After Brenda and Eddie Divorce, Eddie Files for Bankruptcy: The

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Vol. 25, 2012 After Brenda and Eddie Divorce 67

After Brenda and Eddie Divorce,

Eddie Files for Bankruptcy: The

Unusual Life of Defalcation under

BAPCPA

Shayna M. Steinfeld*

and

Dana E. Prescott**

In the 1970s, Billy Joel, cooed, in Scenes from an Italian

Restaurant:

Brenda and Eddie were the popular steadies

And the king and the queen of the prom

Riding around with the car top down and the radio on

Nobody looked any finer

Or was more of a hit at the Parkway Diner

We never knew we could want more than that out of life

Surely Brenda and Eddie would always know how to survive.

Oh, oh, oh, oh . . .

Brenda and Eddie were still going steady in the summer of ‘75

When they decided the marriage would be at the end of July

Everyone said they were crazy

“Brenda you know that you’re much too lazy

and Eddie could never afford to live that kind of life.”

Oh, but there we were wavin’ Brenda and Eddie goodbye.

Oh, oh, oh

Well they got an apartment with deep pile carpets

And a couple of paintings from Sears

A big waterbed that they bought with the bread

They had saved for a couple of years

but they started to fight when the money got tight

And they just didn’t count on the tears.

Oh, oh, yeah rock ‘n roll, Oh, oh, oh

* Shayna M. Steinfeld practices with her husband, Bruce R. Steinfeld, a

Fellow of the American Academy of Matrimonial Lawyers, in Atlanta, Geor-

gia, in Steinfeld & Steinfeld, PC. Ms. Steinfeld would like to thank Alexandra

Ragan, who as a third year law student at Emory University in Atlanta assisted

her with the research for this article.

** Dana E. Prescott, Esq., LMSW, is a partner in Prescott, Jamieson, Nel-

son & Murphy, LLC, Saco, Maine.

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68 Journal of the American Academy of Matrimonial Lawyers

Well, they lived for a while in a very nice style

But it’s always the same in the end

They got a divorce as a matter of course . . . .

While the lyrics happily conclude with they “parted the clos-

est of friends,” in too many divorce cases, particularly those with

unilateral bankruptcies that follow, that cheery outcome is rarely

the case. Statistically, about 20% of all bankruptcies are caused

by divorce and about the same percentage of divorces are caused

by financial problems.

By the sheer volume of reported cases,

bankruptcy often follows divorce in a chess match played be-

tween spouses to avoid obligations imposed by agreement or

court order. The social and legal problems generated from this

form of economic chaos do not even begin to account for the

effect of recession or the perils of the unforeseen, such as illness,

on family systems over the short-, medium-, and long-runs.

For decades, Congress has sought to balance public policy

when divorce (a matter of state law) and bankruptcy (a matter of

federal law) overlap. Throughout various reforms, debtors in a

bankruptcy case have consistently been unable to discharge, or

eliminate, “support-related” debt such as child support, alimony,

or other obligations that are “in the nature of support.” By now,

most divorce lawyers are attuned to the fact that support debt is

non-dischargeable and draft divorce agreements accordingly. In

response to all the litigation generated by the structural tension

inherent in federalism, federal courts have established about

eighteen different elements that may be considered when deter-

mining if a particular obligation is really in the “nature of sup-

port” or not really “in the nature of support” under 11 U.S.C.

sections 523(a)(5) and 523 (a)(15).

One of the authors of this

article (the one from Atlanta) has a book published through the

American Bar Association, The Family Lawyers Guide to Bank-

ruptcy,

which contains a detailed analysis of the distinction be-

tween a support-related debts (acronymically known as a DSO or

“domestic support obligation”) and non-support-related debts.

See generally

ERESA

ULLIVAN ET AL

., T

RAGILE

IDDLE

LASS

MERICANS IN

EBT

(2000).

All Code citations are to 11 U.S.C. unless stated otherwise.

HAYNA

TEINFELD

& B

RUCE

TEINFELD

, T

AMILY

AWYER

’

UIDE TO

ANKRUPTCY

: F

ORMS

, T

IPS

AND

TRATEGIES

(2nd ed., 2007).

Under 11 U.S.C. §101(14A)

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Vol. 25, 2012 After Brenda and Eddie Divorce 69

This book (and a robust body of literature in both specialties)

also contains a detailed analysis of other bankruptcy ramifica-

tions of divorce-related issues. The specifics of these items are,

however, beyond the scope of this article.

Divorce attorneys may be much less familiar with other

more complex exceptions to discharge, including a specific excep-

tion for debts incurred by an individual “for fraud or defalcation

while acting in a fiduciary capacity, embezzlement, or larceny”

under section 523(a)(4). Hence, the specific focus of this article:

the applicability of section 523(a)(4) to the divorce context. Al-

though a seemingly unusual exception in divorce, this truth is

probably more a function of clients being advised that an adver-

sary proceeding is futile even when a lawyer may recognize the

opportunity to challenge dischargeability under section

524(a)(4). Not so much. In the sections below, the authors

briefly explore the history of support-related debts under the

Code before explaining the process and substantive law that

guide non-dischargeability objections. The confluence of more

parties maintaining post-divorce property arrangements due to

The term ‘”domestic support obligation”’ means a debt that accrues

before, on, or after the date of the order for relief in a case under this

title, including interest that accrues on that debt as provided under

applicable nonbankruptcy law notwithstanding any other provision of

this title, that is—

(A) owed to or recoverable by (i) a spouse, former spouse, or child of

the debtor or such child’s parent, legal guardian, or responsible rela-

tive or (ii) a governmental unit;

(B) in the nature of alimony, maintenance, or support (including assis-

tance provided by a governmental unit) of such spouse, former spouse,

or child of the debtor or such child’s parent, without regard to whether

such debt is expressly so designated;

date of the order for relief in a case under this title, by reason of appli-

cable provisions of– (i) a separation agreement, divorce decree, or

property settlement agreement; (ii) an order of a court of record; or

(iii) a determination made in accordance with applicable nonban-

kruptcy law by a governmental unit; and(D) not assigned to a nongov-

ernmental entity, unless that obligation is assigned voluntarily by the

spouse, former spouse, child of the debtor, or such child’s parent, legal

guardian, or responsible relative for the purpose of collecting the debt.

