Persistent Confucion: The Circuit Split Over the Exception to Discharge for Defalcation Under 11 U.S.C. §523(a)(4)

Abstract

Section 523(a)(4) of the Bankruptcy Code provides one of several exceptions to the discharge of debts that an individual debtor enjoys in bankruptcy. Specifically, that provision contains an exception to a debtor’s discharge “for . . . defalcation while acting in a fiduciary capacity . . . .” This provision regulates an area of personal bankruptcy law where the financial insolvency of the individual debtor intersects with his responsibility for some aspect of the financial dealings of the party to whom he owes a fiduciary duty. Particularly in the wake of recent corporate scandals and the current economic downturn, the ability of beneficiaries to recover from individual debtor-fiduciaries whose acts of defalcation have cause them economic loss can serve as an important remedy for and deterrent to carelessness and malfeasance. While the § 523(a)(4) exception to discharge may protect the victim of a debtor’s defalcation, it must be balanced with the countervailing purpose of the bankruptcy laws to provide an honest but unfortunate debtor with a fresh start. Part of a curt’s analysis in determining the applicability of the defalcation exception entails consideration of the level of intent with which an act of defalcation must be committed in order to qualify for the exception to discharge under § 523(a)(4). In September 2007, after reviewing what is called “persistent confusion” among its sister circuits in determining what exactly a defalcation entails, the U.S. Court of Appeals for the Second Circuit, in the case of In re Hyman, held that the exception to discharge for defalcation “requires a showing of conscious misbehavior or extreme recklessness . . . .” The First Circuit had previously adopted this standard. This Note argues that rather than the extreme recklessness standard of defalcation adopted by the First and Second Circuits or the innocent mistake standard of the Fourth, Eight, and Ninth Circuits, the Supreme Court of the United States, if confronted with the circuit split should adopt a mens rea standard modeled on the business judgment rule common to corporate law, which reflects the consensus of the Firth, Sixth, and Seventh Circuits that more than an innocent mistake is necessary for an act of misappropriation to constitute a defalcation. This willful neglect/recklessness standard makes the most interpretive sense in light of the goals of the Bankruptcy Code in general and of the structure and logical consistency of § 523 in particular.