. 

Although the decision in Moxley was entered more than three months after Bullock, the Ninth Circuit did not discuss the case.  In fact, the Ninth Circuit found it unnecessary to discuss whether there was a defalcation because it affirmed the bankruptcy court’s ruling on other grounds.  The author suggests that the higher standard of intent established in Bullock will likely provide additional grounds for discharging a contractor’s pension withdrawal liability notwithstanding Section 523(a)(4) in future cases.

I Trust You, but Not Technically

In In re Mele, 501 B.R. 357 (9th Cir. BAP 2013), the BAP ruled that a property allocation judgment arising from marital dissolution proceedings in Washington is dischargeable notwithstanding Bankruptcy Code Section 523(a)(4).  In Mele, the separated husband spent the spouses’ $274,000 retirement savings (including spending hundreds of dollars on comic books) and stopped paying child support, all apparently in violation of a family court order.  Accordingly, the family court awarded the wife a judgment for return of her interest in the funds.  The husband commenced a chapter 13 bankruptcy case, and the bankruptcy judge ruled in favor of the wife in her nondischargeability action.

The BAP reversed and remanded in light of the subsequent change in the law represented by Bullock.  Although the family court disapproved of the husband’s actions, it did not make any findings as to his mental state, and the bankruptcy court applied the former, lower standard in finding that there was a defalcation.

More fundamentally, the BAP reversed on the grounds that a marriage under Washington law does not constitute a technical trust.  Crucial to the BAP’s ruling was a Washington statute governing when and how a trust is created, which is not applicable to marriages.  Revised Code of Washington Section 11.98.008.  Although Washington case law describes the fiduciary duties of spouses as a confidential relation of trust, the BAP found no authority holding that a marriage constitutes an actual trust.

The outcome would probably have been different under California law.  Specifically, California Family Code Section 721(b) provides that spouses owe a “duty of the highest good faith and fair dealing….  This confidential relationship is a fiduciary relationship subject to the same rights and duties of nonmarital business partners….”  As discussed above, partners are trustees under California law within the meaning of Section 523(a)(4).  Ragsdale780 F.2d 794; see also Lam v. Lam (In re Lam), 364 B.R. 379, 383-384 (Bankr. N.D. Cal. 2007).

#Trending

In all of these cases, the debt was dischargeable notwithstanding Section 523(a)(4) because the existence of an express or technical trust could not be established.  This is in addition to the heightened standard for defalcation after Bullock.  The trend appears to be hewing more closely to the classical understanding of Section 523(a)(4) as barring discharge of a claim for the return of assets taken out of trust in a literal sense.


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Reno F.R. Fernandez III is a partner with Macdonald Fernandez LLP, a bankruptcy, turnaround and insolvency litigation firm with offices in San Francisco and Modesto, California.  Mr. Fernandez is also the chair of BASF’s Commercial Law & Bankruptcy Section.


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