For a brief but helpful survey, see David C. Hoskins & Ellen R.

Welner, Bankruptcy and Divorce: What Divorce Counsel should know about

Bankruptcy, 37

OLO

35 (Oct. 2008).

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70 Journal of the American Academy of Matrimonial Lawyers

economic turmoil and the 2005 changes to the Bankruptcy Code

suggests closer consideration of other Code provisions than the

(now) more mundane exceptions for DSOs.

I. “Waving Goodbye to the Past”

For many years, divorcing parties could eliminate the obliga-

tion to pay non-support-related debts. This policy dramatically

changed in 1994, thereby increasing the frequency and scope of

litigation between former spouses when one party declared

bankruptcy. Euphemistically described as “legislative sausage,”

former spouses were required to litigate “disposable income” is-

sues and a “balancing test” to determine the discharge of the

non-support obligations under section 523(a)(15). Congress

amended the law again in 2005, further strengthening ex-spouses’

rights and remedies under the Bankruptcy Code. In bankruptcy

lawyer vernacular, these amendments to the Code were called

“BAPCPA,” or otherwise dubbed the Bankruptcy Abuse Preven-

tion and Consumer Protection Act of 2005.

For the most part, BAPCPA took effect on October 17,

2005.

The primary consumer beneficiaries under the amend-

ment were mothers and ex-spouses

because, among the most

significant changes under BAPCPA, property settlement debts,

as well as all other divorce-related debts, incurred before, during

and after the bankruptcy case, are now automatically non-dis-

chargeable in Chapter 7, 11 and 12 bankruptcy cases.

BAPCPA

Pub. L. No. 109-8, 119 Stat. 23 (codified as amended in scattered sec-

tions of 11 U.S.C.).

Although a seemingly simple notion, make sure that the case law is

post-2005 to avoid unnecessary embarrassment. These “reforms” have gener-

ated much scholarly debate. See John E. Matejkovic & Keith Rucinski, Bank-

ruptcy “Reform”: The 21st Century’s Debtors’ Prison, 12

. B

ANK

. I

NST

. L.

473 (2004).

For a prior discussion in this journal, see Shayna M. Steinfeld, The Im-

pact of Changes Under the Bankruptcy Abuse Prevention and Consumer Protec-

tion Act of 2005 on Family Obligations, 20

J. A

. A

CAD

. M

ATRIM

. L

. 251

(2007). The use of gender to suggest an advantage or disadvantage at the inter-

section between bankruptcy and divorce raises its own controversy. See Peter

C. Alexander, Building A Doll’s House: A Feminist Analysis of Marital Debt

Dischargeability in Bankruptcy, 48

ILL

. L. R

. 381

(2003).

Each form of bankruptcy has its unique requirements and conse-

quences. See generally Steinfeld & Steinfeld, note 3.

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Vol. 25, 2012 After Brenda and Eddie Divorce 71

eliminated the need for the “section 523(a)(15) balancing test”

adopted in 1994 and the litigation it spawned and also elevated

the priority of support-related debts, now more broadly defined

under BAPCPA as “Domestic Support Order” (“DSO”) debts

as defined in section 101(14A).

Accordingly, the only significant areas where the distinction

between support and non-support-related debt still matters in a

bankruptcy case (provided that Congress does not again change

the law) is in Chapter 13 filings because section 1328 does not

incorporate all of section 523(a), but only incorporates specific

sub-parts of section 523(a), notably excluding section 523(a)(15)-

non-DSOs. Assuming this exclusion is an intended omission by

Congress from BAPCPA, non-support, divorce-related obliga-

tions remain dischargeable (subject to elimination) in Chapter

13, provided that the debtor is able to complete the Chapter 13

plan and obtain a discharge.

Therefore, if you represent a party

with a non-support-related, divorce debt and the opposing party

files a Chapter 13 case, you need to be aware of this possibility

and take steps to protect your client if the facts warrant it. Nota-

bly, the distinction between support and non-support-related

debts is still important as it relates to certain other provisions of

the Bankruptcy Code, especially payment of past-due or future

support-related debts and certain other provisions, which are be-

yond the scope of this paper.

See supra note 6.

The statistics for debtors actually completing Chapter 13 plans and

making it to discharge are actually fairly low. As with many policy debates,

there is more myth than actual reliance on empirical data. BABCPA is no dif-

ferent. See Thomas Evans & Paul B. Lewis, An Empirical Analysis of the 2005

Bankruptcy Reforms, 24

MORY

ANKR

. D

. J.

327 (2008).

Under BAPCPA, the term “Domestic Support Obligation” (“DSO”) is

used throughout the Bankruptcy Code and is incorporated into various other

provisions such as in section 507 for priorities, in the discharge provisions for

chapters 7, 11, 12 and 13, as a defense to the preference provisions of section

547, for certain exceptions to the automatic stay under section 362, requiring

the trustees to give certain notices to the DSO creditor, provisions that require

that all DSO payments must be current for confirmation of Chapter 11, 12 and

13 plans and for discharge under Chapters 12 and 13. Accordingly, the distinc-

tion drawn between support and non-support divorce-related obligations is still

relevant for these other purposes under the Bankruptcy Code but these are

beyond the scope of this article.

