Circuit Split Continues: The Application of Section 523(a)(4) of the Bankruptcy Code to Statutory Fiduciary Duties

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1 Circuit Split Continues: The Application of Section 523(a)(4) of the Bankruptcy Code to Statutory Fiduciary Duties Ri c h a r d J. Co r b i Introduction Recently, the U.S. Supreme Court denied certiorari of a decision from the Sixth Circuit Court of Appeals, In re Bucci. 1 The Sixth Circuit affirmed the bankruptcy court and district court decisions that held that section 523(a)(4) of the Bankruptcy Code does not apply when an employer fails to contribute to employee benefit funds under the Employee Retirement Income Security Act of 1974 (ERISA). 2 Analysis of In re Bucci In Bucci, Charles S. Bucci (Debtor) signed a collective bargaining agreement in 2003 that required his company to make monthly contributions to pension and fringe benefit funds (Funds). 3 The Debtor failed to make the required contributions to the Funds for a year. 4 The Debtor filed for Chapter 7 bankruptcy protection in Various Funds filed an adversary proceeding against the Debtor arguing that the Debtor s debt to the Funds could not be discharged pursuant to section 523(a) (4) of the Code. 6 Section 523(a)(4) of the Code provides: A discharge under section 727 of this title does not discharge an individual debtor from any debt for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny. The Debtor was the president and sole shareholder of Floors by Bucci, Inc. (Floors). 7 The collective bargaining agreement the Debtor entered into with the Northeast Ohio Carpenters Union required him to make monthly contributions to pension, hospitalization, and annuity funds. 8 The author is an associate in the Bankruptcy & Restructuring group of the New York City office of Proskauer Rose LLP and may be reached at rcorbi@proskauer.com. The author would like to thank Professor Richard Lieb of the St. John s University School of Law LL.M. in Bankruptcy Program and of Cooley Godward Kronish LLP of New York City for his guidance. 253

2 254 Norton Journal of Bankruptcy Law and Practice [Vol. 18 # 2] Moreover, the Debtor was required to withhold union dues and vacation benefits from employees wages. 9 When the Debtor filed for Chapter 7 bankruptcy in January 2005, the Debtor scheduled $99,000 debt to the Funds for unpaid employer contributions and withholdings. 10 On April 11, 2005, the Funds filed an adversary proceeding against the Debtor, alleging that the Debtor should be treated as the alter ego of Floors because he acted as the only officer and director of Floors, made all the corporate decisions, owned 100% of Floors stock, and ignored corporate separateness from his personal affairs. 11 The complaint further alleged that, from March 2003 to May 2004, the Debtor failed to remit union dues and vacation benefits that he withheld from employee wages. 12 The Funds sought a declaratory judgment that the Debtor s unpaid contributions and withholdings were not dischargeable in a bankruptcy case because they qualified as debts from defalcation and embezzlement under section 523(a)(4) of the Code. 13 The bankruptcy court for the Northern District of Ohio found that the unpaid employer contributions were not debts from defalcation because the Debtor did not act as a fiduciary of the contributions. 14 The bankruptcy court held that although the Debtor had a contractual obligation to pay the contributions, the Debtor did not act as a trustee to the Funds. 15 As a result, the bankruptcy court held that the embezzlement provision of section 523(a)(4) of the Code did not apply because the Debtor s failure to pay contractual obligations did not amount to embezzlement. 16 The district court affirmed the bankruptcy court s decision and held that, based on the Sixth Circuit decision of In re Blaszak, 17 the defalcation provision of section 523(a)(4) of the Code does not apply unless a debtor holds the money in trust. 18 The Funds appealed to the Sixth Circuit Court of Appeals where the issue was whether the Debtor s debt for failure to remit employer contributions to the collective bargaining agreement is excluded from discharge as a defalcation while acting in a fiduciary capacity. 19 The Sixth Circuit first proceeded to analyze section 523(a)(4) of the Code. The court explained that a defalcation encompasses not only embezzlement and misappropriation by a fiduciary, but also the failure to properly account for such funds. 20 The Sixth Circuit, relying on Blaszak, explained that a debt is nondischargeable as a defalcation when the preponderance of the evidence establishes: (1) a pre-existing fiduciary relationship; (2) breach of that fiduciary relationship and (3) a resulting loss. 21 The court noted that the Sixth Circuit construes the term fiduciary capacity in section 523(a)(4) of the Code more narrowly than when the term is used in other circumstances. 22 The Sixth Circuit has limited the defalcation provision of section 523(a)(4) to express or

