What Is Defalcation?

In legal terms, defalcation predominantly refers to the theft, misuse or misappropriation of money or funds held by an official trustee, or other senior-level fiduciary. Defalcation is a form of embezzlement, either through the misallocation of funds, or the failure to account for received funds. Further, defalcation refers to the sum of monies misappropriated. The term sees frequent use in the context of the title insurance business. In these cases, a title agent improperly uses the escrow funds which have an intended purpose of completing covered transactions.

In a third and less common definition, defalcation may also refer to the consolidation of two opposing debts carried by two related parties, to produce a total amount. As an example, if person A has a $100 obligation to company XYZ, but the company also owes person A $14, defalcation of these two debts becomes $86 due by person A to company XYZ.

However, this bookkeeping measure is usually discouraged because it can muddy the accounting waters. At best, this maneuver may only be legally executed, with the expressed consent of both parties involved.

A Closer Look at Defalcation

In its most common use, defalcation is the misappropriation of funds by public officials. It frequently appears in the U.S. Bankruptcy Code and indicates any illegal maneuver which taints a specific debt. The connection damages the liability to the point that it effectively cannot be discharged in bankruptcy. When this happens, it may also, fraudulently, relieve debtors from their debt obligations at the finalization of Chapter 7 or Chapter 13 bankruptcy.

In 2013, the U.S. Supreme Court addressed the issue, asserting that defalcation, as it pertains to the U.S. Bankruptcy Code demands proof of "a culpable state of mind, involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior."

In other words, the act of misappropriating funds has to have evident intention. However, common law specifies defalcation conduct as involving a degree of culpability greater than negligence but not necessarily rising to the level of fraud. Some cases make it more challenging to pinpoint acts of defalcation. Actions which may be considered to be defalcation when committed by executives or high official entrusted with funds are often, more bluntly, characterized as strict embezzlement when committed by lower-level employees or functionaries. 

Key Takeaways

  • Defalcation predominantly refers to the theft, misuse or misappropriation of money or funds held by an official trustee, or other senior-level fiduciary.
  • Defalcation is a form of embezzlement, either through the misallocation of funds, or the failure to account for received funds.
  • defalcation may also refer to the consolidation of two opposing debts carried by two related parties, to produce a total amount.

Real World Example

In the infamous defalcation case of Bullock v. BankChampaign, N.A., filed in the United States Court of Appeals for the Eleventh Circuit, Randy Bullock filed for bankruptcy in 2009 to discharge a judgment debt from a 1999 lawsuit brought by his brothers. The brothers sued him for breach of fiduciary duty as trustee of their father's trust. Bullock who became the trustee in 1978, took three loans from the trust without the beneficiaries' knowledge, He ultimately paid back in full.