Settlements Redux: A Brief Follow-Up From My Bankruptcy Post

I received a number of e-mails on my three-part series on settlements, which ran over the past few weeks.

Of those e-mails, several dealt with a topic I raised in Part 3 - accounting for the possibility of a settling defendant's bankruptcy. So I felt it was appropriate to answer those questions in a follow-up post.

As I noted in Part 3, a plaintiff settling a competition dispute may be able to litigate, or relitigate, a claim during the course of an adversary proceeding if the defendant files for bankruptcy.

An exception to the general rule of dischargeability is the "fiduciary defalcation" provision contained in Section 523(a)(4) of the Bankruptcy Code. That generally holds that a debt is non-dischargeable when a debtor breaches a duty while acting in a fiduciary capacity.

Because all adversary claims are governed by the Bankruptcy Code, federal law will apply. And federal courts' interpretation of what qualifies for the "fiduciary defalcation" exception to dischargeability is not on all-fours with state law concepts familiar to many readers, such as the common law fiduciary duty of loyalty, rectitute, candor, and good faith.

Let's take a hypothetical and assume a fact pattern we've discussed on this blog before. If a corporate officer sets up a competing business while still employed, this almost certainly would constitute a breach of fiduciary duty under state law. That does not mean that debts arising out of that breach automatically are non-dischargeable under Section 523(a)(4).

Bankruptcy courts generally provide that the debt is non-dischargeable only if the debtor is acting in a fiduciary capacity with respect to the particular conduct giving rise to the debt.

So under the hypothetical I just outlined, the corporate officer may or may not have his debt discharged.

If, for instance, he simply starts a new business, moonlights, and then funnels new customers to his separate entity, any damages for which he's liable under the common law likely would be dischargeable. (I say "likely" because court decisions aren't totally consistent.)

However, if the officer swaps out an order intended for his current employer and runs that through a competing business - essentially the equivalent of a conversion or civil theft - then the company stands a much better chance of claiming that the debt is non-dischargeable.

This is a fine distinction to make, and courts do come out different ways on this.

The 523(a)(4) exception really is intended to provide a remedy for embezzlement or insider corporate theft, such as when a controller - say, in Dixon, Illinois - loots the company till.

Applying the exception to a garden-variety competition case founded on breach of fiduciary duty often yields few clear answers.