3 THE APPLICATION OF SECTION 523(a)(4) TO STATUTORY FIDUCIARY DUTIES 255 technical trusts and refused to extend it to constructive or implied trusts imposed by operation of law as a matter of equity. 23 The Sixth Circuit continued that, in order to establish the existence of an express or technical trust, a creditor must demonstrate: (1) an intent to create a trust; (2) a trustee; (3) a trust res; and (4) a definite beneficiary. 24 The Funds argued that an express trust was created under ERISA because the employer contributions were plan assets pursuant to ERISA and were therefore trust res. 25 The Funds further argued that the Debtor was an ERISA trustee because he had control over the assets by choosing to not pay contributions to the Funds. 26 The Sixth Circuit proceeded to survey the split of authority on the issue of whether being an ERISA fiduciary is sufficient to meet the fiduciary requirement of section 523(a) (4) of the Code. 27 The Sixth Circuit recounted the Eighth Circuit s Hunter v. Philpott 28 which explained that [s]imply possessing property to which an ERISA plan asserts a claim does not place one in a fiduciary relationship with the plan. 29 The Sixth Circuit again noted that it construes the term fiduciary capacity in section 523(a)(4) of the Code more narrowly than when the term is used in other circumstances. 30 The Sixth Circuit noted that the definition of fiduciary capacity does not match the definition of an ERISA fiduciary. 31 The Sixth Circuit further explained that [w]hile 523(a)(4) does not extend to someone who fails to meet an obligation under a common law fiduciary relationship the definition of a fiduciary under ERISA is broader than the common-law definition, and does not turn on formal designations such as who is a trustee. 32 Therefore, the Sixth Circuit s narrow construction of section 523(a) (4) s defalcation provision was consistent with the general rule that section 523(a) of the Code must be construed narrowly. 33 The Sixth Circuit relied on an old Supreme Court holding that it is not enough, that by the very act of wrongdoing out of which the contested debt arose, the bankruptcy has become chargeable as a trustee ex maleficio. He must have been a trustee before the wrong and without reference thereto. 34 The Sixth Circuit noted that it must examine the substance of the alleged fiduciary relationship to determine if the requirements for a defalcation are satisfied. 35 According to the Sixth Circuit, the trust relationship had to have existed prior to the act that created the debt and without reference to the debt. 36 The Sixth Circuit dismissed the Funds argument that, because the Debtor exercised control over the plan assets and contributions, he was the ERISA fiduciary. 37 The Sixth Circuit identified the flaw in the Funds argument. The act that created the debt Bucci s breach of his contractual duties to pay the employer contributions is also the exercise of control that the Funds

4 256 Norton Journal of Bankruptcy Law and Practice [Vol. 18 # 2] allege made Bucci an ERISA fiduciary. But for a trust relationship to satisfy 523(a)(4), the alleged fiduciary must have duties that preexist the act creating the debt. 38 Here, the Debtor only had a contractual obligation to pay the employer contribution to the Funds. 39 No evidence was introduced that the Debtor was the trustee of the employer contributions. 40 Therefore, according to the Sixth Circuit Court of Appeals, the contractual obligation was not enough to satisfy the trust requirement and the fiduciary relationship requirement of the defalcation provision of section 523(a)(4) of the Code. 41 Moreover, the Sixth Circuit also held that the embezzlement provision of section 523(a)(4) of the Code did not apply because a breach of contract, without more, is not considered embezzlement. 42 Because the Debtor was not entrusted with the unpaid employer contributions, the embezzlement provision of section 523(a)(4) did not apply. 43 A Sampling of the Circuit Split The following case illustrates how other circuits have reached different conclusions on similar facts from the Bucci case. The Ninth Circuit Court of Appeals, in In re Hemmeter, 44 reached the opposite conclusion of the Bucci court and held that the fiduciary relationship between ERISA fiduciaries and employees that are ERISA plan beneficiaries creates a technical trust. 45 In Hemmeter, a breach of fiduciary duty claim was brought under ERISA when a company, Morrison Knudsen Corporation (MKC), had 401(k) and Employee Stock Ownership Plans (ESOP) that were invested in the MKC s own shares. 46 Because the 401(k) and ESOP plans were invested in MKC, the value of the plans eventually became worthless when MKC s stock prices plummeted. 47 Christopher Hemmeter, a member of the MKC board of directors, eventually filed Chapter 7 bankruptcy for reasons unrelated to MKC s economic meltdown. 48 The 401(k) and ESOP plan participants sued members of the MKC board of directors for breach of fiduciary duty. 49 The 401(k) and ESOP plans participants filed an adversary proceeding in Hemmeter s Chapter 7 bankruptcy, seeking a declaratory judgment that the losses associated with the ESOP and 401(k) plans were nondischargeable debts pursuant to section 523(a)(4) of the Bankruptcy Code. 50 The issue before the Ninth Circuit was whether fiduciaries under ERISA also constitute fiduciaries under section 523(a)(a) of the Bankruptcy Code. 51 First, the Ninth Circuit explained that Hemmeter was a fiduciary within the provisions of ERISA because Hemmeter was a member of the MKC board of directors, which was the named fiduciary under the ESOP plan. 52 Second, although Hemmeter was not a named

