February 2013

"Last month we came precipitously close to filing for bankruptcy.  We were fully prepared to file bankruptcy.  We’re a very prudent company.”  - Bruce Hicks, spokesman for American Airlines

In this February 2013 issue:

Standard for Defalcation Exception to Discharge Before the U.S. Supreme Court

Appeals Court to Decide Conflict Between Criminal Forfeiture of Assets and Bankruptcy Administration of Assets

Standard for Defalcation Exception to Discharge to be Decided By U.S. Supreme Court

In March of this year, the United States Supreme Court will hear argument on the appropriate standard to apply in determining whether a debtor has engaged in a “defalcation” while acting in a fiduciary capacity. Bullock v. Bank  Champaign NA (In re Bullock), U.S. 11-1518. Under section 523(a)(4) of the Bankruptcy Code, debts arising from “fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny” are not dischargeable in bankruptcy.

In Bullock, the debtor, while acting as a trustee of his father’s trust, and contrary to its express limitations, borrowed substantial sums from the trust for his mother to use to repay a debt owed to the father’s business and for the debtor and his mother to make personal and business investments. All of the loans were paid back with interest. The debtor’s siblings, who were beneficiaries of the trust along with the debtor, brought suit against the debtor in Illinois state court for breach of fiduciary duty based on the debtor’s self-dealing. The state court determined that the debtor was liable for damages in the amount of $250,000, which it measured based on the amount of the benefit the debtor received from the self-dealing. The court also imposed a constructive trust on the property obtained with the borrowed funds, and appointed a bank as trustee of the constructive trust.

After the bank blocked the debtor’s attempt to sell the property to pay off the judgment debt, the debtor filed a Chapter 7 bankruptcy with the objective of having it sold in bankruptcy. The bank filed an action to determine the $250,000 judgment debt non-dischargeable by reason of what it claimed was the debtor’s defalcation based on self-dealing. Summary judgment was granted to the bank without any evidence of the debtor’s mental state in borrowing the funds, on the basis that his self-dealing was objectively reckless and thereby satisfied the standard for a “defalcation.” The Eleventh Circuit affirmed.Certiorari was granted to resolve a split among the circuits on the level of culpability a debtor must have to engage in a “defalcation.” In the First and Second Circuit, a “defalcation” under §523(a)(4) can only occur if there is “extreme recklessness.” In re Hyman, 502 F. 3d 61 (2d Cir. 2007); In re Baylis, 313 F. 3d 9 (1st Cir. 2002). The “objectively reckless” standard was applied in the Bullock case by the Eleventh Circuit and was previously adapted by the Fifth, Sixth and Seventh Circuits. An even lesser standard, mere negligence or a failure to account for entrusted property, has been applied by the Fourth, Eighth and Ninth Circuits.


U.S. Government’s Right to Criminal Forfeiture of Assets Pitted Against Competing Interests of Bankruptcy Trustee of Criminal Defendant’s Law Firm  

The well-publicized Ponzi scheme perpetrated by Scott Rothstein, a disgraced and formerly high-profile attorney in South Florida, has given rise to a battle between the federal government’s right to seize assets under the criminal forfeiture statue, 21 U.S.C. §853, and a bankruptcy trustee’s right to claim those assets for all creditors. In U.S. v. Rothstein, 2010 WL 2730749 (S.D. Fla. July 9, 2010), the government, pursuant to a preliminary order of forfeiture, seized all funds in the accounts of Rothstein’s law firm, Rothstein Rosenfeldt Adler, P.A. (RRA), all other property involved in Rothstein’s RICO and money laundering conspiracies and all property derived from his mail and wire fraud offenses. This property included real property and miscellaneous assets which the Chapter 11 trustee of RRA claimed were purchased by Rothstein with RRA funds and thus were held in a constructive trust for the benefit of RRA’s bankruptcy estate and creditors.

Under 28 U.S.C. §853(a), property that is subject to criminal forfeiture is any property constituting, or derived from, any proceeds the criminal defendant obtained as a result of his crimes or any of the criminal defendant’s property used or intended to be used to commit or facilitate commission of the crimes. Under 28 U.S.C. §853(c), any property described in subsections (a) vests in the United States upon commission of the act giving rise to the forfeiture.

A third party claiming an interest in the forfeited property may, however, petition the court to claim a superior right to it as compared to the interest of the defendant at the time of the commission of the crime. 28 U.S.C. §853(n). RRA’s bankruptcy trustee claimed such an interest in the RRA accounts and in the other properties seized on the basis that they were obtained with RRA’s money, and therefore were held in a constructive trust for RRA.

The district court acknowledged that a constructive trust can serve as a superior legal interest and thus can serve as grounds for invalidating a criminal forfeiture. It further acknowledged that the trustee adequately alleged the elements of a constructive trust, but refused to impose one because the trustee had an adequate remedy at law, viz., participating in the restitution process that would be overseen by the district court in dolling out the forfeited property to the appropriate parties. As to the RMA accounts, the district court held that the trustee’s competing claim was colorable and would be subject to further evidentiary proceedings.

The trustee appealed the adverse ruling to the Eleventh Circuit, which heard oral argument on December 6. According to reports, the most contentious arguments focused on the right of the bankruptcy court to administer assets for the benefit of all creditors and whether the district court usurped the automatic stay by its rulings. A related issue raised was whether the government had police powers to seize assets of wrongdoers like Rothstein and thus was exempt from the automatic stay under §362(b)(1) of the Bankruptcy Code, which allows for “the commencement or continuation of a criminal action or proceeding against the debtor” notwithstanding the automatic stay. It has been held by at least one circuit court that “because criminal forfeiture is part and parcel of a criminal case ... , it falls squarely within this exemption.” U.S. v. Erpenbeck, 682 F. 3d 472, 481 (6th Cir. 2012). It remains to be seen whether the Eleventh Circuit will adopt this view.


Please feel free to contact any of our attorneys in this practice area for additional information.

Elizabeth Austin                                                         Irve Goldman
eaustin@pullcom.com                                             igoldman@pullcom.com
203.330.2243                                                             203.330.2213

Jessica Grossarth                                                      


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