Samuels v. Ellenbogen (In Re Ellenbogen)Samuels v. Ellenbogen (In Re Ellenbogen)
DECISION ON CLAIM UNDER 11 U.S.C. § 523(a)(4)
Plaintiff Daniel Samuels (“Samuels”) filed this adversary proceeding against debtor Paul Ellenbogen (“Ellenbogen”) to declare non-disehargeable Ellenbogen’s debt to Sam-uels. The debt is based on a decision and judgment of the Surrogate’s Court, West-chester County, which held Ellenbogen liable for negligent performance of his duties as a fiduciary.
Samuels has moved for summary judgment based on the complaint, the Surrogate’s Court decision and judgment and a statement of material facts which Ellenbogen does not dispute. The sole issue presented on this motion is whether a fiduciary’s negligence constitutes “defalcation” under 11 U.S.C. § 523(a)(4). This Court holds that the term “defalcation” as used in section 523(a)(4) does not include mere negligent conduct on the part of a fiduciary. Therefore, Ellenbogen’s debt is dischargeable in bankruptcy.
The Court has jurisdiction of this core proceeding under 28 U.S.C. §§ 1334(a) and 157(a) and (b)(2).
Background
Ellenbogen was the trustee of an express trust established for Samuels, as life beneficiary, and Samuels’ children. Wfiien Ellenbo-gen assumed the trusteeship, the trust corpus valued approximately $194,000. In an attempt to increase income for the life beneficiary, Ellenbogen made several high-risk investments with trust funds. In June 1987 he invested $30,000 at 15% interest in the Gouverneur Commons Limited Partnership, a builder of townhouses in Newark, New Jersey. This investment generated about $6,500 of income before Gouverneur collapsed resulting in a complete loss of the $30,000 principal. The Surrogate’s Court concluded that:
[tjhere is no persuasive evidence on this record that the investment, viewed objectively as of the time it was made, was unnecessarily risky or imprudent. While, as a mattеr of hindsight, the investment should not have been made, the court cannot hold petitioner to a standard of investment infallibility or to imbue him with a foreknowledge of events, (citations omitted)
Decision of the Surrogate’s Court, Westches-ter County, at 3 (June 17, 1994) (file no. 1980/3689) (Emanuelli, S.). Ellenbogen was surcharged by the Surrogate’s Court for two improvident investments. One was a personal loan of $4,500 to an unrelated individual. The Surrogate’s Court found this “unsecured personal loan to be among the riskiest and most imprudent of investments” and held that the loan “was a violation of the trustee’s duty of prudent investing.” Id. at 5.
The other improvident investment was a loan of $100,000 to another unrelated individual secured by a third mortgage. The borrower was to repay the principal of the loan in six months at a 16% interest rate. The loan was subordinate to first and second mortgages totaling $600,000. The borrower defaulted, and the trust fund recovered only $14,000 of the $100,000 loan. The Surrogate’s Court found as follows:
Obviously the trust did not have the financial ability to buy out the superior mortgages if either, or both, of those loans went into default. It appears that the trustee ignored negative items contained in the mortgagor’s credit report, relying instead on personal assurances of the mortgagor’s credit-worthiness made by the attorney/mortgage broker who solicited the loan and who had a personal financial interest in the making of the loan. It appears further that the trustee’s assessment of the mortgagor’s net worth was based in large part on his holdings in substantially-leveraged real estate and not discounted for the declining real estate market. The *711 court credits the testimony of the respondent’s expert, a certified financial planner, to the effect that the inherently risky nature of third mortgage loans makes them wholly inappropriate fiduciary investments. The court finds that the making of the third mortgage loan by the petitioner-trustee was improvident and negligent and in violation of the “prudent man” rule of fiduciary investment. [Ellenbogen] must be surcharged for the losses incurred by the trust as the result of the making of this loan.
Id. at 4-5.
