Defalcation

Article bySushant Deoskar
Edited byAnkush Jain
Reviewed byDheeraj Vaidya, CFA, FRM

What is Defalcation?

Defalcation is a term used in chapter 7 of the United States Bankruptcy Code, is an act of misappropriating funds or resources by a person entrusted with the office of those assets. It is considered defalcation when a trustee or a fiduciary is found guilty of misappropriating funds through negligence or embezzlement.

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A person charged with defalcation implies that they have mishandled the funds or resources of the office or trust that they were in charge of. It is common law in the United States of America and applies more often to officials who serve in a public capacity. For example, Chapter 7 of the U.S. Bankruptcy Code establishes law on the discharge orders on a debt or other forms of debt. The primary purpose of the bankruptcy code is to discharge certain debts to give the debtorDebtorA debtor is a borrower who is liable to pay a certain sum to a credit supplier such as a bank, credit card company or goods supplier. The borrower could be an individual like a home loan seeker or a corporate body borrowing funds for business expansion. read more a “fresh start” in cases where one is honest and the court finds him reasonably incapable of satisfying debt conditions.

Key Takeaways

  • Defalcation is a term in Chapter 7 of the United States Bankruptcy Code. It is an act of misappropriating funds or resources by a person entrusted with the office of those assets.
  • The types are embezzlement, defalcation on debt, and fiduciary defalcation.
  • The standard bases of defalcation are intention or degree of intent involved, amount of money or resources involved or defalcated, and the accused involved in the prior cases.
  • A defalcation-accused person must take the help of an attorney with experience imploring in these cases.

Defalcation Explained

Defalcation according to the U.S. bankruptcy code is the misappropriation of funds by an individual to whom the charge of those funds was given. It is the type of debt that cannot be discharged or waived off in the event of bankruptcy.

It was mostly confined to the law books of the United States from where it transgressed borders. Today, it is a law in many countries, in some form or the other. It is closely associated with the misappropriation of funds in an official capacity. Nevertheless, it is more common to see cases of debt and liability misappropriations adjudicated on the law of defalcation.

The law finds substance because the crux of the bankruptcy code establishes that such a debtor who has filed for bankruptcy and been granted a discharge debts motion is not liable to be held for not satisfying discharge debts. However, such a privilege is not accessible to partnerships or corporations.

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Examples

Let us understand the concept of cash defalcation better with the help of a few examples.

Defalcation

Bullock vs. BankChampaign case, courts had a tough time speaking out on what constitutes defalcation by a fiduciary. So let us understand the issue first.

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#1 – The Case

The case goes back to 1978, when Mr. Bullock was made the trustee of his father’s trust. Mr. Bullock had four siblings. Thus, his father’s trust had five beneficiaries. Bullock was allowed to pay his life insurance premiums and satisfy a withdrawal request from another trustee. The trust operations guidelines distinctly mentioned this.

#2 – The Breach

Despite these restrictions, Bullock violated the terms of the trust guidelines and borrowed from the trust on three different occasions: –

  1. To settle debt payments of his father’s business.
  2. To purchase certificates of depositCertificates Of DepositA certificate of deposit (CD) is an investment instrument mostly issued by banks, requiring investors to lock in funds for a fixed term to earn high returns. CDs essentially require investors to set aside their savings and leave them untouched for a fixed period.read more.
  3. To buy the real asset.Real AssetReal Assets are tangible assets that have an inherent value due to their physical attributes. These assets include metals, commodities, land, and factory, building, and infrastructure assets. read more

Although, he repaid all the loans.

#3 – The Accusation

Bullock’s two brothers learned of the borrowings of Bullock from the trust. As a result, they sued their brother in state court, claiming that Bullock had breached his fiduciary duty by borrowing money from the trust, violating the trust’s guidelines.

#4 – The Summary Judgement

The court ordered Bullock to pay the damages upon a summary judgment appealed by the brothers. In addition, the state court required Bullock to satisfy payments against the mill that Bullock had purchased from the trust’s money. However, he could not sell his mill, make payments, and file for bankruptcy.

