DEBTOR EMBEZZLEMENT OF COLLATERAL.

• Author: Byington, Jonathon S.

This Article is about collateral and the "embezzlement" exception to discharge under [section] 523(a)(4) of the Bankruptcy Code. Under the Uniform Commercial Code, collateral is property subject to a security interest. The "embezzlement" exception to discharge requires a debtor fraudulently appropriate entrusted property. A debtor fraudulently appropriates a security interest when the debtor, in conjunction with circumstances indicating fraud, transfers collateral or proceeds of collateral to a transferee who takes free of the security interest. A secured party "entrusts" its security interest to a debtor in situations where a debtor has power or control over collateral. There is a split among bankruptcy courts on whether a security interest can satisfy the "property" requirement of embezzlement. Some courts hold that it does. Others conclude that when a debtor appropriates collateral, the security interest is merely a lien and is therefore insufficient to support a claim of embezzlement. The rationale is that the debtor is the owner of the collateral and a debtor cannot embezzle the debtor's own property. This Article challenges that premise by evaluating the history and nature of a Uniform Commercial Code security interest. It argues that a security interest satisfies the "property" requirement of embezzlement because it embodies the fundamental property interests of the right to transfer, the right to control, and the right to use. A debtor can embezzle a security interest. Debt related to such embezzlement should not be discharged.

TABLE OF CONTENTS I. INTRODUCTION II. BACKGROUND A. Bankruptcy Act of 1867 and Two Supreme Court Decisions B. Bankruptcy Act of 1898 and One Supreme Court Decision C. Bankruptcy Law Reform Act of 1978 and One Supreme Court Decision D. The U.S. Circuit Courts of Appeals Have Adopted a Criminal Law Definition of Embezzlement from the 1895 Supreme Court Decision of Moore v. United States III. ANALYSIS OF THE "EMBEZZLEMENT EXCEPTION DISCHARGE A. The Requirement of "Fraudulent Appropriation" B. The Requirement of "Property" 1. The Split on Whether a UCC Security Interest Satisfies the "Property" Requirement 2. The Nature of a UCC Security Interest a. Right to Transfer b. Right to Possess (or Control) c. Right to Use C. The Requirement of "Entrustment" of Property. IV. CONCLUSION I. INTRODUCTION

One purpose of bankruptcy law is to give the "honest but unfortunate debtor" a fresh start. (1) The exceptions to discharge are a statutory implementation of the "honest" aspect of that policy. They place limits on the scope of the discharge. (2) This Article is about collateral and the "embezzlement" exception to discharge under [section] 523(a)(4) of the Bankruptcy Code. For purposes of this Article, collateral is property subject to a Uniform Commercial Code Article 9 security interest ("UCC security interest"). (3) This Article argues that a debtor can embezzle a UCC security interest in situations where a debtor, in conjunction with circumstances indicating fraud, transfers collateral or proceeds of collateral to a transferee who takes free of the UCC security interest.

This Article begins by skimming over the appearances of the term "embezzlement" in the bankruptcy acts as well as the Supreme Court's limited guidance on its meaning. It then observes that nearly every U.S. Circuit Court of Appeals has defined embezzlement for bankruptcy purposes based on an 1895 federal criminal law decision entitled Moore v. United States, wherein the Supreme Court defined embezzlement as "the fraudulent appropriation of property by a person to whom such property has been entrusted, or into whose hands it has lawfully come." (4)

This Article walks through the Moore definition of embezzlement with an emphasis on the "property" element. On its face, applying the Moore definition in a bankruptcy context seems fairly straightforward. But there is a split among bankruptcy courts on whether a UCC security interest can satisfy the "property" element. Some courts hold that it does. Others conclude that when a debtor appropriates property subject to a UCC security interest, the security interest is merely a lien and is therefore insufficient to support a claim of embezzlement. The rationale is that the debtor is the owner of the collateral and a debtor cannot embezzle the debtor's own property.

