National Association of Attorneys General
Trusts, Trustees, and Defalcation: Writing Your Own Protections into Your Bankruptcy Cases
On Oct. 29, the U.S. Supreme Court took certiorari in Bullock v. BankChampaign, N.A., 670 F.3d 1160 (11th Cir. 2012), (No. 11-1518, 81 U.S.L.W. 3228, 2012 U.S. LEXIS 8408). The case specifically deals with the issue of what is the standard for excepting a debt that arises from an act of “defalcation” by a fiduciary from discharge in a bankruptcy case. The specifics of the decision will be discussed below, but the Supreme Court’s decision to place it on their docket serves as a reminder of the many ways in which the concepts of trusts and trustee liability come into play in bankruptcy cases. A proper understanding of their role may allow states to substantially improve their position in such cases.
Bankruptcy cases, by definition, involve parties that can’t pay all their debts in full – or at least not within the time frames and under the conditions to which they had originally agreed. That inescapable fact is, in turn, why creditors resist being pulled into a bankruptcy case. When they are forced to participate, creditors want to have their claims given priority, or to have specific assets dedicated to payment of those claims, or, at a minimum, to have those claims excepted from the discharge that the debtor so fervently hopes to obtain.
The twin concepts of trust funds and trustee liability for defalcations from such funds apply in many ways under the Bankruptcy Code so as to provide many of the protections those creditors are looking for. The benefit of those concepts is especially clear for states because they can often enact laws creating the very trust funds that they then can rely upon in a later bankruptcy. That is, while bankruptcy operates as an overall federal umbrella, the vast majority of substantive determinations in those cases are based on nonbankruptcy law that creates the property rights and liabilities upon which the bankruptcy framework operates. See Butner v. United States, 440 U.S. 48, 55 (1979).
State law can, for instance, impose a particular set of rights, responsibilities, and obligations upon a party alleged to be acting as a fiduciary for certain trust funds; bankruptcy law then evaluates whether, under a uniform federal standard, that particular state-law construct creates a fiduciary relationship that the Code recognizes. Importantly, if the state law construct does not match the federal standards, the state is free to change it at any time and, thereby, change the result to match what it wants to see happen.
Property of the Estate
An example of the power of trust law principles is with respect to determining what is “property of the estate.” Under 28 U.S.C. § 1334(e), the bankruptcy court is given exclusive jurisdiction over all such property, and it is that estate property that is distributed to creditors through the bankruptcy process. Property of the estate is defined, at 11 U.S.C. § 541(a), as including “all legal or equitable interests of the debtor in property as of the commencement of the case,” but does not include “any power that the debtor may exercise solely for the benefit of an entity other than the debtor” (Section 541(b)(1)). Further, “property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest, . . . becomes property of the estate . . . only to the extent of the debtor’s legal title to such property, but not to the extent of any equitable interest that the debtor does not hold.” (Section 541(d)). In short, the cases make clear, the debtor’s estate takes all of the debtor’s rights and interests but those rights and interests are subject to any limitations thereon existing under nonbankruptcy law. See, e.g., United States v. Whiting Pools, 462 U.S. 198, 205 n. 8 (1983) (“Similar statements to the effect that § 541(a)(1) does not expand the rights of the debtor in the hands of the estate were made in the context of describing the principle that the estate succeeds to no more or greater causes of action against third parties than those held by the debtor). See H. R. Rep. No. 95-595, pp. 367-368 (1977); Ryan v. Sullivan, Hill, Lewin, Rez, Engel & Labazzo, 316 B.R. 101, 108-09 (D. D. Col. 2005) (same).
These limitations on estate property can be very helpful to the states and other non-debtor parties. To the extent that the debtor holds property in a valid trust or escrow for the benefit of others, that property does not become property of the estate and the debtor’s powers to deal with it on behalf of the beneficiaries do not fall under the bankruptcy court’s jurisdiction. See, e.g., In re Perry, 2009 Bankr. LEXIs 385 (Bankr. D. S.D. 2/12/09) (Parent holds child support payments in trust for her children; funds are not property of her estate). If the escrow agreement provides that the debtor may eventually receive some of all of the funds back, it is only those reversionary rights, not the principal of the escrow account or trust fund that becomes property of the estate. See, e.g., PNC Bank v. Spring Ford Indus. (In re Spring Ford Indus.), 338 B.R. 255, 260 (E.D. Penn. 2006).