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72 Journal of the American Academy of Matrimonial Lawyers

We have set forth the “gap” for non-DSO, divorce-related

debts found in Chapter 13 and the changes contained in

BAPCPA because post-BAPCPA it may be quite rare for an at-

torney to need to litigate an issue under section 523(a) (4) in a

Chapter 7, 11 or 12 case. There may be isolated instances like

domestic partners or long-term, live-in relationships, where there

is no court order or divorce decree that meets the parameters of

a DSO. In such a case, the aggrieved party who is owed money

by the party filing bankruptcy may be looking for other ways to

collect his or her debt and section 523(a) (4) may then be viable

in one of the other bankruptcy chapters. The vast majority of

divorce-related debts are automatically carved out of the dis-

charge pursuant to section 523(a)(5) as a DSO or pursuant to

section 523(a)(15) as a debt owed “to a spouse, former spouse, or

child of the debtor.” Because this article is being published for a

divorce lawyer audience and post-BAPCPA, at a time when most

every divorce-related obligation is automatically excepted from

discharge under either section 523(a)(5) or 523(a)(15) pursuant

to section 523(c) in Chapter 7, 11 and 12 cases, this article will

focus on the criteria to file a complaint to determine dis-

chargeability under sections 523(c) and Federal Rule 4007 in

other circumstances, most likely arising in a non-DSO context in

a Chapter 13 case.

With that caveat, we move to section

523(a)(4).

Rule 4007. Determination of Dischargeability of a Debt

(a) Persons entitled to file complaint.

A debtor or any creditor may file a complaint to obtain a determi-

nation of the dischargeability of any debt.

(b) Time for commencing proceeding other than under § 523(c) of the

Code.

A complaint other than under § 523(c) may be filed at any time. A

case may be reopened without payment of an additional filing fee

for the purpose of filing a complaint to obtain a determination

under this rule.

chapter 11 reorganization, chapter 12 family farmer’s debt adjust-

ment case, or chapter 13 individual’s debt adjustment case; notice

of time fixed.

Except as otherwise provided in subdivision (d), a complaint to

determine the dischargeability of a debt under § 523(c) shall be

filed no later than 60 days after the first date set for the meeting of

creditors under § 341(a). The court shall give all creditors no less

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Vol. 25, 2012 After Brenda and Eddie Divorce 73

II. “Everyone Said They Were Crazy”

The brief discussion above has much that lawyers under-

stand. But what of the crazy twist so common to the alternate

universe of divorced couples? After entering a divorce decree,

Brenda and Eddie sell their home but Eddie convinces Brenda to

give her share of the settlement from their property division to

buy another property in his name because they have kids and he

can manage the rentals and pay the mortgage. Brenda decides to

become his “partner” (for “the kids”) and a few months later he

evicts her from the home and declines to pay her for her contri-

bution. Brenda sues in state court, which results in a decision af-

ter a trial that her claims that Eddie converted her property and

breached her fiduciary duty were “subsumed in her claim for a

partnership accounting.” The state court then rules that Eddie

breached his fiduciary duty

to Brenda and awards her damages

and enters a judgment in favor of Brenda and against Eddie.

than 30 days’ notice of the time so fixed in the manner provided in

Rule 2002. On motion of a party in interest, after hearing on no-

tice, the court may for cause extend the time fixed under this sub-

division. The motion shall be filed before the time has expired.

(d) Time for filing complaint under § 523(a)(6) in a chapter 13 indi-

vidual’s debt adjustment case; notice of time fixed.

On motion by a debtor for a discharge under § 1328(b), the court

shall enter an order fixing the time to file a complaint to deter-

mine the dischargeability of any debt under § 523(a)(6) and shall

give no less than 30 days’ notice of the time fixed to all creditors in

the manner provided in Rule 2002. On motion of any party in in-

terest, after hearing on notice, the court may for cause extend the

time fixed under this subdivision. The motion shall be filed before

the time has expired.

(e) Applicability of rules in Part VII.

A proceeding commenced by a complaint filed under this rule is gov-

erned by Part VII of these rules.

Under Maine law, for example, the confidential relationship between

married partners requires good faith between them. See Smith v. Farrington,

139 Me. 241 (Me. 1943); Dennison v. Dawes, 121 Me. 402 (Me. 1922). In

Thomas v. Fales, 577 A.2d 1181 (Me. 1990), the Law Court affirmed the imposi-

tion of constructive trust for the benefit of a wife on real estate held by the

husband’s brother which the husband had transferred and stated:

A person can be found to stand in a fiduciary relation to another

“When he has rights and duties that he is bound to exercise for the

benefit of (another) person. . . . Whenever one person is placed in such

a relation to another that it becomes interest for him . . . and any

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74 Journal of the American Academy of Matrimonial Lawyers

Eddie naturally files a Chapter 7 bankruptcy to avoid the

civil judgment. Several lawyers tell Brenda her situation is hope-

less because the judgment was post-divorce and not in the nature

of support. (As a caveat, we must mention that “success” in a

bankruptcy adversary proceeding is a piece of paper that says

“nondischargeable”—it is not “cash.” The debt must still be col-

lected.) Brenda, though, perseveres and eventually finds a law-

yer who initiates an adversary proceeding on her behalf. The

preliminary issue is whether Eddie’s breach of fiduciary duty is

an exception to dischargeability under section 523(a)(4). The an-

swer requires a discussion in two parts. First, is the state court

order subject to the doctrines of res judicata or collateral estop-

pel in the bankruptcy court? Second, if so, do the findings of fact

and conclusions of law constitute an exception to the discharge

provisions of the Code?

