Fraud and Bankruptcy

April 2, 2012

Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Thumbnail image for Supreme Court.jpgIt is not uncommon in a contract dispute between parties to have allegations of fraud. In Northern California because of the economic recession and parties inability to fulfill contracts there have been a large number of lawsuits filed for breach of contract and fraud. If you have been sued and you do not have the financial resources to defend the lawsuit, bankruptcy may be a solution for you. You should be aware, however, that bankruptcy will not discharge a debt involving fraud.

In Destfino v. Bockting (unpublished opinion) the Ninth Circuit recently reviewed dischargeability of debt where there are allegations of fraud pursuant to 11 U.S.C.§ 523 (a)(4). It is important to remember that Chapter 7 and Chapter 13 bankruptcy will allow you to discharge debt that has accumulated as a result of a failed business, job loss, medical problems etc. but it does not relieve debt that is the result of fraud. In the Destfino v. Bockting case, the Ninth Circuit Court of Appeals affirmed the District Court and Bankruptcy Court decision that the debtor appellant and her husband were liable for debt and that debt was excepted from discharge by 11 U.S.C.§ 523 (a)(4). Appellant Bockting and Appellee Ila Destfino entered into an agreement under which Bockting would invest money with Destfino into a scheme purported to eliminate their debt and tax liability. The Bankruptcy Court found that the debt was non-dischargeable and awarded appellee Bockting a judgment of $388,327).

The District Court affirmed and the Ninth Circuit, in an unpublished Memorandum decision, affirmed on liability but vacated and remanded for the Bankruptcy Court to recalculate the damages. In the case, the Ninth Circuit confirmed that both parties entered the scheme "because of their own greed", and that the contract between the parties was not enforceable as an illegal contract, but while the scheme may have been an illegal scheme because it allegedly defrauded its own investors by taking their money and promising them impossible results, this does not mean that investing in the scheme was illegal. According to the Court, it simply turned out to be an unwise business decision. The Court found that both Destfinos had committed embezzlement and that a trust existed due to the repeated use of the word "trustee" in the agreement . The court stated, a debt falls under 11 U.S.C. § 523(a)(4) "where 1) an express trust existed, 2) the debt was caused by fraud or defalcation, and 3) the debtor acted as a fiduciary to the creditor at the time the debt was created." Otto v. Niles (In reNiles), 106 F.3d 1456, 1459 (9th Cir. 1997). "Defalcation is defined as the misappropriation of trust funds or money held in any fiduciary capacity [or] the failure to properly account for such funds." Lewis v. Scott (In re Lewis), 97 F.3d 1182, 1186 (9th Cir. 1996) . The existence of a trust is a question of fact to be reviewed for clear error. Long v. Neeland, 4 P.2d 815, 816 (Cal. Ct. App. 1931).

The Ninth Circuit determined the bankruptcy court's finding that a trust existed was not clearly erroneous due to the repeated use of the word "trustee" in the agreement. The Destfinos argued, however, that no trust was created because Bockting testified at trial that he intended to form a partnership with Destfino, rather than a trust. This argument failed according to the Ninth Circuit because the fiduciary duties between partners under California law can also give rise to a non-dischargeable debt under § 523(a)(4). See Ragsdale, 780 F.2d at 796-97. The Ninth Circuit concluded that Destfino acted in a fiduciary capacity when managing Bockting's funds, whether it was a trust or a partnership that was created by the agreement between them.

After affirming on liability, the Court ruled that the Bankruptcy Court had erred in entirely rejecting Mrs. Destfino's accountings (despite their inconsistencies) and entering judgment for the full $388,327. This was clear error given the testimony that some part of those moneys invested by Bockting were later (i) paid on his behalf and (ii) the payments were authorized by Bockting. Therefore, the Ninth Circuit determined the Destfinos liability was limited to the amount misappropriated or unaccounted for by the Destfinos.

If you have a lawsuit that has been filed against you, the debt may dischargeable in bankruptcy. There may be an exception, however, if the debt involves fraud. In order to determine whether or not the debt is dischargeable, you should consult with a bankruptcy attorney. We provide free legal consultations for bankruptcy in San Francisco County, Sacramento County, Alameda County, Contra Costa County, San Mateo County, Santa Clara County, Stanislaus County, San Joaquin County, Marin County, Solano County and throughout Northern California. Contact us for a free legal consultation today.