When will a debt be non-dischargeable in bankruptcy under 11 U.S.C. § 523(a)(4)?

(a) A discharge under section 727, 1141, 1192 1 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt-

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(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny;

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First, Ritz contends that interpreting "actual fraud" in § 523(a)(2)(A) to encompass fraudulent conveyances would render duplicative two other exceptions to discharge in § 523. Section 523(a)(4) exempts from discharge "any debt ... for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." And § 523(a)(6) exempts "any debt ... for willful and malicious injury by the debtor to another entity or to the property of another entity."

Ritz makes the unremarkable point that the traditional definition of "actual fraud" will cover some of the same conduct as those exceptions: for example, a trustee who fraudulently conveys away his trust's assets. But Ritz' interpretation does not avoid duplication, nor does our interpretation fail to preserve a meaningful difference between § 523(a)(2)(A) and §§ 523(a)(4), (6). Just as a fiduciary who engages in a fraudulent conveyance may find his debt exempted from discharge under either § 523(a)(2)(A) or § 523(a)(4), so too would a fiduciary who engages in one of the fraudulent misrepresentations that form the core of Ritz' preferred interpretation of § 523(a)(2)(A). The same is true for § 523(a)(6). The debtors who commit fraudulent conveyances and the debtors who make false representations under § 523(a)(2)(A) could likewise also inflict "willful and malicious injury" under § 523(a)(6). There is, in short, overlap, but that overlap appears inevitable.

And, of course, our interpretation of "actual fraud" in § 523(a)(2)(A) also preserves meaningful distinctions between that provision and §§ 523(a)(4), (a)(6). Section 523(a)(4), for instance, covers only debts for fraud while acting as a fiduciary, whereas § 523(a)(2)(A) has no similar limitation. Nothing in our interpretation alters that distinction. And § 523(a)(6) covers debts "for willful and malicious injury," whether or not that injury is the result of fraud, see Kawaauhau v. Geiger, 523 U.S. 57, 61, 118 S.Ct. 974, 140 L.Ed.2d 90 (1998) (discussing injuries resulting from " ‘intentional torts' "), whereas § 523(a)(2)(A) covers only fraudulent acts. Nothing in our interpretation alters that distinction either. Thus, given the clear differences between these provisions, we see no reason to craft an artificial definition of "actual fraud" merely to avoid narrow redundancies in § 523 that appear unavoidable.

Section 523(a)(4) provides that:

(a) A discharge under section 727 ... or 1328(b) of this title does not discharge an individual debtor from any debt—... (4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny....

A debt is excepted from discharge under § 523(a)(4) where “1) an express trust existed, 2) the debt was caused by fraud or defalcation, and 3) the debtor acted as a fiduciary to the creditor at the time the debt was created.” Otto v. Niles (In re Niles),106 F.3d 1456, 1459 (9th Cir.1997), quoting Klingman v. Levinson, 831 F.2d 1292, 1295 (7th Cir.1987). “Case law makes clear that the broad, general definition of fiduciary—a relationship involving confidence, trust and good faith—is inapplicable in the context of exception to a bankruptcy discharge.” Utnehmer v. Crull (In re Utnehmer), 499 B.R. 705, 712 (9th Cir. BAP 2013), citing Ragsdale v. Haller, 780 F.2d 794, 796 (9th Cir.1986).

The question as to whether the debtor is or was a “fiduciary” for purposes of a claim under § 523(a)(4) is governed by federal law. Cal–Micro, Inc. v. Cantrell (In re Cantrell), 329 F.3d 1119, 1125 (9th Cir.2003), citing Lee–Benner v. Gergely (In re Gergely), 110 F.3d 1448, 1450 (9th Cir.1997). “[T]he fiduciary relationship must be one arising from an express or technical trust that was imposed before and without reference to the wrongdoing that caused the debt.” Lewis v. Scott (In re Lewis), 97 F.3d 1182, 1185 (9th Cir.1996), citing Ragsdale, 780 F.2d at 796; Davis v. Aetna Accept. Co., 293 U.S. 328, 333, 55 S.Ct. 151, 79 L.Ed. 393 (1934). We consult state law to determine whether the requisite trust relationship exists. In re Cantrell, 329 F.3d at 1125, citing In re Lewis, 97 F.3d at 1185, and Ragsdale, 780 F.2d at 796.