III. “But It Is Always the Same in the End”

Traditional elements of “preclusion” apply in bankruptcy

court. Historically referred to as the doctrines of res judicata and

collateral estoppel, these terms are known, respectively, in mod-

ern terminology as “claim preclusion” and “issue preclusion.”

Under federal law, the bankruptcy court “retains jurisdiction to

ultimately determine the dischargeability of the debt.”

The

preclusive effect of state court judgments may be a function of

full faith and credit.

The doctrine of claim preclusion (res judi-

cata) prevents the relitigation of claims that were previously

brought and litigated, arising out of the same transaction and

subject of property . . . he is prohibited from acquiring rights and that

subject antagonistic to the person with those interests.”

Id. at 1182-83.

See

ESTATEMENT

ECOND

)

UDGMENTS

§27 (1982); see also

Machias Sav. Bank v. Ramsdell, 689 A.2d 595, 599 (Me. 1997) (“Issue preclu-

sion, also referred to as collateral estoppel, prevents the relitigation of factual

issues already decided if ‘the identical issue was determined by a prior final

judgment, and . . . the party estopped had a fair opportunity and incentive to

litigate the issue in a prior proceeding.’”).

Matter of Schwager, 121 F.3d 177, 181 (5th Cir. 1997); see also Grogan

v. Garner, 498 U.S. 279, 285 n.11 (1991); In re Ingeneri, 321 B.R. 601, 606 n.3

(Bankr. D. Me. 2005).

Id.

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Vol. 25, 2012 After Brenda and Eddie Divorce 75

that could have been brought in the original transaction.

The

U.S. Supreme Court has determined that the doctrine of claim

preclusion (res judicata) does not apply in dischargeability litiga-

tion in bankruptcy cases.

The doctrine of “issue preclusion” (collateral estoppel),

however, prevents the re-litigation of specific issues that were

previously litigated between identical parties, which issues were a

necessary part of the prior litigation.

The U.S. Supreme Court

has determined that issue preclusion (collateral estoppel) does

apply to dischargeability proceedings and can be a useful tool for

litigants.

A secondary matter with regard to issue preclusion is

whether the bankruptcy court should apply state or federal issue

preclusion law.

In most jurisdictions, however, modern doc-

trines of issue preclusion have evolved on parallel tracks so the

distinction may be meaningless. In either case, the doctrine only

applies to those material issues that were actually litigated and

upon which a final judgment was entered.

IV. “They Started to Fight”

A. An Adversary Proceeding

An adversary proceeding (complaint) must be initiated in

the bankruptcy court by specifically setting forth the grounds for

objecting to the dischargeability of a debt pursuant to section

523(a)(4). This complaint must be timely, i.e. within 60 days of

the first scheduled meeting of creditors in the bankruptcy case.

In a Chapter 13 case, this is sometimes too early in the case, so it

Christopher Klein et al., Principles of Preclusion and Estoppel in

Bankruptcy Cases, 79

MER

. B

ANKR

.L.J

. 839, 842 (2005), citing 18

HARLES

LAN

RIGHT

, A

RTHUR

R. M

ILLER

& E

DWARD

H. C

OOOPER

, F

EDERAL

RACTICE AND

ROCEDURE

§ 4402 (2d Ed. 2003).

See Brown v. Felsen, 442 U.S. 127 (1979).

See

ESTATEMENT

ECOND

)

UDGMENTS

§27 (1982).

See Grogan v. Garner, 498 U.S. 279 (1991).

See Colorado West Trans. Co., Inc. v. McMahon (In re McMahon), 356

B.R. 286, 301 (Bankr. N.D. Ga. 2006), rev’d, 380 B.R. 911 (N.D.Ga. 2007). For

an interesting discussion of this issue, see Pincus v. Long (In re Long), 2006

Bankr. LEXIS 2619 (Bankr. N.D. Ga. June 30, 2006)

See Penkul v. Matarazzo, 983 A.2d 375, 377-78 (Me. 2009); see also In

re Gauvreau, 375 B.R. 14, 19 (Bankr. D. Me. 2007).

See 11 U.S.C.§523(c); See

. R. B

ANKR

. P.

4007(c).

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76 Journal of the American Academy of Matrimonial Lawyers

is prudent to try and extend this date by motion and court order,

which also must be timely.

This is particularly true if the Chap-

ter 13 plan provides for a high payment on the underlying non-

DSO claims or when the Chapter 13 plan may be modified

before the claim is paid in full but after the bar date for the filing

of the adversary proceeding complaint. Of particular practice in-

terest, a proof of claim must be filed within 90 days after the first

section 341 meeting of creditors for the creditor to be paid any-

thing at all.

B. The Threshold Policy and Definition

The tension between section 523(a)(4) and the policies that

undergird the Code begin with this proposition: “The historic

purpose of bankruptcy is for honest, but insolvent, debtors to get

a fresh start in their financial lives.”

At its core, the bankruptcy

process seeks to provide debtors with a discharge from their debt

obligations.

Because “the basic objectives underlying the hope

of bankruptcy [is to] afford a bankrupt a new chance,”

bank-

ruptcy courts generally construe discharge exceptions against the

creditor and in favor of the debtor.

Accordingly, the spouse

objecting to the discharge bears the burden of proving, by a pre-

ponderance of the evidence, that the debtor’s discharge should

be denied as to that particular state court judgment.

Under section 523(a)(2), false pretenses, false representa-

tions or actual fraud may constitute the basis for nondis-

See, e.g.,

. R. B

ANKR

. P.

9006(b).

See

. R. B

ANKR

. P.

