Adas v. Rutkowski, 2013 WL 6865417 (N.D.Ill. 2013), illustrates the confluence of Federal bankruptcy law and state law fiduciary duty and express trust principles in a case involving a failed construction partnership.
The plaintiff and bankrupt debtor (defendant) formed a partnership to buy real estate, build a house on it and split the profits once the house was sold.
The venture failed and the plaintiff got stuck with a sizeable deficiency judgment in a lender’s foreclosure suit. After the defendant filed for bankruptcy, the plaintiff objected to defendant’s discharge based on defendant’s lengthy pattern of keeping plaintiff in the dark about the failed venture’s finances. The bankruptcy court agreed and the defendant appealed.
Held: Affirmed. Defendant’s obligation to plaintiff is nondischargeable.
Normally, a bankruptcy filing gives a debtor a reprieve from creditor collection efforts and forgives (or “discharges”) most of his debts.
An exception is where the bankrupt debtor engages in fraud, defalcation, embezzlement or larceny. 11 U.S.C. §. 523.
The creditor must show (1) an express trust or fiduciary relationship between the debtor and creditor, and (2) that the debt was caused by fraud or defalcation. Defalcation equals (roughly) intentional conduct that’s more than negligence but less than fraud. * 4, 8.
Express Trust – State and Federal Law
The court held that the parties’ business relationship constituted an express trust.
In Illinois, an express trust exists where (1) there is an intent to create a trust, (2) definite subject matter or trust property, (3) trust beneficiaries, (4) a trustee, (5) a specific trust purpose, and (6) delivery of trust property to the trustee.
While trusts are normally manifested in a writing (such as a will or property deed), it doesn’t have to be and a trust can be shown through circumstantial evidence.
The Federal courts view the trust hallmarks as (1) segregation of funds (no commingling, e.g.), (2) management of the funds by an intermediary, and (3) the entity that controls the trust funds or property has only bare legal title to the funds. *6.
The court found the evidence established a trust arrangement between the parties. There was an intent to create a trust, trust property (loan funds), subject matter (the house), a trustee (defendant), a beneficiary (plaintiff) and delivery of the trust property. *5.
The Court also blocked defendant’s discharge because defendant breached his fiduciary duties to the plaintiff. Federal law defines a fiduciary relationship as one where there is an imbalance of power between parties and a stronger party takes advantage of weaker one.
Here, the defendant occupied a position of power and influence over the plaintiff and abused the position by excluding the plaintiff from all aspects of the parties business. *7.
Finally, the Court refused to discharge defendant’s debt to plaintiff because of the defendant’s “defalcation.”
Defalcation applies where a debtor’s conduct is intentional or criminally reckless. The conduct must go beyond negligence, doesn’t rise to the level of fraud, but still requires subjective intent.
Defendant’s conduct easily met the defalcation standard. He engaged in a pattern of secretive and ethically challenged business activity by submitting inflated sworn statements and phantom receipts, commingling funds, and hiding project data from the plaintiff. *8-9.
(1) An express trust will exist where someone gives money or property to another with explicit directions as to how to apply those funds; and no writing is required;
(3) a creditor can defeat a bankrupt debtor’s discharge if it can show the debtor intentionally or recklessly violates an obligation to the creditor – even if the debtor’s conduct doesn’t rise to the level of fraud.