“[W]e have adopted a narrow definition of ‘fiduciary’ for purposes of § 523(a)(4).” In re Cantrell, 329 F.3d 1119, 1125 (9th Cir.2003). Under such definition, “[t]he broad, general definition of fiduciary—a relationship involving confidence, trust and good faith—is inapplicable.” Ragsdale, 780 F.2d at 796. As the pre-eminent bankruptcy treatise explains, “[f]or purposes of section 523(a)(4), the definition of ‘fiduciary’ is narrowly construed, meaning that the applicable nonbankruptcy law that creates a fiduciary relationship must clearly outline the fiduciary duties and identify the trust property.” 4 Collier on Bankruptcy, ¶ 523.10 (Alan N. Resnick & Henry J. Sommer eds., 16th ed.).

While we may consult state law—like the alter ego doctrine—when interpreting whether an individual is a “fiduciary” under Section 523(a)(4), we ultimately are interpreting a federal statute, and the issue presented is one of federal law. See Ragsdale, 780 F.2d at 796. Thus, “the mere fact that state law places two parties in a relationship that may have some of the characteristics of a fiduciary relationship does not necessarily mean that the relationship is a fiduciary relationship under 11 U.S.C. § 523(a)(4).” 4 Collier on Bankruptcy, ¶ 523.10 (Alan N. Resnick & Henry J. Sommer eds., 16th ed.). Indeed, “[i]f applicable nonbankruptcy law does not clearly and expressly impose trust-like obligations on a party, [courts] will not assume that such duties exist and will not find that there was a fiduciary relationship.” Id.

Further, “the fiduciary relationship must be one arising from an express or technical trust that was imposed before and without reference to the wrongdoing that caused the debt.” In re Cantrell, 329 F.3d at 1125 (emphasis added) (quoting

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Lewis v. Scott (In re Lewis ), 97 F.3d 1182, 1185 (9th Cir.1996) ). Thus, Section 523(a)(4) applies “only to a debt created by a person who was already a fiduciary when the debt was created.” Davis v. Aetna Acceptance Co., 293 U.S. 328, 333, 55 S.Ct. 151, 79 L.Ed. 393 (1934) (internal quotation marks omitted).

The next issue is whether under federal law the relationship of a majority shareholder to a minority shareholder establishes a fiduciary relationship under § 523(a)(4). Section 523(a)(4) provides that "A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt — (4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny". The term "fiduciary" in § 523(a)(4) is given a very narrow definition and relates only to "express" or "statutory" trusts. See In re Short, 818 F.2d 693, 695 (9th Cir.BAP 1987).

Two Ninth Circuit cases bear directly on this question. In In re Hultquist, 101 B.R. 180 (9th Cir.BAP 1989), plaintiff appealed the bankruptcy court's dismissal of its cause of action on the basis that under § 523(a)(4) there was no pre-existing fiduciary relationship between the parties. The plaintiff in Hultquist asserted that the debtor fraudulently obtained a $20,000 commission. In moving under § 523(a)(4), plaintiff argued that debtor's status as a corporate officer was sufficient to establish a fiduciary relationship between plaintiff corporation and debtor. Id. at 185. To support this view, plaintiff cited several Washington cases that hold that corporate officers owe a fiduciary duty to the corporation. Id.