3002.

Gamble v. Gamble (In re Gamble), 196 B.R. 54, 55 (Bankr. N.D. Tex.

1996)(citing Local Loan Co. v. Hunt, 292 U.S. 234 (1934)).

See Dilworth v. Boothe, 69 F.2d 621, 624 (5th Cir. 1934).

Hughes v. Lieberman (In re Hughes), 873 F.2d 262, 263 (11th Cir.

1989).

HSSM # 7 Ltd. Partnership v. Bilzerian (In re Bilzerian), 100 F.3d 886,

891 (11th Cir. 1996); see also Chauncey v. Dzikowski (In re Chauncey), 454 F.3d

1292, 1295 (11th Cir. 2006); Equitable Bank v. Miller (In re Miller), 39 F.3d 301,

304 (11th Cir. 1994).

See Grogan v. Garner, 498 U.S. 279, 285-91 (1991); Hawley v. Cement

Indus., Inc., 51 F.3d 246, 249 (11th Cir.1995); Chalik v. Moorefield (In re

Chalik), 748 F.2d 616, 619 (11th Cir. 1984); In re Murphy, 297 B.R. 332, 348

(Bkrptcy. D. Mass. 2003).

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Vol. 25, 2012 After Brenda and Eddie Divorce 77

chargeability.

Unlike defalcation under section 523(a)(4),

section 523(a)(2) specifically requires a showing of scienter.

Both “provisions codify a long-standing bankruptcy policy that

any debt which is shown to have arisen from a dishonest or oth-

erwise wrongful act committed by a debtor is not entitled to the

benefits of a bankruptcy discharge.”

To prevent discharge of a

debt under section 523(a)(4), a creditor must demonstrate that:

(1) the debtor was acting in a fiduciary capacity within the mean-

ing of section 523(a)(4); (2) that the debtor’s actions constituted

a defalcation; and (3) the debtor’s acts caused an actual loss to

the creditor/plaintiff.

Although the term fiduciary capacity under section

523(a)(4) may not be as broad as state law in other circum-

stances, facts may be sufficient to establish such a relationship

between husband and wife or the finding of a post-divorce part-

nership.

The U.S. Supreme Court has generally defined “fidu-

ciary” narrowly under section 523(a)(4) “holding that the trust

upon which the fiduciary relationship relies must be an express

or technical trust.”

As to the second prong, the meaning of

defalcation under section 523(a)(4), there is a split in the federal

courts of appeal concerning the scope (or definition) of defalca-

tion.

The First Circuit has adopted a narrower test than other

circuits but aptly summarizes the policy debate:

A defalcation for purposes of §523(a)(4) necessarily means there has

been a breach of fiduciary duty, but not all breaches of fiduciary duty

constitute a defalcation. Courts are divided on the standard to be em-

ployed in determining which breaches of fiduciary duty reach the level

of “defalcation” for purposes of nondischargeability under that Code

See In re Anstead, Docket No. 10-3094 (Bankr. Ohio No. Dist. 2010).

Id. at 2.

Id. Applying a different part of the Code, the court in In re Gauvreau,

375 B.R. at 18, noted the tension between “the Code’s twin policies of giving

honest debtors a leg up and protecting the interests of creditors from debtors

who would attempt to exploit them.”

See In re Patel, 565 F.3d 963, 968 (6th Cir. 2009).

Davis v. Aetna Acceptance Co., 293 U.S. 328 (1934)(decided under

section 17(a)(4) of the Bankruptcy Act, which was transplanted virtually un-

changed to §523(a)(4)). For an interesting discussion of this issue see Dynaspan

v. Evilsizer(In re Evilsizer), 2009 Bankr. LEXIS 942 (Bankr. N.D. Ga. Mar. 18,

2009)

See e.g., In re Hyman, 502 F.3d 61, 66-69 (2nd Cir. 2007) (reviewing

case law).

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78 Journal of the American Academy of Matrimonial Lawyers

section. In this Circuit, however, the question is now conclusively de-

cided. In Baylis, the First Circuit Court of Appeals defined “defalca-

tion” for purposes of §523(a)(4) as an act “so egregious in nature that

[it] come[s] close to the level that would be required to prove fraud,

embezzlement, or larceny.” Baylis, 313 F.3d 9 at 20.

Even though defalcation is determined through an objective

standard, proof still involves some degree of fault that is closer to

fraud, without the necessity of meeting a strict specific intent re-

quirement. The Baylis court analogized the requisite degree of

fault to the “scienter” standard for securities fraud. “A form of

recklessness can meet the requirement of scienter but it is ‘more

like a lesser form of intent.” Id. at 20 (quoting Rizek v. SEC, 215

F.3d 157, 162 (1st Cir. 2000)).

Accordingly, mere acts of negli-

gence or conscious risk taking do not constitute “defalcation” for

the purposes of section 523(a)(4) but an act or omission tending

to show such an extreme departure from the standards of ordi-

nary care as to reach the level of extreme recklessness. The to-

tality of the circumstances in each particular case “will provide

the level of wrongdoing needed to constitute a defalcation.”

The process of distinguishing cases is often an interesting in-

tellectual exercise (like Sudoku) but rarely does it actually matter

when applying, in particular, principles of law to the factual ma-

trix of each case. But – and it is an important but – none of the

cases cited or derived from Baylis involved a husband and wife,

a divorce judgment, or a subsequent express – not implied –

partnership or conversion of money within that partnership. As

the court in In re Murphy summarized, defalcation is an objective

standard that requires “some degree of fault” without the neces-

sity of meeting a specific intent requirement. Indeed, in Murphy,

In re Murphy, 297 B.R. 332 at 350.

Id.

