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Making Sense of Bankruptcy: Discharging a Debt Owed for Committing Fraud in a Fiduciary Capacity

You may not be able to write off debts “for fraud or defalcation while acting in a fiduciary capacity.” Should this concern you?

Here’s the sentence that we’re explaining today:

In a Chapter 7 or 13 bankruptcy case you may be challenged in your attempt to discharge (write off) a claim arising out of “fraud” or “defalcation” while acting in a fiduciary capacity.

Challenges to Discharge Under Either Chapter 7 or Chapter 13

In the last few blog posts we’ve been looking at types of debts which might not be discharged—legally written off—in bankruptcy. You may have heard that more types of debts can be discharged in one kind of consumer bankruptcy—specifically Chapter 13 “adjustment of debts”—than in Chapter 7 “straight bankruptcy.”

But that’s mostly outdated information. For decades since the late 1970’s, Chapter 13 provided what came to be called a “super-discharge” because of the various kinds of debts that could not be discharged under Chapter 7 but could under Chapter 13. But over the years Congress kept cutting back on this Chapter 13 advantage little by little until there are now very few debts that can be discharge only in a Chapter 13 case.

Specifically for a long time the discharge of debts arising from “fraud or defalcation while acting in a fiduciary relationship” could not be challenged by the creditor under Chapter 13. But that’s changed. The last major overhaul to the bankruptcy laws in 2005 gave creditors the ability to raise this challenge under both of the two major consumer bankruptcy options, Chapter 7 AND Chapter 13.

“Challenges to Discharge”

We keep using the words “challenges to discharge” because debts arising from “fraud or defalcation while acting in a fiduciary capacity” in fact CAN BE AND ARE discharged IF NOT timely CHALLENGED.

Certain kinds of debts do not get discharged as a matter of law without the creditor needing to take any action to make that happen. If you owe back child support or recent income taxes, those simply are not discharged in bankruptcy. But like other types of debts covered in the last couple earlier blog posts, “fiduciary capacity” debts ARE discharged if the creditor-claimant fails to challenge dischargeability by the deadline given by the bankruptcy court.

Assuming the creditor on a “fiduciary capacity” debt has received appropriate notice of the debtor’s bankruptcy case (usually by being listed on the debtor’s creditor schedules filed at court with the bankruptcy petition), this creditor has a very short time to raise its challenge to discharge. Its deadline to do this is only about three months after the bankruptcy case is filed, and must do so by filing a formal complaint with the bankruptcy court. If the creditor fails to file a complaint on time, it loses its chance to do so ever again.

“Fraud or Defalcation”

Fraud is basically cheating someone. For a debtor to commit fraud requires him or her to 1) make a statement or representation, 2) which the debtor knows at the time is false and 3) makes it for the purpose of deceiving the creditor, 4) who then relies on debtor’s statement/representation, and 5) as a result gets damaged (by losing money, usually).

Defalcation is basically embezzlement. For a debtor to commit a defalcation requires 1) the presence of a pre-existing fiduciary relationship between creditor and debtor in which the debtor holds funds for the creditor, 2) debtor’s breach (breaking) of that fiduciary relationship, and 3) the creditor’s resulting financial loss from that breach.

While “Acting in a Fiduciary Capacity”

As you can see this component is already incorporated into the meaning of “defalcation.” But generally, someone with fiduciary capacity has the right and responsibility to act on behalf of another through a relationship of trust.

People with fiduciary capacity potentially include a partner as to the partnership and each of the other partners, a real estate broker towards the buyer and/or seller she is contracted with, and the executor of a decedent’s estate towards the beneficiaries, and the corporate officers and directors of an insolvent corporation towards the corporation’s creditors.

Defrauding someone or embezzling from someone with whom the debtor has a fiduciary relationship enables that someone to challenge the discharge of his or her losses from the fraud or embezzlement.