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High Court Takes Pass on Circuit Split Over Defalcation Case

By Rudolph J. Di Massa, Jr. and Adrian C. Maholchic
February 6, 2009
The Legal Intelligencer

High Court Takes Pass on Circuit Split Over Defalcation Case

By Rudolph J. Di Massa, Jr. and Adrian C. Maholchic
February 6, 2009
The Legal Intelligencer

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On Jan. 12, the Supreme Court denied a petition for writ of certiorari to resolve the split among circuit courts over the interpretation of "defalcation" for dischargeability purposes. In the case of Denton v. Hyman, (In re Hyman), the 2nd U.S. Circuit Court of Appeals held that the conduct of the debtor, in his capacity as fiduciary, did not rise to the level of defalcation under 11 U.S.C. § 523(a)(4). The court determined that defalcation required a showing of conscious misbehavior or extreme recklessness. It reasoned that the state court judgment, which included findings that the debtor had breached his fiduciary duty and misappropriated property, lacked the necessary factual determinations regarding intent. Consequently, it held that the debtor was not collaterally estopped from litigating the claim of defalcation.

The Facts

In 1984, the debtor, Andrew Hyman, and George W. Denton worked for an insurance agency representing the Guardian Life Insurance Co. of America. The agency marketed Guardian life insurance products through pension plans that were administered through National Pension Services Inc., a separate company affiliated with the insurance agency, according to court documents.

By 1988, Hyman and Denton purchased the agency business from the original owner and formed three companies: the Denton-Hyman Agency, or DHA; a separate pension administration company, also called National Pension Services Inc., or NPS; and a company devoted to generating business for the agency, National Pension Actuaries, or NPA. Guardian's business transitioned to DHA under a new agency agreement and continued subject to termination if either Hyman or Denton left the business. Both partners obtained 50 percent ownership in the three entities, served as directors and executive officers of the entities, and jointly and severally guaranteed approximately $1.6 million in indebtedness incurred in connection with starting up the businesses, according to court documents. Within this business organization, only DHA was profitable. NPS operated at a loss, and the returns from NPA were negligible.

In 1989, Denton died and Hyman succeeded him as president and sole director of the three companies, as noted in court documents. Because of Denton's death, the agreement with Guardian automatically terminated, and neither DHA nor the Denton estate was contractually permitted to become party to any agency agreement with Guardian. Thereupon, Hyman formed the Andrew A. Hyman Agency, or AHA, to serve Guardian under a new agreement. Hyman continued to run the companies, and used both NPA and NPS to generate business for AHA.

In order to liquidate the $1.6 million startup debt, Hyman used commission income earned by DHA that accrued after Denton's death, as well as earnings from AHA. In 1994, the agreement between Guardian and AHA terminated, according to court documents. By that time, however, the $1.6 million startup debt had been fully liquidated. During the period from 1989-1994, in the absence of a shareholder agreement providing for the buyout of Denton's share of the business, Hyman negotiated unsuccessfully with Denton's executor for the purchase of DHA, NPS and NPA. The negotiations ceased in 1994 with the termination of AHA's agency agreement with Guardian.

In March 1994, Denton's executor sued Hyman in the Westchester County Surrogate's Court asserting a derivative claim to recover profits earned by AHA through the exploitation of the jointly owned companies and damages resulting from the diversion of corporate assets. In 2002, the Surrogate's Court found that Hyman had breached his fiduciary duty by co-opting the jointly owned companies for his personal enrichment and for the benefit of AHA. In April 2003, the Surrogate's Court entered judgment against Hyman in the amount of $2.7 million for profits earned by AHA after Denton's death.

In February 2003, Hyman filed for protection under Chapter 11 of the Bankruptcy Code. In July 2004, the case was converted to a case under Chapter 7 after the appellate division affirmed the Surrogate's Court decision. Denton's executor filed a claim in the bankruptcy case in the amount of the Surrogate's Court judgment and subsequently commenced an adversary proceeding against Hyman seeking a declaration that the claim was non-dischargeable pursuant to 11 U.S.C. § 523(a)(4).

The bankruptcy court dismissed the claim of Denton's executor, finding that collateral estoppel did not apply to the claim for non-dischargeability of the outstanding judgment. According to the bankruptcy court, the factual requirements for liability under New York state law differed from those required to show "defalcation" under § 523(a)(4). The court noted that the Surrogate's Court had made no finding that Hyman committed any wrongful, illegal, or morally reprehensible act while an officer and director of DHA, which finding would have been necessary to support a claim for defalcation under the Bankruptcy Code. On appeal, the district court affirmed the decision of the bankruptcy court, and the executor appealed the case to the 2nd Circuit.

Analysis of the Court

The appellate court analyzed the elements of collateral estoppel, which requires that the issue indispensable to the disputed action be identical to the issue that was joined in the original action, and that a full and fair opportunity to litigate the issue in the original action was afforded to the party against whom the doctrine would otherwise be applied.

First, the court found that "defalcation" had not been decided by the state court. The court noted that other courts disagree over whether defalcation requires some degree of wrongful conduct, or whether the claimant need only prove a misappropriation of funds or failure to adequately account for these funds. In a previous decision, the circuit court had held that wrongful intent could be inferred by charging the debtor with the knowledge that certain actions were unlawful. However, the court found the case distinguishable and did not interpret it as holding that defalcation did not require actual intent.

In evaluating the proper standard for defalcation, the court noted that an innocent mistake was all that was required for a finding of defalcation within the 4th, 8th and 9th Circuits, while the remainder of the circuit courts appeared to require some level of misconduct. In keeping with what it saw as the underlying policy of the Bankruptcy Code to provide an honest debtor with a new beginning, the court took the position that a showing of misconduct was necessary for defalcation. More specifically, the court adopted the standard enunciated by the 1st Circuit, which held that defalcation under § 523(a)(4) required "conscious misbehavior" or "extreme recklessness" — the same showing necessary for scienter in the securities law context.

In addition, the court expressed that a scienter requirement would be consistent with the existing standards applicable to fraud, embezzlement and larceny under § 523(a)(4). Further, the standard of scienter as applied in the securities law context would provide a developed body of law, thereby facilitating application of the standard in bankruptcy cases.

Finally, the court found that the standard adopted would support the underlying goal of the Bankruptcy Code to provide a fresh start for innocent debtors. In applying the standard to the debtor in this case, the court affirmed the decision of the district court and found that the record from the Surrogate's Court contained evidence of the debtor's good faith in using proceeds from AHA to pay the mutual debts of the debtor and Denton's estate, but not of misconduct or recklessness on the part of the debtor.


While the Supreme Court has yet to decide the split among circuits over the requirements for defalcation pursuant to 11 U.S.C. § 523(a)(4), the majority of appellate courts, including the 2nd Circuit, require a showing of wrongful conduct. Still, the courts of the 4th, 8th and 9th circuits maintain that an innocent mistake can give rise to a claim of defalcation. Lawyers representing fiduciaries in those circuits would be well-advised to apprise their clients of the harsh potential of the non-dischargeability of claims arising from unintentional breaches of fiduciary duties.

Rudolph J. Di Massa, Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.

Adrian C. Maholchic is an associate with the firm and practices in the area of business reorganization and financial restructuring. He graduated from the University of Pittsburgh School of Law in 2007 where he was a member of the Pittsburgh Journal of Environmental and Public Health Law. He is admitted to practice in Pennsylvania and New Jersey.

Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.