It is not uncommon for a successful plaintiff in a breach of fiduciary duty case to have their collection efforts thwarted by a defendant filing for bankruptcy. The issue is whether the state court judgment is dischargeable in bankruptcy. “[T]he issue of nondischargeability [is] a matter of federal law governed by the terms of the Bankruptcy Code.” Grogan v. Garner, 498 U.S. 279, 284 (1991). In such a proceeding, the plaintiffs must “establish by a preponderance of the evidence that [their] claim is not dischargeable.” Id. at 287. “Intertwined with this burden is the basic principle of bankruptcy that exceptions to discharge must be strictly construed against a creditor and liberally construed in favor of a debtor so that the debtor may be afforded a fresh start.” In re Hudson, 107 F.3d 355, 356 (5th Cir. 1997). At the same time, the Bankruptcy Code “limits the opportunity for a completely unencumbered new beginning to the honest but unfortunate debtor.” Grogan, 498 U.S. at 287

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). A defalcation must involve either (i) moral turpitude, bad faith, or other immoral conduct, or (ii) in lieu of these, an intentional wrong, which includes 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, such as where 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. Bullock v. BankChampaign, N.A., 133 S.Ct. 1754, 1759, 185 L.Ed.2d 922 (2013). 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. at 1760.

In an adversary proceeding under § 523(a)(4), a bankruptcy court may apply collateral estoppel “to preclude relitigation of state court findings that are relevant to dischargeability.” Whitaker v. Moroney Farms Homeowners’ Ass’n (In re Whitaker), No. 15-40926, 2016 U.S. App. LEXIS 5018 (5th Cir. March 18, 2016). To have preclusive effect: 1) “the facts sought to be litigated in the second action” must have been “fully and fairly litigated in the prior action,” 2) those facts must have been “essential to the judgment in the first action,” and 3) the parties (in the second action) must have been “cast as adversaries in the first action.” Id. (quoting Bonniwell v. Beech Aircraft Corp., 663 S.W.2d 816, 818 (Tex. 1984)). Where the state court judgment has sufficient findings of fact that support a finding of defalcation, a bankruptcy court may apply collateral estoppel and deny the discharge of the debt.  Id. (“The state court concluded that Whitaker breached his fiduciary duties to the HOA when he: 1) ‘knowingly incur[ed] attorney’s fees and litigation and settlement expenses on behalf of the [HOA] to oppose a homeowner’s proper request for association documents,’ 2) ‘knowingly sought and received money from the [HOA] for reimbursement of personal expenses,’ and 3) ‘knowingly sought and received money as a personal benefit from a third party contractor that was performing work paid for by the [HOA].’”).

However, where the state court judgment does not have sufficient findings of fact to support defalcation, a bankruptcy could may grant discharge.  A bankruptcy court presented with a state court judgment as evidence in support of a Section 523 exception may inquire into the true nature of the debt in order to make a dischargeability determination. Brown v. Felsen, 442 U.S. 127, 138 (1979).

In the recent case of Smith v. Saden, a plaintiff obtained a judgment against a defendant, which included a disgorgement award based on a breach of fiduciary duty. No. 10-35051, 2016 Bankr. LEXIS 877 (S.D. Tex. Bankr. March 7, 2016). The defendant filed for bankruptcy, and the plaintiff sought to have the judgment not discharged due to Section 523 (a)(2), (a)(4), and (a)(6). The plaintiff filed a motion for summary judgment.  The bankruptcy court noted that regarding the breach of fiduciary duty claim, the plaintiff failed to plead or submit a jury question on whether the defendant committed acts of fraud, defalcation, and embezzlement.  Because collateral estoppel could not apply, the court had to determine whether there was a fact question in the adversary proceeding regarding those issues. The court concluded:

Without the benefit of Smith’s pleading fraud or defalcation and obtaining a jury finding to that end, the Court declines to make such a determination at this stage. A material issue of fact exists as to whether the debt Saden owes Smith was obtained through actual fraud or fraud or defalcation while serving in a fiduciary capacity. Accordingly, Smith’s motion is denied as to the trial court’s award for equitable disgorgement and the interest thereon.

The court then noted that the plaintiff needed to request a trial on whether any amounts should be excepted from discharge due to the breach of fiduciary duty disgorgement.

So, it is important for a plaintiff who is suing a fiduciary who may file for bankruptcy to plead and seek express findings for fraud, defalcation while acting in a fiduciary capacity, embezzlement, or larceny so that the plaintiff can later take advantage of a breach of fiduciary duty liability finding and a damage, disgorgement, or forfeiture award. Otherwise, the bankruptcy court may discharge the debt or make the plaintiff retry the issues.