The meaning of “defalcation”
Section 523(a)(4) of the Bankruptcy Code provides that a discharge under section 727 does not discharge an individual debtor from any debt
(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.
The meaning of “defalcation” in section 523(a)(4) is a matter of federal law.
Otto v. Niles (In re Niles),
There is apparent conflict among the federal decisions in the interpretation of defalcation. Some courts have held that the term impliеs at least some element of consciously wrongful or reprehensible conduct. Others have stated that defalcation comprehends “innocent” failure of a trustee to account 1 for trust funds and that mere negligence or mistake is sufficient to hold a debt non-dis-chargeable under section 523(a)(4).
The leading case in the Second Circuit is
Central Hanover Bank & Trust Co. v. Herbst,
Colloquially perhaps the word, “defalcation,” ordinarily implies some moral dereliction, but in this context it may have included innocent defaults, so as to include all fiduciaries who for any reason were short in their accounts.... Whatever was the original meaning of “defalcation,” it must have covered other defaults than de *712 liberate malversations, else it added nothing to the words, “fraud or embezzlement.” * * * * * *
In the case at bar the bankrupt had not been entirely innocent — not, for instance like the victim of an employee — though possibly one may acquit him of deliberate wrongdoing. A judge had awarded him the money, and prima facie he was entitled to it; but he knew, or if he did not know, he was charged with notice ... that the order would not protect him if it were reversed; and that it might be reversed until the time to appeal had expired.... We do not hold that no possible deficiency in a fiduciary’s accounts is dischargeable; In re Bernard,87 F.2d 705 , 707, we said that “the misappropriation must be due to a known breach of the duty, and not to mere negligence or mistake.” Although that word probably carries a larger implication of misconduct than “defalcation,” “defalcation” may demand some portion of misconduct; we will assume arguendo that it does.
All we decide is that when a fiduciary takes money upon a cоnditional authority which may be revoked and knows at the time that it may, he is guilty of a “defalcation” though it may not be a “fraud,” or an “embezzlement,” or perhaps not even a “misappropriation.”
Id. at 511-12.
Surely there is grist in the
Herbst
decision for both sides of the argument whether defalcation includes innocent or merely negligent conduct, or requires some element of malfeasance. Thus, the statement in
Herbst
that “in this context it [defalcation] may have included innocent defaults, so as to include all fiduciaries who for any reason were short in their accounts” has been cited as precedent, or is similar to like statements, in a number of decisions.
2
However, the remainder of the above-quoted passage from the
Herbst
decision suggests a contrary rule in the Second Circuit — that “defalcation” demands proof of some element of misconduct. Thus, the Court noted that the conduct of Herbst “had not been entirely innocent,” and the Court made clear that “[w]e do
not
hold that no possible deficiency in a fiduciary’s accounts is dischargeable” (emphasis supplied). The Court then quoted its decision in
In re Bernard,
A number of authorities have followed the narrower interpretation of defalcation expressed in the latter portion of the
Herbst
quotation.
See, e.g., Meyer v. Rigdon,
36
*713
F.3d at 1384-85 (“a mere negligent breach of a fiduciary duty is not a ‘defalcation’ ”);
see also Moreno v. Ashworth (In re Moreno),
Since debts аrising from breaches of ordinary care are normally dischargeable in bankruptcy and exceptions to discharge are strictly construed in favor of debtor, Some degree of culpability is required to make a debt non-disehargeable as a, defalcation under section 523(a)(4).
4
Collier on Bankruptcy,
§ 523.10 [1] [b] (15th ed. rev.1996). To the same effect,
see Black’s Law Dictionary
at 504, 505 (4th ed. 1951) (“Colloquially, perhaps, the word ‘defalcation’ ordinarily implies some moral dereliction. As used in the Bankruptcy Act, it may demand some portion of misconduct, but it is not synonymous with ‘embezzlement’ ”).