In analyzing the law, the BAP affirmed the principle that the term "fiduciary" in § 523(a)(4) is a narrowly defined question of federal law and state law is consulted only for purposes of determining when a trust exists. Id. It also confirmed that the trust must have been created before the act of wrongdoing. Id. The bankruptcy court held that there was no pre-existing trust. The BAP affirmed the bankruptcy court stating that "Although the debtor may have owed a general fiduciary duty as a corporate officer under state case law, no pre-existing or statutorily created trust existed at the time of the alleged wrongdoing." Id.

The key words in this statement are "no pre-existing or statutorily created trust". I was surprised that the BAP did not discuss Ragsdale v. Haller, 780 F.2d 794 (9th Cir.1986), to shed some additional light on the meaning of these words. Ragsdale, is certainly a leading case in this area. Reviewing

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the facts in Ragsdale, Ragsdale and Haller were partners. Haller, the debtor, took undisclosed bonus payments contrary to the percentage allowed by permit. Ragsdale filed a nondischargeability complaint under § 523(a)(4). Haller argued that there was no fiduciary relationship within the meaning of § 523(a)(4). The court reviewed state law to determine if a pre-existing or statutorily created trust existed between them. Ragsdale pointed to Cal.Corp.Code § 15021 (West 1977) and to California cases holding that California partners are trustees for each other. Section 15021(1) provides: "Every partner must account to the partnership for any benefit, and hold as trustee for it any profits. . . ." (Emphasis added). In reviewing California case law, the court determined that partners in California are trustees for each other. As the court stated "This is more than just a fiduciary relationship created in response to some wrongdoing; California has made all partners trustees over the assets of the partnership. Accordingly, we hold that California partners are fiduciaries within the meaning of § 523(a)(4) and that Haller's debt to Ragsdale is non-dischargeable." Id. at 796-97. The court concluded that if state law holds that a partner is a trustee over partnership assets, then the partner is a fiduciary within the narrow meaning of § 523(a)(4). Id. at 797.

Is Hultquist consistent with the Ninth Circuit's opinion in Ragsdale? I think it is because of one critical distinction. It appears from the Hultquist decision that a corporate officer is not a trustee of the corporate assets. On the other hand, in Ragsdale, it is clear that a partner in California is a trustee of the partnership's assets. This is a critical distinction. It is a distinction that governs the proceeding before me. As far as I can determine, California law does not hold that a majority shareholder is a trustee of the corporate assets or any interests that shareholders may have in the corporate res. For this reason, like in Hultquist, there is no preexisting or statutorily created trust existing at the time of the alleged wrongdoing. Accordingly, plaintiff cannot maintain a § 523(a)(4) cause of action.

5. Indeed, in Roots v. Bangerter (In re Bangerter), 106 B.R. 649, 654 (Bankr.C.D.Cal.1989), the court concluded that "California law does not hold that a majority shareholder is a trustee of the corporate assets or any interests that shareholders may have in the corporate res." As a result, the court held that a minority shareholder could not maintain a § 523(a)(4) cause of action against a majority shareholder. While In re Bangerter addressed the status of a controlling shareholder, the court recognized that whether an officer is a fiduciary under § 523(a)(4) represented a similar issue and cited approvingly to Alexander & Alexander of Washington, Inc. v. Hultquist (In re Hultquist), 101 B.R. 180 (9th Cir. BAP 1989).

There, the BAP held that under Washington law, "although the debtor may have owed a general fiduciary duty as a corporate officer under state case law, no pre-existing or statutorily created trust existed at the time of the alleged wrongdoing." In re Hultquist, 101 B.R. at 185 (emphasis in original). As a result, the BAP concluded that the corporate officer was not a fiduciary for purposes of § 523(a)(4). It is true that In re Hultquist concerned Washington law and does not constitute binding precedent. But the holding of In re Bangerter that majority shareholders under California law are not fiduciaries within the meaning of § 523(a)(4), and In re Bangerter's reliance on In re Hultquist to support its holding, underscore that corporate officers under California law are not fiduciaries for purposes of § 523(a)(4).