Thus, if the consumer protection division, for instance, is holding funds for a particular set of victims until their claims are fully liquidated, then if a proper escrow is established (and after the preference period passes), those funds will not pass into the overall bankruptcy estate. Rather, they will remain pledged for the remediation of the harm to the victims. Thus, whether or not the Code grants a specific priority right to those particular claims, the creation of the escrow has that de facto effect. A similar principle protects amounts deducted by the debtor from his employees’ wages for taxes and benefits; such amounts remain outside of the property of the estate, so they must remain dedicated to their intended purpose. (Section 541(b)(7)).
It is important to realize that not all “trusts” are created equal in terms of the various Code provisions. One category of trusts are those created explicitly, with respect to an existing set of funds, based on either the consent of the parties or on obligations imposed by statute. In both cases, the trust must be created at the time the res of funds comes into existence and without regard to any conduct (or more accurately, misconduct) of the trustee. A trust that is imposed only after the fact, as a remedy for such misconduct, or as a way to ensure that funds are held for distribution to other parties, will generally not qualify for several of the special provisions discussed herein. See, e.g, Arvest Mortg. Co. v. Nail (In re Nail), 680 F.3d 1036, 1039-40 (8th Cir. 2012).
As a result, one of the most important things state law can do is to create these “in advance” trust requirements where necessary to ensure that funds are properly maintained by the debtor. States have used these statutory trusts in many circumstances. Two of the most common are with respect to lottery ticket sellers who are required to hold receipts in trust in order to protect the state’s right to payment, and general contractors who are required to hold funds received from the home buyer in trust to ensure that the payments used are actually applied to the construction of the particular home and the payment of subcontractors.
There is no “uniform law” dealing with lottery sellers or general contractor obligations. As a result, the decisions on their trust fund status vary in accordance with the different ways the laws are drafted. Among the factors that the courts consider – and that a state should take into account in drafting its law – are a) was there a written document signed by the “trustee” party (i.e., the lottery seller) accepting responsibilities to act as such; b) alternatively, did a clear statutory directive exist requiring the party to act as a trustee; c) was a specific trust res identified; d) was there a requirement imposed on the trustee to segregate the trust res in a separate account; e) did such segregation actually occur; f) was there any attempt to monitor and enforce those requirements; and g) were all of those obligations imposed at the time the trustee obtained the funds and independent of its later actions. Not every one of these requirements is absolutely required, but the more that exists the more likely it is that the relationship will be viewed as one creating the requisite advance trust.
Compare In re Thompson, 686 F.3d 940 (8th Cir. 2012) (failure of state law to require segregation of funds and obligation to hold them for specific contractors meant that fiduciary obligation was not created) with Patel v. Shamrock Floorcovering Servs., (In re Patel), 565 F.3d 963 (6th Cir. 2008) (state law imposed duty on general contractor to hold funds for subcontractors and suppliers (even before any were yet employed) and to pay them first before taking its own payment; held sufficient to make contractors fiduciaries of the funds received). And compare Texas Lottery Comm'n v. Tran (In re Tran), 151 F.3d 339, (5th Cir. 1998) (state law declared lottery sellers to be fiduciaries but did not require segregation of funds or prohibit spending of lottery receipts on other matters; sellers were not statutory fiduciaries) with Appalachian Oil Co. v. Tenn. Educ. Lottery Corp. (In re Appalachian Oil Co.), 471 B.R. 199 (Bankr. E.D. Tenn. 2012) (where statute defined res of lottery ticket receipts, describes them as being held in trust and requires seller to act as trustee, and requires that they be deposited into segregated account, seller was fiduciary even though he violated those duties in some respects).
If such a trust has been created, then there are several beneficial results. First, to the extent that the funds were retained in a properly segregated account, the trust beneficiary has the right to demand that they be excluded from the property of the estate being treated within the case. Second, even if the funds have been improperly commingled with other assets, one may still use principles of tracing and the “lowest intermediate balance test” to assert rights in whatever funds were left in the commingled account.
Third, in the case of trust fund taxes, i.e., those collected by the debtor company from third parties to be held in trust for the government (sales taxes and employee withholding taxes are common examples of this), the Supreme Court has utilized an even stronger measure of protection. In Begier v. IRS, 496 U.S. 53 (1990), the Court held that Congress had intended to ensure that payments of such taxes should be treated as having been made with trust assets so long as a reasonable nexus could be established between the funds paid to the taxing authority and the funds collected by the debtor. Where payments of such taxes were voluntarily made from a commingled account, the Court held that the payment itself sufficed to show that the debtor had “designated” the funds used as those that were held in trust, thereby providing the required nexus. Id. at 66-67. (This presumptive nexus treatment is a far simpler and more certain method of exempting the funds from the estate than attempting to apply the lowest intermediate balance test.)