5 THE APPLICATION OF SECTION 523(a)(4) TO STATUTORY FIDUCIARY DUTIES 257 fiduciary under the 401(k) plan, Hemmeter was a member of the MKC board of directors when it wrongfully transferred assets of the 401(k) plan by investing it in MKC s stock. 53 As a result, the Ninth Circuit concluded that Hemmeter met the prerequisites to be considered a statutory fiduciary to qualify as a fiduciary under section 523(a)(4) of the Bankruptcy Code. 54 Conclusion The Supreme Court s declination to resolve a circuit split will continue to confront courts until the Supreme Court reviews the issue anew or until Congress amends section 523(a)(4) of the Code. NOTES 1. In re Bucci, 493 F.3d 635, 48 Bankr. Ct. Dec. (CRR) 113, 41 Employee Benefits Cas. (BNA) 1544, Bankr. L. Rep. (CCH) P 80971, 2007 FED App. 0251P (6th Cir. 2007), cert. denied, 128 S. Ct. 2903, 171 L. Ed. 2d 841, 44 Employee Benefits Cas. (BNA) 1288 (2008). 2. Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at In re Blaszak, 397 F.3d 386, 2005 FED App. 0051P, 15 A.L.R. Fed. 2d 793 (6th Cir. 2005). 18. Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at 639 (citations omitted). 21. Bucci, 493 F.3d at 639 (citations omitted). 22. Bucci, 493 F.3d at 639 (citations omitted). 23. Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Hunter v. Philpott, 373 F.3d 873, 43 Bankr. Ct. Dec. (CRR) 57, 52 Collier Bankr. Cas. 2d (MB) 634, 32 Employee Benefits Cas. (BNA) 2994, Bankr. L. Rep. (CCH) P 80126, 17 A.L.R. Fed. 2d 713 (8th Cir. 2004).

6 258 Norton Journal of Bankruptcy Law and Practice [Vol. 18 # 2] 29. Bucci, 493 F.3d at 641 (quoting Hunter v. Philpott, 373 F.3d 873, 876, 43 Bankr. Ct. Dec. (CRR) 57, 52 Collier Bankr. Cas. 2d (MB) 634, 32 Employee Benefits Cas. (BNA) 2994, Bankr. L. Rep. (CCH) P 80126, 17 A.L.R. Fed. 2d 713 (8th Cir. 2004)). 30. Bucci, 493 F.3d at 641 (citations omitted). 31. Bucci, 493 F.3d at Bucci, 493 F.3d at (citations omitted). 33. Bucci, 493 F.3d at 641 (citations omitted). 34. Bucci, 493 F.3d at 641 (quoting Davis v. Aetna Acceptance Co., 293 U.S. 328, 333, 55 S. Ct. 151, 79 L. Ed. 393 (1934)). 35. Bucci, 493 F.3d at Bucci, 493 F.3d at 641 (citations and quotations omitted). 37. Bucci, 493 F.3d at Bucci, 493 F.3d at 643 (citations omitted). 39. Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at Bucci, 493 F.3d at In re Hemmeter, 242 F.3d 1186, 37 Bankr. Ct. Dec. (CRR) 172, 25 Employee Benefits Cas. (BNA) 2590, Bankr. L. Rep. (CCH) P (9th Cir. 2001). 45. Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at Hemmeter, 242 F.3d at 1190.