But see Norton Bankruptcy Law and Practice 2d,
§ 47:27 (1997) (“[Defalcation involves the slightest misconduct and indeed may not involve misconduct at all”). The
Collier
footnote supporting the quotation above also cites the Ninth Circuit B.AP. decision in
In re Martin,
Other than the Ninth Circuit, it appears that the circuit courts have tended to conclude that mere negligence does not suffice for defalcation without some element of willfulness or other misconduct such as violation of law, while a larger number of. district and bankruptcy courts have stated that merely negligent conduct may constitute defalcation. For eases holding that mere negligence does not meet the minimum level of culpability required for defalcation
see Meyer v. Rigdon,
Black’s Law Dictionary 1599 (6th ed.1990) defines “willful” as “[proceeding from a conscious motion of the will; voluntary; knowingly; deliberate. Intending the result which actually comes to pass; designed; intentional; purposeful; not accidental or involuntary.” According to Black’s, “[a] willful act differs essentially from a negligent act.” Id.
Meyer,
Actually, the conflict between those cases which state that defalcation may include innocent conduct or mere negligence and those which hold that some element of misconduct is necessary may be more apparent than real, because the former cases almost invariably involve conduct which is not innоcent, such as that described by the Second Circuit in the
Herbst
case. Indeed, no case has been discovered where it clearly appears that a court denied a debtor discharge for a defalcation for truly innocent or merely negligent conduct. For example: in
Peerless Insurance Co. v. Casey (In re Casey), supra,
the defendant-debtor could not account for
(i.e.,
could not explain the disappearance of) $138,-390 of lottery sales receipts which he held as a trust fund; in
Semilof v. Waskew (In re Waskew), supra,
the defendant-debtor, a home builder, could not account for his disposition of $34,579 of funds paid to him and held by him in trust under the New York Lien Law; in
Stone v. Stone (In re Stone),
The mere failure to meet an obligation while acting in a fiduciary capacity simply does not rise to the level of defalcation....
... the funds were merely lost because the venture turned out to be a poor investment. Because all funds in this case werе properly accounted for, no defalcation occurred, and the debt is dischargeable under Chapter 7 of the Bankruptcy Code.
Id. at 179,180.
Likewise, the court in
Kinsler v. Pauley (In re Pauley),
The Plaintiffs do not make any allegations that the Pauleys misappropriated funds raised from the investors by failing to use the proceeds to drill for oil. There is no evidence in the record which even suggests that the Pauleys absconded with any money by placing it in their personal accounts. Nor is there any evidence that the Pauleys improperly failed to account for the funds that were invested_However, even assuming that Plaintiffs did not receive any returns and lost all of the monies they invested, this fact alone would not constitute a. “defalcation” on the part of the Pauleys. Just because an investment proves unsuccessful does not mean that there was a “defalcation” within the meaning of section 523(a)(4).
This conclusion is consistent with other cases decided in this district in which courts have refused to find that losses on investments were nondischargeable under section 523(a)(4).
Id. (citations omitted; emphasis in original).
On the record before the Court, this case presents squarely for decision the question whether mere negligence of a fiduciary constitutes defalcation within the meaning of section 523(a)(4) so as to warrant denial of discharge. The Surrogate’s Court found two of Ellenbogen’s investments of trust funds to be “improvident and negligent and in violation of the ‘prudent man’ rule of fiduciary investment” (Decision at 5). But there is no intimation of bad faith or willful misconduct on Ellenbogen’s part in the Surrogate’s decision or elsеwhere in the record before this Court. Indeed, the decision notes that El-lenbogen had testified “that Daniel Samuels, the income beneficiary of the trust, was dissatisfied with the conservative investment *716 approach taken by the previous trustees. Mr. Samuels is alleged to have instructed petitioner to seek investments with a higher interest yield” (Decision at 1-2), and the Surrogate concluded that “[i]t is also clear that investments were made with a view toward maximizing income at the expense of trust preservation” and that “the trustee’s action would hаve to be deemed negligent and improvident” (id. at 6).
