Tuesday, July 19, 2016
"Defalcation" is "a word that only lawyers and judges could love," according to a recent decision of the U.S. Court of Appeals for the Seventh Circuit. In re Jahrling, No. 15-2252, Slip Op. at 5 (7th Cir. Mar. 18, 2016). Congress first used the term in a federal bankruptcy statute enacted in 1867 shortly after the end of the Civil War, and "legal authorities have disagreed about its meaning ever since." Id. (citing Bullock v. BankChanpaign, 133 S. Ct. 1754 (2013).
The Jahrling case involved a claim not for fraud, but for defalcation -- something less than fraud or embezzlement but something greater than negligence or mistake. In Jahrling, the Seventh Circuit affirmed a bankruptcy court ruling that a legal malpractice judgment was not dischargeable in bankruptcy because the judgment was for a "defalcation while acting in a fiduciary capacity." The lawyer had prepared closing documents for a real estate transaction for a 90-year-old man who sold his $106,000 home for just $35,000 on the understanding that he would keep a life estate in the property. All well and good, but the lawyer forgot to include the life estate for the man when he drafted the documents. The man spoke only Polish and could not read the closing documents. When the buyers tried to evict the man after the sale, he sued for legal malpractice but died before that case went to trial. The estate pursued the action and obtained a malpractice judgment against the lawyer, who tried to have it discharged in bankruptcy.
The Supreme Court said that defalcation requires proof of "a culpable state of mind . . . involving knowledge of, or gross recklessness to, the improper nature of the relevant fiduciary behavior." 133 S. Ct. at 1757. The Supreme Court also said that defalcation can also be used "to refer to nonfraudulent breaches of fiduciary duty." Id. at 1759.
The bankruptcy court refused to discharge the debt because the judgment was for a "defalcation while acting in a fiduciary capacity." The Seventh Circuit affirmed that ruling, and affirmed that "defalcation" was a word that "only lawyers and judges could love."