Thus, to the extent that the state imposes this sort of agency liability on the debtor to collect funds from another, those funds remain outside of the property of the estate and can always be used by the debtor to pay its taxes. Moreover, because the payment is made from non-estate funds, it is never a preferential transfer and cannot be voided once the petition is filed. This is another area where the creation of the tax and the designation of which party is liable therefore is totally within the control of the state. Accordingly, those that do not use the trust fund sales tax concept as part of their tax scheme lose out on a powerful benefit.
Finally, the other major benefit of trust fund designations is the ability of the creditor party to have its debt excepted from the discharge in certain circumstances. With respect to the trust fund taxes discussed above, just as they are not considered property of the estate, so too the obligation to satisfy those tax liabilities is not treated as either a contractual or even statutory obligation by the debtor to make those payments. Rather, those monies owed are treated, conceptually, as property of another that the debtor is simply holding for turnover to the state. Thus, while the Code gives priority status to most taxes for only a specific period of time (one year for some, three years for others), taxes that the debtor is required to withhold from others on behalf of the state retain their priority forever. Those trust funds held by the debtor remain outside of property of the estate and never become “stale.” The final benefit from that fact is that priority taxes are, in turn, automatically nondischargeable. See In re Calabrese, 689 F.3d 312 (3rd Cir. 2012). Thus, a taxing agency that uses the trust fund tax concept receives a double benefit – the taxes are given a higher payment status during the case and, whatever amounts cannot be paid from the property of the estate in the case remain nondischargeable and may be collected from the debtor from its postpetition earnings.
The final benefit for creditors is the issue being dealt with by the Supreme Court in the Bullock case. Section 523(a)(4) excepts from discharge (for individual debtors) debts “for . . . defalcation while acting in a fiduciary capacity.” Determining whether this provision applies has two main components. First, is one a trustee or fiduciary – which primarily looks at the “pre-existing trust” issues discussed above, and second, what constitutes a “defalcation” by such a trustee. Bullock deals with some of those latter issues.
A trustee’s basic duties with respect to funds entrusted to him are to hold them in a safe account so as to preserve them for the beneficiaries, to invest them wisely as allowed by the trust agreement, to follow the directives of the trust agreement as to the uses to be made of the funds, and to account to the beneficiaries for the monies initially received. The trustee may violate those duties in numerous ways. He might place the funds in an account in a failing institution, or invest them in risky stocks, or spend money from the account for unauthorized purposes or fail to maintain adequate records to explain to the beneficiaries what happened to the funds with which he started. He may also take those actions with different levels of knowledge or intent.
In Bullock, the debtor used trust funds for unauthorized purposes, primarily to invest in profit making ventures for his own benefit. While he paid back the amount he removed from the account, he did not turn over the profits he made to the trust. The state court held that, while he had not acted with the intent to harm the others, he had clearly violated the trust agreement and exposed them to possible losses. The appropriate remedy, it held was to require payment of his profits to the trust. The bankruptcy court agreed that those findings established the requisite defalcation. On appeal, the Eleventh Circuit noted that the courts had used three standards to determine what constituted a “defalcation” – the Fourth, Eighth, and Ninth hold that even an innocent or merely negligent act could be sufficient (although, on closer view, most of the decisions made that statement only in dicta; the Fifth, Sixth, and Seventh, use a “recklessness” standard that requires something more than simple negligence but does not require proof of fraud or intention to harm the other parties), and the First and Second have used an “extreme recklessness” standard, establishing something akin to conscious misbehavior. The Eleventh Circuit in this case adopted the middle standard; it will be up to the Supreme Court to decide whether that choice was correct and to further explicate the standard. The decision will probably still leave many other aspects of this issue to be resolved, but the approach the Court takes will likely help to clarify what level of accountability can be imposed on trustees.
This article merely skims the surface of issues relating to trust funds and trustees and their treatment under the Code; it should though suggest the importance of such concepts and the value to any state in examining its statutes to determine whether they take full advantage of the possibilities of leveraging state law to improve the position of the state and those on whose behalf it litigates.
 Under the Code, any transfer of debtor assets that allows a party to obtain more than it would otherwise be paid in a liquidation may be challenged as a preferential transfer if it occurs within 90 days before the bankruptcy petition is filed. If that time period passes, the creation of the escrow account is no longer subject to attack.
 The discharge exceptions are not relevant for corporate debtors which generally either receive no discharge if they are liquidating or a total discharge if they reorganize. After 2005, there are now a few discharge exceptions for reorganizing debtors but Section 523(a)(4) is not among them.