In Maine, the “partnership theory of marriage” under section 953 is “a

major guiding principal in the separation and division of property at divorce.”

Tibbetts v. Tibbetts, 406 A.2d 70, 76 (Me. 1979). Under general principles of

partnership law, much less a marriage or intimate partnership with children, it is

well-settled that a partner has a fiduciary responsibility that obliges him to ac-

count for disposition of partnership property. See Dalton v. Austin, 432 A.2d

114 (Me. 1981); see also Rosenthal v. Rosenthal, 543 A.2d 348 (Me.1980) (de-

fining fiduciary responsibility in a complex family partnership, which entitles a

party to restitution for breach of fiduciary duty, including recovery of money

for lost value).

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Vol. 25, 2012 After Brenda and Eddie Divorce 79

involving nonrelations to stock transactions, the bankruptcy

court found the obligation nondischargeable under section

523(a)(4) because the debtor’s acts went beyond an act of omis-

sion constituting mere negligence or conscious taking of a risk.

Objective facts, taken as a whole and in the context of a spousal

relationship, may establish a record of misbehavior or reckless-

ness that does reserve the “harsh sanction” of nondis-

chargeability for a debtor who has exhibited “some portion of

misconduct.”

C. Grounds or Not?

So, are there grounds to file a section 523(a)(4) complaint?

There is very little case law following the enactment of BAPCPA

exploring the divorce/section 523(a)(4) overlay. Collier Family

Law and the Bankruptcy Code

notes that

[g]enerally, courts have held that a debtor may be considered a fiduci-

ary subject to this section [section 523(a)(4)] only when an express or

technical trust exists, rather than when one is created by law due to

the debtor’s status or a constructive trust is created as a result of

wrongful conduct. However, courts have held that state statutory pro-

visions may create a fiduciary relationship when a marriage in a com-

munity property state is dissolved with the res of the trust being the

community property under a spouse’s control.

Leaving aside the distinction between community property

and equitable distribution states, when there has been an absence

of a valid, technical, trust, arguments have been unsuccessful.

The parties may, of course, affirmatively place a provision in a

divorce decree that would create an express trust and fiduciary

duties as was the case in In re Eichelberger

with regard to a

pension plan.

Id. at 352.

In re Hyman, 502 F.3d 61 at 69 (citation omitted) (declining to apply

collateral estoppel on findings of a prior court judgment when adopting the

Baylis standard for the first time in the Second Circuit).

ISCHARGEABILITY OF

ARITAL

BLIGATIONS IN

ANKRUPTCY

ch. 6

at [5] (MB 2010).

Id.

In re Eichelberger, 100 B.R. 861 (Bankr. S.D. Tex. 1989); see also In re

Dahlin, 94 BR. 79 (Bankr. E.D. Va. 1988). Collier’s at [5] footnote 64.

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80 Journal of the American Academy of Matrimonial Lawyers

In Eichelberger,

a pre-BAPCPA case, the court noted that

under the Bankruptcy Act (prior to 1978) and the Bankruptcy

Code (the current bankruptcy law), “courts have consistently

held that to be a fiduciary for purposes of dischargeability, the

debtor must be a trustee under either an express or technical

trust rather than a trust imposed ex-maleficio.”

A trust that is

created “ex-maleficio” is one that is created by virtue of the act

of the wrong doing and is applied by courts constructively as a

remedy for wrongdoing to prevent unjust enrichment.

In Ei-

chelberger, the wife did not seek to enforce the divorce decree

but rather sought to have the bankruptcy court determine that

any damages arising as a result of her ex-husband’s breaches of

fiduciary duties, while he was serving as her trustee under their

divorce decree, were non-dischargeable under section 523(a)(4).

In cases under section 523(a) (4), federal law controls whether a

fiduciary relationship exists and the critical inquiry is whether the

trust created between the parties is express, technical or ex-

maleficia.

A “long line of case authority has held that an ex-

press or technical trust may be created by a statute which ex-

pressly imposes fiduciary obligations on a party, which explains

why pension and ERISA conflicts between spouses arise more

often under this scenario.”

The bankruptcy court held in the ex-wife’s favor, finding

that the state family court judge intended to create an express or

technical trust to protect the ex-wife’s community property inter-

ests in her share of the debtor’s ERISA qualified pension plan.

This was made clear by the divorce decree’s express designation

of the debtor as a “trustee” for the ex-wife with respect to the

pension fund, coupled with the identification of the “res” – a spe-

cifically identifiable property for the trust – half of the pension

fund. Finally, the divorce decree also identified specific duties

that the debtor was to perform vis ´a vis the pension fund.

100 BR 861 (Bankr. S.D. Tex. 1989); see also Eichelberger v. Eichel-

berger, 584 F. Supp. 899 (S.D. Tex. 1984).

Eichelberger, 100 BR at 863 (citations to various circuit court opinions

omitted).

Id. at 864.

Id.

Id. at 864 (internal string citations omitted).

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Vol. 25, 2012 After Brenda and Eddie Divorce 81

The bankruptcy court further found that the debtor commit-

ted a defalcation that would cause the debt to be non-dischargea-

ble in the bankruptcy case, though the majority of cases in this

arena are to the contrary, including the Ninth Circuit, which has

held that “as a general rule, the exception to discharge in Section

523(a)(4) should not apply in connection with a property settle-

ment agreement or divorce decree.”

The Eichelberger court

states in response that “the need for imposing an express or

technical trust via a divorce decree will only arise when the bene-

ficial and legal interest in a particular piece of community prop-

erty cannot be vested immediately in the spouse awarded the

property . . . [this] has all the characteristics of an express or tech-

nical trust.”