Section 523(a)(4) of the Federal Bankruptcy Code provides that an individual cannot obtain a bankruptcy discharge from a debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." 11 U.S.C. § 523(a)(4). We here consider the scope of the term " defalcation." We hold that it includes a culpable state of mind requirement akin to that which accompanies application of the other terms in the same statutory phrase. We describe that state of mind as one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior.

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Thus, where the conduct at issue does not involve bad faith, moral turpitude, or other immoral conduct, the term requires an intentional wrong. We include as intentional

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not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent. Thus, we include reckless conduct of the kind set forth in the Model Penal Code. Where actual knowledge of wrongdoing is lacking, we consider conduct as equivalent if the fiduciary "consciously disregards" (or is willfully blind to) "a substantial and unjustifiable risk" that his conduct will turn out to violate a fiduciary duty. ALI, Model Penal Code § 2.02(2)(c), p. 226 (1985). See id., § 2.02 Comment 9, at 248 (explaining that the Model Penal Code's definition of "knowledge" was designed to include

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" ‘wilful blindness' "). That risk "must be of such a nature and degree that, considering the nature and purpose of the actor's conduct and the circumstances known to him, its disregard involves a gross deviation from the standard of conduct that a law-abiding person would observe in the actor's situation." Id., § 2.02(2)(c), at 226 (emphasis added). Cf. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 194, n. 12, 96 S.Ct. 1375, 47 L.Ed.2d 668 (1976) (defining scienter for securities law purposes as "a mental state embracing intent to deceive, manipulate, or defraud").

Transamerica contends that by not remitting the cash proceeds to Transamerica, the individual debtors engaged in embezzlement, and therefore the debt should not be dischargeable. Section 523(a)(4) of the Bankruptcy Code does not allow an individual debtor to discharge a debt incurred by "fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." 11 U.S.C. § 523(a)(4). Clearly, a debt can be nondischargeable for embezzlement under 523(a)(4) without the existence of a fiduciary relationship. In the Matter of Shuler, 21 B.R. 643 (Bankr.D.Idaho 1982); In re Talcott, 29 B.R. 874, 878 (Bankr.D.Kan.1983).

Under federal law, embezzlement in the context of nondischargeability has often been defined as "the fraudulent appropriation of property by a person to whom such property has been entrusted or into whose hands it has lawfully come." Moore v. United States, 160 U.S. 268, 269 (1885). Embezzlement, thus, requires three elements: "(1) property rightfully in the possession of a nonowner; (2) nonowner's appropriation of the property to a use other than which [it] was entrusted; and (3) circumstances indicating fraud." In re Hoffman, 70 B.R. 155, 162 (Bankr.W.D.Ark.1986); In re Schultz, 46 B.R. 880, 889 (Bankr.D.Nev.1985).

Transamerica contends that when the individual debtors did not segregate the proceeds and did not pay Transamerica, they intended to defraud Transamerica, and therefore the debtors embezzled the proceeds. Transamerica relies on California Penal Code § 504b, which reiterates the federal requirement of intent to defraud when proving embezzlement.

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Whether the debtors intended to defraud Transamerica is a question of fact. The bankruptcy court held that Transamerica did not meet its burden of proof on the embezzlement claim. The BAP affirmed this ruling stating that the bankruptcy court's finding that

at all times the debtors acted with the intent to benefit the corporation by securing financing so that the company could pay all its debts ... negates any contention that the debtors intended to defraud Transamerica.

Littleton, 106 B.R. at 639.

Given the bankruptcy court's finding that the debtors applied their entire effort and resources to make the business survive and that this was their dominant motivation, it was not clearly erroneous for the BAP to hold that the debtors did not act with the intent to defraud Transamerica. The BAP correctly affirmed the bankruptcy court's decision that the debtors did not commit embezzlement. Therefore, the debts to Transamerica are dischargeable.