#5 – The Court Verdict

  • In later developments, the trusteeship changed hands and went to BankChampaign. The bank argued in the court that while acting in a fiduciary capacity and defalcating, a person cannot discharge owed debts through a bankruptcy filing. The court granted the motion that held Bullock guilty of knowingly breaching his fiduciary duty.
  • In all cases where the involved individuals argue their incapability to pay debts, those cases with the slightest element(s) of defalcation will not be granted a discharge motion outrightly. Such cases have been tried in courts, and special rulings have been ordered.

Source: United States Bankruptcy Code

Types

The different types of defalcations can be found in cases historically. Let us understand the crux of the concept better through the discussion below.

#1 – Embezzlement

Fraudulent activities supported by manipulation and acts to conceal fraud constitute embezzlementConstitute EmbezzlementEmbezzlement refers to the act of secretly taking, withholding, or misappropriating money or other asset that is kept, maintained, or placed under an individual's responsibility by the company for which he or she works.read more.

#2 – Defalcation of Debt

It involves the absence of consent of all parties involved in debt consolidationDebt ConsolidationDebt consolidation is a process which streamline several loans into a single one to receive the benefit of a lower interest rate. The reduced periodic payment leads to a reduction in liability.read more cases. If debt consolidation and payments are made without the permission of all the involved parties, the agreement would be termed invalid and void.

#3 – Fiduciary Defalcation

It is where a person entrusted with a duty to look after a firm’s resources or funds utilizes the same for purposes other than those defined in the agreement.

Penalties

It is a punishable offense, and there are several penalties. However, penalties differ a lot from one jurisdiction to another. But the guidelines on which the penalties are based have similarities. Following are some common bases for punishment: –

  1. Intention or degree of intent involved.
  2. Amount of money or resources that were involved or defalcated.
  3. Involvement of the accused in prior cases.

Remedy: A defalcation-accused person should seek the help of an attorney with experience pleading in these cases. On the other hand, the victim should report defalcation or breach of agreement (in fiduciary negligence case) to enforcement authorities. That may help him recover as much loss as possible.

Defalcation vs Embezzlement

Both cash defalcation and embezzlement are often misunderstood for one another. Let us briefly compare the two and understand their differences through the explanation below.

  • Defalcation is when someone deducts or takes away a part of (or whole) income or funds. On the other hand, embezzlement is when someone steals or fraudulently misappropriates the money along with manipulation to cover up an act.
  • Embezzlement is also a type of defalcation. For example, If a person with access to company funds misuses their position and steals funds, it will come under defalcation. However, if the person tries to manipulate and create records or reports to prevent his theft or fraud from being discovered, they will be involved in embezzlement.

Frequently Asked Questions (FAQs)

What is the cash defalcation meaning?

Cash defalcation refers to the intentional or unintentional misappropriation of cash funds entrusted to an individual, such as an employee or a financial professional. Cash defalcation occurs in various settings, including businesses, non-profit organizations, government agencies, and financial institutions.

What is defalcation in auditing?

In auditing, a defalcation is a misappropriation or theft of assets by employees or officers of a corporation. It occurs when a debtor commits a horrible act while acting in a fiduciary capacity. Hence, if the auditor concludes that defalcation appears, they will report their findings to the appropriate parties, such as the management of the audited organization, the audit committee, or regulatory authorities.

Which is the largest form of defalcation?

The most effective form of defalcation is the theft of cash through disbursement schemes and money directly from the company.

How can companies prevent defalcation?

Companies can prevent this by implementing strong internal controls, segregating duties, conducting background checks on employees and contractors, and establishing a whistleblower hotline or other mechanism for reporting suspected fraud.

Recommended Articles

This article is a guide to what is Defalcation. Here we explain the examples, types, and penalties and compared it with embezzlement. You can learn more about it from the following articles: –