To be non-dischargeable under section 523(a)(4),

the court must determine that the debtor owed fiduciary obliga-

tions which were breached in a manner that rises to the level of a

defalcation. “Defalcation” may be caused by misconduct, negli-

gence or even just a failure to account.

The Fifth Circuit, in a 1987 case, broadly defined defalcation

as “an abuse of a fiduciary position.” Therein lays the impor-

tance of the trial court’s findings of fact and legal conclusions.

The Eichelberger bankruptcy court found, by utilizing collateral

estoppel of the district court’s findings, that the debtor commit-

ted a defalcation that would be non-dischargeable in the bank-

ruptcy case.

D. Other Examples

There is significant bankruptcy case law holding that

QDROs and other provisions assigning rights in pension funds to

former spouses actually transfers title to the party receiving that

interest under the divorce decree. These cases incorporate vari-

ous provisions of the Bankruptcy Code, as debtors have tried dif-

ferent ways to challenge the terms of their divorce decrees in a

bankruptcy case to eliminate these obligations and keep their

share of these funds. In a situation that addresses a breach of

fiduciary duty argument, In re Dahlin,

the court determined

Id. at 865, citing In re Teichman, 774 F.2d 1395, 1400 (9th Cir. 1985).

Id.

Id. at 866 (internal citations omitted).

94 B.R. 79, 81 (Bankr. E.D. Va. 1988), aff’d, 911 F.2d 721 (4th Cir.

1990). In Bush v. Taylor, 912 F.2d 989 (8th Cir. 1990), although the debtor had

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82 Journal of the American Academy of Matrimonial Lawyers

that the divorce decree created an express trust for pension bene-

fits and found that the debtor’s failure to hold the benefits in

trust for his ex-wife’s benefit and to turn them over to her, estab-

lished grounds to deny discharge of the debt to her pursuant to

section 523(a)(4). Similarly, in a California case, Lovell v.

Stanifer (In re Stanifer),

the debtor’s failure to account for lump

sum distribution from an IRA, as community property during

their marriage, gave rise to an express trust under California law,

such that the debt would be excluded from discharge for the

debtor’s breach of fiduciary duty and defalcation under section

523(a)(4). These cases, though, are fact specific. For a contrast-

ing ruling, the court in In re Albert

held that there was not a

sufficient trust under state law to warrant non-dischargeabililty

of the debt under section 523(a)(4).

In a Florida bankruptcy case from 1989, the court noted that

the vast majority of cases determine that the defalcation issue

will not generally arise in the divorce context. In In re Pattie,

the debtor-husband filed a complaint, prior to the 1994 changes

to the Bankruptcy Code, asserting that his property settlement to

his ex-wife was “in the nature of a property settlement” and,

therefore, subject to discharge. The ex-wife defendant raised va-

rious affirmative defenses, including that the debtor had commit-

ted a defalcation in his capacity as a fiduciary regarding certain

obligations due and owing to her under their divorce decree. Af-

ter much litigation, including a series of appeals, she was ulti-

mately unsuccessful. The court ruled:

[A]s far as it appears, the divorce decree did not designate the Debtor

as trustee and did not establish an express or technical trust which

existed prior to any alleged breach of fiduciary duty. There is no alle-

gation in the amended counterclaim that an express trust existed prior

to any alleged defalcation or any breach of any duty on the party of

the Debtor. For this reason, the [ex-wife] cannot establish a viable

claim under Section 523(a) (4) of the Bankruptcy Code under any set

of facts. Moreover, it is also well established as a general rule, that the

exception to discharge in Section 523(a)(4) has no application to con-

died the court determined that the ex-wife’s share of the pension funds were

held in constructive trust for her.

236 B.R. 709 (B.A.P. 9th Cir. 1999).

194 B.R. 907 (D. Kan. 1996).

Pattie v. Pattie (In re Pattie), 108 B.R. 791 (Bankr. M.D. Fla. 1989).

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Vol. 25, 2012 After Brenda and Eddie Divorce 83

troversies relating to property settlement agreements arising out of a

divorce proceeding.

This case may have limited utility today because it was a Chapter

7 discharge that the debtor was seeking and under BAPCPA, as

discussed above, all divorce-related debts are automatically non-

dischargeable from all chapters except for property-settlement,

non-DSOs, in Chapter 13.

In a more recent Chapter 13 case in 2009, Berger v. Jacobson

(In re Jacobson),

the Texas bankruptcy court ruled on a former

wife’s complaint seeking to except the debt due to her by the

debtor, her former husband, on grounds that he committed a de-

falcation while acting in a fiduciary capacity. In Jacobson, the ex-

wife asserted that she was due approximately $1.2 million in oil

and gas lease revenue that she was awarded by the family court.

The protracted litigation was over which oil and gas leases and

wells belonged to the debtor, which should have been transferred

to his ex-wife; and how the debtor was to pay his ex-wife her

interest in the wells and reserves. The bankruptcy judge ruled in

favor of the debtor, on the breach of fiduciary duty aspect of the

case, declining to find that the Texas state law provisions, that

facially appear to give a spouse awarded certain property fiduci-

ary obligations to the other party, do not rise to the level of

“fiduciariness” required under the Bankruptcy Code for defalca-

tion under section 523(a)(4).

The Fifth Circuit has held that the threshold issues for a debt

to be rendered non-dischargeable due to defalcation are: (1) the

presence of a definable res, (2) the imposition of trust-like duties,

and (3) the trust’s existence prior to any claimed misappropria-

Pattie, 108 B.R. at 797, citing Teichman, 774 F.2d at 1400 and In re

Wheeler, 101 B.R. 39 (Bankr. N.D. Ind. 1989). In Wheeler the court denied the

debtor’s discharge altogether under grounds that found that he intended to hin-

der, delay and defraud his ex-wife with his post-petition sale of a motorcycle.

