When is there sufficient evidence to hold that a fiduciary’s debt to an ERISA benefit plan is non-dischargeable in bankruptcy? The Bankruptcy Court for the Eastern District of New York recently held in In re Kern, Case No. 13-08096 (Dec. 10, 2015), that there was not sufficient evidence to support a non-dischargeability claim even though the fiduciary had used almost $1.4 million in company funds that otherwise were to be contributed to the ERISA plans. The Kern case provides guidance not only to ERISA plans seeking to recover missed contributions, but also to creditors seeking to except their claims from the bankruptcy discharge.
The debtor, Richard Kern, was the owner of Cool Sheetmetal, Inc. (“CSI”), a closely held corporation located in New York. CSI was a union shop and had entered into collective bargaining agreements that required CSI to make various contributions to certain benefits funds (the “Funds”) with money from its general corporate funds. The obligations were not funded through any specific employee withholdings or subject to any earmarking.
In April 2014, Kern filed a personal Chapter 11 bankruptcy case. Kern’s case was subsequently converted to Chapter 7. Following the conversion, the Funds commenced an adversary proceeding seeking a declaration that their claims were non-dischargeable pursuant to section 523(a)(4) of the Bankruptcy Code. In summary, the Funds alleged that Kern was a fiduciary and that he committed a defalcation or other bad acts respecting the Funds, such that the debt to the Funds should be non-dischargeable.
The court rejected the Funds’ claims, holding that in order to have the claims declared non-dischargeable, the Funds need to prove three elements: (1) the existence of an express or technical trust; (2) that Kern acted in a fiduciary capacity with respect to the trust; and (3) that the debt arose from a defalcation committed by Kern. The court easily disposed of the first and second elements. First, after analyzing ERISA law, and noting Kern’s lack of objection, the court held that CSI’s funds were held in an express trust for the benefit of the Funds. Next, the court held that Kern was a functional fiduciary under ERISA and sided with the First and Ninth Circuit Court of Appeals in finding that “functional” fiduciaries under ERISA also qualify as fiduciaries for the purposes of section 523(a)(4) of the Bankruptcy Code. Without diving too deeply into ERISA law, the Court found Kern was a functional fiduciary based on, among other reasons, his discretionary authority and control respecting contributions to the Funds.
The “rub” was third element, specifically, whether Kern’s debt to the Funds arose as a result of a defalcation committed while acting in a fiduciary capacity. In analyzing this last element, the court noted that the Supreme Court had recently held that defalcation “includes a culpable state of mind…one involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary.” See Bullock v. BankChampaign, N.A., 133 S. Ct. 1754, 1757 (2013). Citing to Bullock, the court framed the question as whether Kern used CSI’s funds in an intentionally wrong or criminally reckless manner.
Luckily for Kern, the court was not persuaded that his use of CSI’s funds was improper. The funds were not withheld from employee paychecks and the fact that Kern and his wife drew salaries over the years in which contributions were supposed to have been made was not persuasive as the couple also spent hundreds of thousands of dollars of their own money to support the failing company. Moreover the court was especially cautious not to (i) elevate the rights of pension benefit plans over the rights of secured creditors with liens, or (ii) put those in control of faltering companies in the impossible position of choosing between their duties to pension funds and their duties to general creditors.
Bankruptcy courts typically favor the debtor when creditors seek a ruling that their debt is not dischargeable, as such favor is consistent with the “fresh start” policy underlying the Bankruptcy Code. The CSI case serves to underscore the fact that creditors seeking to make a case under section 523(a)(4) of the Bankruptcy Code should be sure they can establish improper or criminally reckless conduct. Without evidence of such conduct, the court’s inclination to provide a fresh start is likely going to prevail. Moreover, CSI shows that simply favoring a faltering company’s creditors over the company’s pension fund obligations is not enough to give rise to defalcation under the Bankruptcy Code, especially where such general corporate funds are not earmarked.