Jennifer Liotta, Erisa Fiduciaries in Bankruptcy: Preserving Individual Liability for Defalcation and Fraud Debts Under 11 U.s.c. Sec. 523(a)(4)

Publication year2011



Corporate officers may go to jail for stealing from employee benefit funds, and may become personally liable to the funds for the lost assets, but can the beneficiaries recover the money if the culprit declares bankruptcy? There are numerous recent examples of employers who have stolen or grossly mismanaged employee benefit plan funds. In 2002, Enron employees lost big when they were blocked from selling their 401(k) Enron stock during part of the company's free fall from ninety dollars per share to less than fifty cents per share.1The same year, a trustee for a benefit plan was sentenced to two years in prison for fraud stemming from theft of employee benefit plan funds.2In this particularly egregious case, the plan trustee converted over $240,000 of employee benefit plan funds for his own use,3costing insurers and employees nearly half a million dollars.4

Plans and plan beneficiaries may be able to sue individuals who have abused their authority over employee benefit plan funds.5Employee benefit plans are covered by the Employee Retirement Income Security Act of 1974 ("ERISA").6ERISA is federal law that provides a comprehensive statutory framework for regulating the formation and management of employee benefit funds7as well as defining rights and causes of action regarding such funds.8

Under ERISA, individuals may be held liable for criminal9and civil10sanctions. Plan beneficiaries may sue11a fiduciary who breaches his or her responsibilities to recover resulting losses to the plan, restore profits gained through use of plan assets, or for other legal and equitable relief.12

But what happens when an ERISA fiduciary with an individual debt to an ERISA fund declares bankruptcy? As a matter of public policy,13the U.S. Bankruptcy Code ("Code") bars discharge14of certain debts,15including debts

Id. created by the debtor's16bad acts. Section 523(a)(4) of the Code17bars an individual debtor from discharging debts arising from "fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny."18If the debt arose from larceny or embezzlement,19the resulting debt is not discharged in bankruptcy. Where the debt is incurred by the debtor's acts of "fraud or defalcation while acting in a fiduciary capacity,"20however, the bar to discharge only applies where "fiduciary capacity" can first be shown.21

For an ERISA plan beneficiary, however, this "fiduciary capacity" is not so easily established, and ERISA fiduciaries22may likewise discover bankruptcy is an effective escape hatch from personal liability. There is a circuit split over whether ERISA fiduciary status satisfies the requirements for finding a "fiduciary capacity" under Sec. 523(a)(4) of the Code.23The consequence of this inconsistency is that some ERISA fiduciaries may be able to discharge debts in bankruptcy that should otherwise be non-dischargeable under Sec. 523(a)(4).

The recent circuit split on this issue highlights the need for a comprehensive approach. Both the initial rule by the Ninth Circuit24and the recent split decision by the Eighth Circuit25fail to completely address ERISA fiduciary law in the context of Sec. 523(a)(4) of the Code. The Ninth Circuit was the first to address this issue in Blyler v. Hemmeter.26It established the per se rule that ERISA fiduciaries satisfy the "fiduciary capacity" requirements of

Sec. 523(a)(4) and, therefore, any debts incurred from defalcation of ERISA fiduciary duties were barred from discharge.27

The Eighth Circuit, in Hunter v. Philpott, recently disagreed with the per se rule.28The Philpott court held a determination of ERISA fiduciary status was not sufficient to satisfy the requirements of Sec. 523(a)(4).29Philpott threatens the integrity of both ERISA and bankruptcy law in multiple ways, all stemming from the court's vague reasoning and cursory analysis of ERISA fiduciary law. First, and most importantly, Philpott created uncertainty by rejecting the accepted rule while failing to replace it with any framework for analyzing ERISA fiduciary status in the context of Sec. 523(a)(4).30Second, if Philpott is read broadly, it creates a potential judicial exception to ERISA fiduciary liability that is contrary to the intent and purpose of both ERISA and the Code.31Finally, courts may apply Philpott to incorrectly withhold application of the Sec. 523(a)(4) bar to dischargeability against other, non-ERISA statutory fiduciaries.32