For example, in the Chapter 7 case of In re Barnes, inventory was subject to a UCC security interest. (5) The debtor agreed in a security agreement to not sell the inventory out of the ordinary course of business unless he received written permission from the secured party. (6) In what the bankruptcy court characterized as "a most cavalier manner," the debtor sold the inventory out of the ordinary course of business to a third party and spent the sale proceeds. (7) The debtor did not get written permission. (8) In fact, on the day the debtor sold the inventory, the debtor had a conference call with the secured party but "[a]t no time during this exchange of information ... did [the debtor] ever inform them that he was in the process of closing the sale that very day." (9) After reviewing the matter, the bankruptcy court found that the debtor "willingly breached" the security agreement and that the debtor's actions were wrong but not embezzlement. (10) The bankruptcy court explained:

It was not the security interest of the Bank that was in the hands of [the debtor]. It was property of [the debtor] in the hands of [the debtor] which the [d]ebtor sold. ... [W]here a creditor holds nothing more than a security interest in a debtor's property, the relationship is insufficient to support a finding of embezzlement. (11) This Article challenges the premise that a UCC security interest cannot be embezzled when a debtor transfers collateral or proceeds of collateral to a transferee who takes free of the UCC security interest. It does so by evaluating the nature of a UCC security interest. It explores a debtor's and secured party's respective interests in collateral along with the inevitable passage of the totality of all property interests in collateral to either the debtor (upon satisfaction of the obligation and release of the UCC security interest), the secured party (upon default and either disposition, collection, or acceptance of collateral), or a transferee who takes free of the UCC security interest. (12) The nature of a UCC security interest is analyzed by considering the fundamental property interests of the right to transfer, the right to possess (or control for intangible personal property), and the right to use. A UCC security interest satisfies the "property" element of embezzlement because it embodies each of these fundamental property interests.

As for the other elements of embezzlement, a secured party entrusts its UCC security interest to a debtor in situations where a debtor has power or control over the collateral. A debtor fraudulently appropriates a UCC security interest when the debtor, in conjunction with circumstances indicating fraud, transfers collateral or proceeds of collateral to a transferee who takes free of the UCC security interest. Importantly, the requirement that a debtor's appropriation be fraudulent separates dischargeable debt relating to run-of-the-mill debtor defaults under a security agreement from the rarer cases that rise to the level of embezzlement. From a policy perspective, an exception to discharge should not be interpreted in a way that applies the exception to every debt. (13) The "fraudulent appropriation" requirement ensures that the embezzlement exception to discharge is not applied in a way that results in the exception encompassing every debt involving a UCC security interest.

2. BACKGROUND

   This Part surveys the term "embezzlement" in the bankruptcy acts as well as the few Supreme Court decisions that have mentioned the term in a bankruptcy context. The Supreme Court's bankruptcy decisions are not helpful in determining the meaning of embezzlement. No bankruptcy scholarship has focused solely on embezzlement. (14) Nearly all of the U.S. Circuit Courts of Appeals have adopted a criminal law definition from the 1895 Supreme Court decision of Moore v. United States. (15) This Part ends by examining Moore.

   1. Bankruptcy Act of 1867 and Two Supreme Court Decisions

      Neither the Bankruptcy Act of 1800 (16) nor the Bankruptcy Act of 1841 (17) contained the word "embezzlement." The term first appeared in the Bankruptcy Act of 1867 as an exception to discharge. (18) As for legislative history, this part of the Bankruptcy Act of 1867 was modeled after Massachusetts insolvency law. (19) The 1859 Massachusetts statute on courts of insolvency allowed a judge to examine under oath "anyone suspected of having fraudulently received, concealed, embezzled, or conveyed away, any money, goods, effects, or other estate, of the debtor." (20)

      Supreme Court decisions interpreting the Bankruptcy Act of 1867 do not define embezzlement. In 1877, when it was interpreting the "fraud" exception to discharge, the Supreme Court remarked that embezzlement involved an "intentional wrong." (21) Seven years later, the Supreme Court mentioned but did not concentrate on embezzlement when it addressed exceptions to discharge involving fraud and fiduciary character. (22) In 1878, Congress repealed the Bankruptcy Act of 1867 for reasons unrelated to the "embezzlement" exception to discharge. (23)

   2. Bankruptcy Act of 1898 and One Supreme Court Decision

      About twenty years later, the term "embezzlement" appeared in the Bankruptcy Act of 1898 as an exception to discharge. (24) In 1904, the Supreme Court clarified that a debtor must be acting in a fiduciary capacity in order for a debt created by the debtor's embezzlement to be excepted from discharge. (25) This is the only Supreme Court decision on embezzlement under the Bankruptcy Act of 1898.

   3. Bankruptcy Law Reform Act of 1978 and One Supreme Court...