Ormsby suggests that the state court judgment against him did not constitute larceny within the federal definition of the term and that the court made no findings of willful or malicious injury. As a result, he contends, summary judgment was inappropriate because the issues are not precluded by the state court judgment. We disagree.² The state court judgment is sufficient to preclude relitigation of whether Ormsby's conduct meets the requirements of subsection 523(a)(4) or of subsection 523(a)(6), either of which would be sufficient to prevent the discharge of the judgment debt.³

A. Section 523(a)(4)

Section 523(a)(4) prevents discharge "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." 11 U.S.C. § 523(a)(4). "For purposes of section 523(a)(4), a bankruptcy court is not bound by the state law definition of larceny but, rather, may follow federal common law, which defines larceny as a `felonious taking of another's personal property with intent to convert it or deprive the owner of the same.'" 4 Collier on Bankruptcy ¶ 523.10[2] (15th ed. rev. 2008).⁴

Ormsby's main contention is that the facts of the state court judgment do not prove larceny for the application of section 523(a)(4) because the federal definition of larceny requires fraudulent intent whereas conversion⁵ under Nevada state law does not require a finding of fraudulent intent. Conversion is defined as "a distinct act of dominion wrongfully exerted over another's personal property in denial of, or inconsistent with his title or rights therein or in derogation, exclusion, or defiance of such title or rights. Additionally,

[591 F.3d 1206]

conversion is an act of general intent, which does not require wrongful intent and is not excused by care, good faith, or lack of knowledge." M.C. Multi-Family Development, L.L.C. v. Crestdale Assoc., Ltd., 193 P.3d 536, 542-43 (Nev.2008) (internal citations omitted). Accordingly, Ormsby argues that the state court's finding of conversion does not translate to a finding of larceny; therefore, the issue is not precluded.

We make no determination concerning whether federal law requires a finding of fraudulent intent for larceny as Ormsby contends.⁶ Were we to find that larceny required fraudulent intent, the state court judgment would provide enough information to determine that the court found that his actions amounted to fraud, because "[i]ntent may properly be inferred from the totality of the circumstances and the conduct of the person accused." Kaye v. Rose (In re Rose), 934 F.2d 901, 904 (7th Cir.1991). The totality of the circumstances as described in the state court's findings of fact make clear that Ormsby acted with fraudulent intent. When he started Inter-County, he purchased the rights to use the title plant for 2000 until the present, demonstrating that he was aware of the lawful means of obtaining access to them. Rather than purchasing the rights to the title plants for the 1900s, he hired McCaffrey away from a competing title company and discussed with him the importance of the title plants to a new title company. While McCaffrey still had access to the plants that FATCO possessed, Ormsby encouraged, cooperated, and assisted McCaffrey's removal of the plants and their reproduction. Of particular note, Ormsby sent the microfiche containing the plants to a non-local copying service, likely to avoid detection. Based on these facts found by the state court, Ormsby's conduct constituted larceny within the federal meaning of the term; accordingly under section 523(a)(4), his debt cannot be discharged.

2. The bankruptcy court held that the debt was nondischargeable as to Mrs. Jennings as well because the debt was for "embezzlement[] or larceny" and "for willful and malicious injury by the debtor to another entity or to the property of another entity." 11 U.S.C. § 523(a)(4), (6). Larceny is the "felonious taking of another's property with the intent to convert it to deprive the owner of the same." In re Ormsby, 591 F.3d 1199, 1205 (9th Cir. 2010) (citation omitted). Felonious intent, in turn, requires "proceeding from an evil heart of purpose; malicious; [or] villainous." Id. at 1205 n.4 (citation omitted). Embezzlement similarly requires circumstances indicating fraudulent intent. In re Littleton, 942 F.3d 551, 555 (9th Cir. 1991). Mrs. Jennings put forth evidence that created a genuine issue of material fact as to her intent by claiming that she did not know what she was

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signing and signed forms merely because Mr. Jennings told her to. Therefore, summary judgment should not have been granted as to Mrs. Jennings.