But the court did not find grounds to exclude the debt to her under section

523(a)(4) for breaches of fiduciary duty because no express or technical trust

was established in the divorce decree establishing the debtor as a trustee on her

behalf: “A trust in either real or personal property is enforceable only if there is

written evidence of its terms bearing the signature of the settlor or his author-

ized agent.”

433 B.R. 183 (S.D.Tex. 2010).

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84 Journal of the American Academy of Matrimonial Lawyers

tion.

The court incorporates what has been stated in the other

cases about express, technical and constructive trusts and goes on

to state that a statutory trust may be sufficient for section

523(a)(4) but that the situation must also include the elements of

a res and defined duties.

It is important to note that in Jacob-

son, the parties had been engaged in protracted litigation over

fifteen years and the court appears more focused on the abuse of

the fiduciary position. The court specifically held that the debtor

did not commit a defalcation and reserved judgment on the al-

leged embezzlement issue. It is notable, that despite debt limita-

tions to qualify for Chapter 13, the debt by the debtor to his ex-

wife was “okay” in that it was found to be “unliquidated.”

In what would appear to be a post-BAPCPA case, but is not,

the In re Lewis

Court determined that to exclude a debt from

discharge pursuant to section 523(a)(4) for breach of fiduciary

duty, a plaintiff must show that there is a fiduciary relationship

between the parties and that the debtor committed a fraud or

defalcation while performing his fiduciary duties.

The court

found that there was no evidence of a trust, or even a contract,

rising to the level necessary to create a “fiduciary relationship”

necessary under section 523(a)(4). In this particular case, the un-

derstanding between the parties, that the debtor would re-convey

title to the home back to the ex-wife after he refinanced, was oral

and not even reduced to writing and, therefore, the court found

in favor of the debtor.

In another pre-BAPCPA situation, where section 523(a)(4)

has been utilized on the domestic front to allege that a debt was

“The trust created by Tex. Fam. Code Ann . . . does not suffice for

purposes of the defalcation exception to discharge.” Jacobson, 433 B.R. at 191.

Id. at 192.

Id. at 189.

359 B.R. 732 (E.D. Mo. 2007).

In re Lewis, 359 B.R. 732 (E.D. Mo. 2007). The case was filed under

Chapter 7 at the end of September 2005, just weeks before the law changed in

October 2005 to provide that all divorce-related debts would be non-discharge-

able from Chapters 7, 11 and 12. His ex-wife filed a complaint seeking to ex-

clude debts due to her under the divorce decree as non-dischargeable,

specifically relating to the marital home lost to foreclosure, which became

caught up in a dispute over a refinance and reconveyances between the parties.

The ex-wife filed her complaint under the 1994 amendments to the Code, spe-

cifically sections 523(a)(4), (5), (6) and (15).

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Vol. 25, 2012 After Brenda and Eddie Divorce 85

obtained by fraud or defalcation while acting in a fiduciary ca-

pacity and should not be discharged, the court in Law Firm of

Wendy R. Morgan v. LeRoy,

found that there was no fiduciary

relationship between a law firm and/or ex-wife client and the

debtor-attorney for the firm to successfully pursue a section

523(a)(4) complaint to except an assigned debt for attorney’s fees

from debtor’s discharge as a breach of fiduciary duty. In Sculler

v. Rosen (In re Rosen),

the debtor’s obligation to account for

monies removed from daughter’s bat mitzvah fund was not in the

nature of an express trust for purposes of section 523(a)(4). In

summary, section 523(a)(4) “has been at the root of much judi-

cial debate because courts disagree as to whether a fiduciary

must have intent to commit defalcation.”

V. “But It’s Always the Same in the End”

Then the king and the queen went back to the green

But you can never go back there again.

Brenda and Eddie had had it already

By the summer of ‘75

From the high to the low to the end of the show

For the rest of their lives

They couldn’t go back to the greasers

The best they could do was pick up the pieces

But we always knew they would both find a way to get by

Oh, that’s all I heard about Brenda and Eddie

Can’t tell you more cause I told you already

And here we are waving Brenda and Eddie goodbye.

Now you have tools to use if Brenda and Eddie’s divorce

decree creates a res, that can be construed as an express or tech-

nical trust, and assigns Eddie specific duties thereunder and Ed-

die breaches those duties, causing direct harm to Brenda. If the

marital relationship creates a fiduciary duty recognized by fed-

eral law, then a defalcation objection to dischargeability remains

a viable option. If Eddie files for bankruptcy then Brenda may

not need to do anything under Chapter 7, 11 or 12 because any

debt created pursuant to a divorce decree is automatically non-

251 B.R. 490 (Bankr. N.D. Ill. 2000).

232 B.R. 284 (Bankr. E.D.N.Y. 1999).

Andrea Johnson, Note, Bankruptcy – The Defalcation Exception to

Discharge: Should a Fiduciary’s Mistake Prohibit a Discharge from Debt?, 27

W. N

. L. R

93, 93 (2005).

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86 Journal of the American Academy of Matrimonial Lawyers

dischargeable from the bankruptcy case in Chapters 7, 11 and 12.

If, however, Eddie files for a Chapter 13, Brenda may file her

adversary complaint pursuant to section 523(a)(4) within 60 days

of the first set meeting of creditors (or succeed in getting that

deadline extended). Whether or not the court allows the ex-

spouses to “gesture goodbye” may hinge on technical distinctions

between state and federal law. Of critical importance is that the

Bankruptcy Code provides a forum for legitimate complaints

against dischargeability arising from the divorce relationship.