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In Re: Elizabeth E. Nail v. Elizabeth E. Nail

June 5, 2012

IN RE: ELIZABETH E. NAIL,
DEBTOR.
ARVEST MORTGAGE COMPANY,
APPELLANT,
v.
ELIZABETH E. NAIL,
APPELLEE.



Appeal from the United States Bankruptcy Appellate Panel for the Eighth Circuit.

The opinion of the court was delivered by: Loken, Circuit Judge.

Submitted: February 14, 2012

Before LOKEN, BYE, and MELLOY, Circuit Judges.

Elizabeth E. Nail borrowed from Arvest Mortgage Company ("Arvest") to purchase a newly-constructed home, executing a promissory note and mortgage. In April 2009, Ms. Nail filed a voluntary petition for Chapter 13 bankruptcy relief. Arvest then purchased the mortgaged property at a foreclosure sale for substantially less than what Ms. Nail owed on the promissory note and filed this adversary proceeding, seeking a judgment declaring the mortgage debt non-dischargeable under 11 U.S.C. §§ 523(a)(2) and (4). At trial, the bankruptcy court directed a verdict for Ms. Nail on the § 523(a)(2) claim but concluded that $65,000 of the remaining debt was non-dischargeable under § 523(a)(4) because Ms. Nail held that amount of settlement proceeds in a fiduciary capacity created by § 4-58-105(b)(2) of the Arkansas Code. The Bankruptcy Appellate Panel (BAP) reversed. Arvest appeals, arguing that, as to the settlement proceeds, Ms. Nail committed "fraud or defalcation while acting in a fiduciary capacity" and "embezzlement" within the meaning of § 523(a)(4). We review findings of fact for clear error and the BAP's conclusions of law de novo. See Hunter v. Philpott, 373 F.3d 873, 875 (8th Cir. 2004). Agreeing with the BAP that the Arkansas statute did not create the requisite fiduciary relationship, and that Ms. Nail was not guilty of embezzlement within the meaning of § 523(a)(4), we affirm.

I. Background

Section 523(a) of the Bankruptcy Code defines various classes of debts that are excepted from an individual Chapter 13 debtor's discharge in bankruptcy. Section 523(a)(4) excepts debts "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." At issue here are the distinct exceptions for defalcation while acting in a fiduciary capacity and embezzlement. We construe these exceptions narrowly, imposing the burden of proof on Arvest, the party opposing Ms. Nail's discharge. In re Belfry, 862 F.2d 661, 662 (8th Cir. 1988).

Soon after Ms. Nail moved into the new home, she discovered significant structural defects and sued the builders for constructive fraud, breach of warranty, and breach of contract. Arvest granted her a twelve-month loan forbearance while she litigated the dispute. When the forbearance period ended and Ms. Nail did not resume the required loan payments, Arvest commenced foreclosure proceedings in state court. At Ms. Nail's deposition in the foreclosure suit, Arvest learned that the builders had paid $65,000 to settle her state court lawsuit. After the Chapter 13 filing, Arvest obtained relief from the automatic stay to complete the foreclosure.

The mortgage assigned to Arvest all "Miscellaneous Proceeds," a term defined to include "any . . . settlement . . . paid by any third party . . . for . . . damage to, or destruction of, the property." Rather than remitting the settlement proceeds to Arvest pursuant to this assignment provision, Ms. Nail invested part of the proceeds in a new home and spent the remainder, primarily to pay legal fees and reduce her credit card debts. After a trial, the bankruptcy court concluded that the $65,000 settlement proceeds were Miscellaneous Proceeds; the written assignment created an express trust under Ark. Code § 4-58-105(b)(2);*fn1 and therefore Ms. Nail's failure to apply those proceeds to the mortgage debt was a defalcation while acting in a fiduciary relationship. The court declared the $65,000 non-dischargeable subject to an allowance or set-off for Ms. Nail's litigation expenses. It entered a judgment in favor of Arvest in the amount of $46,016.25. Ms. Nail appealed.

The BAP reversed the bankruptcy court's decision on three distinct grounds:

(1) because Arvest failed to prove the settlement proceeds were "Miscellaneous Proceeds" under the mortgage assignment provision; (2) because those proceeds arose, at least in part, from Ms. Nail's tort causes of action against the builders, and Arkansas law prohibits the assignment of tort claims or the proceeds of tort claims; (3) because, even if the settlement proceeds were validly assigned Miscellaneous Proceeds, neither the mortgage agreement nor Ark. Code § 4-58-105(b)(2) created the fiduciary relationship that is necessary to render a debt non-dischargeable under § 523(a)(4). Arvest appeals, arguing that two § 523(a)(4) exceptions apply -- defalcation while acting in a fiduciary capacity and embezzlement.

II. Defalcation While Acting in a Fiduciary Capacity

Section 523(a)(4) bars discharge of an obligation a debtor incurs through fraud or defalcation "while acting in a fiduciary capacity." "The meaning of these words has been fixed by judicial construction" since before the Civil War; "the statute 'speaks of technical trusts, and not those which the law implies from the contract.'" Davis v. Aetna Acceptance Co., 293 U.S. 328, 333 (1934), quoting Chapman v. Forsyth, 43 U.S. 202, 208 (1844). "It is not enough that, by the very act of wrongdoing out of which the contested debt arose, the bankrupt has become chargeable as a trustee ex maleficio. He must have been a trustee before the wrong and without reference thereto." Id. "Whether a relationship is a 'fiduciary' one within the meaning of § 523(a)(4) is a question of federal law." In re Cochrane, 124 F.3d 978, 984 (8th Cir. 1997) (quotation omitted).

The fiduciary relationship reflected in an express or technical trust is typically created by contract. Numerous cases have addressed whether a bankrupt debtor's alleged defalcations of contractual obligations to a secured lender such as Arvest were committed while acting in a fiduciary capacity. "It is the substance of a transaction, rather than the labels assigned by the parties, which determines whether there is a fiduciary relationship for bankruptcy purposes." In re Long, 774 F.2d 875, 878-79 (8th Cir. 1985). Most secured lending agreements impose duties on the borrower in dealing with the creditor's collateral, but those duties seldom create a § 523(a)(4) fiduciary capacity. In Davis, for example, the Supreme Court affirmed the discharge of an automobile dealer from its secured debt to a bank even though the debtor had breached duties reflected in a document called a "trust receipt." The trust receipt and bill of sale were "a mortgage in another form," the Court explained. "A mortgagor in possession before condition broken is not a trustee for the mortgagee within the meaning of this statute, though he has charged himself with a duty to keep the security intact." 293 U.S. at 334. In In re Long, 774 F.2d at 878-79, we cited Davis in affirming a decision that § 523(a)(4) did not render a secured debt non-dischargeable; we concluded that the contract between a secured inventory lender and the bankrupt merchant in which the borrower agreed to become trustee of an "express trust" was nonetheless "intrinsically more contractual than fiduciary."

Applying these authorities, the bankruptcy court and the BAP properly rejected Arvest's contention that the mortgage document itself created an express trust. That document did nothing more than provide for a contractual assignment of certain proceeds. Indeed, Arvest has more or less abandoned that contention on appeal,*fn2 instead urging, as the bankruptcy court concluded, that Ark. Code ยง 4-58-105(b)(2) created the requisite fiduciary relationship by declaring that Ms. Nail "became the trustee of the funds ...


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