Lacking definitive precedent to the contrary in the Second Circuit, this Court holds that mere negligence, without some element of intentional wrongdoing, breach of fiduciary duty or other identifiable misconduct, does not constitute “defalcation” within the meaning of section 523(a)(4). This result accords with customary principles of statutory interpretation and with the over-arching objectives of the Bankruptcy Code.
It is an accepted rule of statutory interpretation that words used in a statutе should be accorded their normal dictionary meanings in accordance with accepted custom and usage.
See Aquarius Marine Co. v. Pena,
The word “defalcation,” in ordinary and customary usage, undoubtedly connotes some element of misconduct beyond mere negligence. For example, “defalcation” has been defined as follows: Oxford English Dictionary at 369 (2d ed.1989) (“a monetary deficiency through breach of trust by one who has the management or charge of funds; a fraudulent deficiеncy in money matters; also concr. (in pi), the amount so misappropriated”; “defalcator: one guilty of defalcation; one who has misappropriated money or other property committed to his care”); Funk and Wagnalls — New “Standard” Dictionary of the English Language at 668 (1951) (“an embezzlement or fraudulent appropriation of money held in trust; a deficiency caused by breach of trust”); Webster’s Third New International Dictionary of the English Language Unabridged at 590 (vol. I 1965) (“3a: misappropriation of money in one’s keeping: b: a sum of money so misappropriated”). See also the quotations from the Second Circuit decision in Herbst, Collier and Black’s Law Dictionary set forth above. To con *717 strue defalcation to mean mere negligence would conflict with the meaning attributed to the word in common parlance and in virtually every authoritative source.
It would also conflict with the fundamental objectives of the bankruptcy laws in this country. In one of the earliest Supreme Court decisions dealing with the Bankruptcy Act. Justice Day commented:
Systems of bankruptcy are designed to relieve the honest debtor from the weight of indebtedness which has become oppressive, and to permit him to have a fresh start in business or commercial life, freed from the obligation and responsibilities which may have resulted from business misfortunes.
Wetmore v. Markoe,
It follows that non-dischargeability is “perceived to be a punitive exception to the ‘fresh start’ policy and should be found reluctantly.”
Matter of Martonak,
See also REL Commercial Corp. v. Materetsky (In re Materetsky),
The rule or maxim of
ejusdem generis
further supports the narrower interpretation of defalcation. The other operative words used in section 523(a)(4) — fraud, embezzle
*718
ment and larceny — all relate to affirmative misconduct by the debtor. Indeed, the same may be said for all of the exceptions to discharge under section 523(a) which are based upon the debtor’s conduct
(viz,
subsection (2) fraud, (6) willful and malicious injury, (9) death or injury resulting from driving while intoxicated with alcohol or drugs, (12) malicious and reckless failure). In defining the term “misappropriation” under the predecessor statute of section 523(a), using language equally applicable to defalcаtion, the Second Circuit in
In re Bernard,
Counsel for Ellenbogen will settle an order dismissing the adversary proceeding.
Notes
. There is some ambiguity in the word "account” which may contribute to the aрparent conflict among the courts. If “to account” is used in the sense of to produce and pay over when called upon to do so, a failure to account in this sense may result (1) from some cause of which the fiduciary is entirely innocent (e.g., the unpredictable failure of a bank or other investment vehicle, or loss of the trust res by an act of God), or (2) from conduct of the trustee which is negligent but not morally reprehensible or violative of some basic fiduciaiy obligation (other than reasonable care), or (3) from аctual malfeasance of the trustee. On the other hand, if failure "to account” is used in the sense of a trustee’s failure to explain the disappearance of trust assets, this alone constitutes malfeasance, for a fiduciary must be able to explain what he did with the properly entrusted to him. Stated differently, a trustee's failure to explain what became of trust assets can never be characterized as innocent or merely negligent.
.
See, e.g., Stone v. Stone (In re Stone),
. For lower court cases stating that mere negligence suffices to establish defalcation,
see In re Tripp,