The conflicting case law regarding ERISA fiduciaries under Sec. 523(a)(4) highlights the need for a better analytical approach. This Comment suggests such an approach. Part I provides a brief overview of the relevant bankruptcy and ERISA statutes. Part II analyzes the In re Hemmeter and Philpott interpretations of the ERISA fiduciary statute in the context of Sec. 523(a)(4) of the Code. This analysis shows the circuit split is based largely on faulty understanding and application of the ERISA and Bankruptcy statutes. Part III shows the need for a unified approach to this question by discussing the public policy underlying the ERISA fiduciary statute and the non-dischargeability provisions of Sec. 523(a)(4). Part III also highlights how an inconsistent approach to individual fiduciary bankruptcies creates the danger of eroding the intended protections of both statutes. Finally, in Part IV, this Comment proposes a five-part analysis addressing the requirements of both statutes in determining the applicability of Sec. 523(a)(4) non-dischargeability to ERISA fiduciary debts. This analysis, by providing a comprehensive and structured approach, assures that individual fresh start is protected without sacrificing the legitimate claims of ERISA trust beneficiaries.

I. STATUTORY ANALYSIS: ERISA AND FIDUCIARY CAPACITY IN Sec. 523(a)(4) For Sec. 523(a)(4) to apply, the debtor must be both a fiduciary under ERISA and act in a "fiduciary capacity" as defined by Sec. 523(a)(4). The crux of the problem lies here-"fiduciary" under ERISA and "fiduciary capacity" under

Sec. 523(a)(4) are not co-extensive. Therefore, a debtor's fiduciary status must satisfy both ERISA and the Code. Where both statutes are satisfied, the

Sec. 523(a)(4) bar will apply if the debt was incurred through an act of defalcation or fraud within the scope of the fiduciary's duties.33The meaning of fiduciary under Sec. 523(a)(4) of the Code and ERISA are each explained below.

A. "Fiduciary Capacity" Under Sec. 523(a)(4) of the Code

Section 523(a)(4) bars discharge of individual debts arising from fraud or defalcation while acting in a fiduciary capacity.34The Code does not define "fraud," "defalcation," or "fiduciary capacity."35These terms are judicially interpreted. Bankruptcy courts have consistently held only actual fraud is barred from discharge under Sec. 523(a)(4); the policy of fresh start allows good faith debtors to discharge debts based on constructive fraud because such debts do not indicate any "moral turpitude" on the part of the debtor.36Defalcation, within the meaning of Sec. 523(a)(4), generally includes "misappropriation of trust funds or money held in any fiduciary capacity" or the failure to account for such funds.37Fiduciary capacity was interpreted by the Supreme Court in

Davis v. Aetna Acceptance Co.38This interpretation remains authoritative.39

Although Davis was decided under the Bankruptcy Act of 1898,40the interpretation of "fiduciary capacity" as stated in Davis was retained when Congress enacted the Bankruptcy Reform Act of 1978.41

The Court in Davis held that only a subset of fiduciary debts was barred from discharge. The Court distinguished between two types of fiduciary capacities: those that exist before the debt is created and those that are created when the debt is incurred.42The Court held the second type of fiduciary status was not sufficient to satisfy the bar to dischargeability.43"It is not enough that, by the very act of wrongdoing out of which the contested debt arose, the bankrupt has become chargeable as a trustee ex maleficio. He must have been a trustee before the wrong and without reference thereto."44

The core requirement of Davis is that the fiduciary capacity be established before the debt is incurred.45Thus to create a fiduciary capacity "in the strict and narrow sense,"46there must be an express, technical, or statutory trust.47

An express trust is one intentionally entered into by the parties, either through formal contract or through intent inferred from the circumstances.48In a technical trust the fiduciary's only duty is to transfer the trust property to the beneficiary.49In a statutory trust the trust obligations are imposed on the parties by law.50

Davis does not bar discharge of debts arising from equitable trusts created by incomplete transfers or acts of wrongdoing. Davis itself dealt with an ex malificio trust that arose out of a wrongful act of conversion.51Ex malificio trusts are created by operation of law as a matter of equity.52Davis has been applied to exclude defalcation and fraud liability under Sec. 523(a)(4) for fiduciary duties based on ex post trusts such as constructive,53resulting,54and implied55trusts.56A statutory trusts also fails the Davis test where the statute creates ex post trusts such as those described above.57

Whether the Davis threshold requirement for fiduciary capacity is met is a question of federal law.58State law is often important in this analysis because state law (either statutory or common) often imposes trust-type obligations on parties.59However, federal statutes can and do create fiduciary duties; ERISA is only one example of a federal law that creates fiduciary liability.60

Whatever the source of the fiduciary duty, legal or contractual labels are not controlling.61Where an express or technical trust is asserted, the court will look to the intentions of the parties.62Where a...

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