Rutanen v. Baylis

United States Court of Appeals
For the First Circuit

Nos. 02-1364, 02-1415

IN RE: CARL E. BAYLIS,

Debtor.

CONSTANCE B. RUTANEN; ELLA QUEVILLON, by and for the
ESTATE OF ROBERT S. QUEVILLON; THERESA J. ALEXANDER,

Plaintiffs, Appellees/Cross-Appellants,

ROBERT D. QUEVILLON; MARC QUEVILLON; PAULA L. FLOWERS;
JOHN QUEVILLON,

Plaintiffs,

v.

CARL E. BAYLIS, individually and in his capacity as
co-trustee of the ANTONIA QUEVILLON TRUST,

Debtor, Appellant/Cross-Appellee.

APPEAL FROM THE UNITED STATES DISTRICT COURT
FOR THE DISTRICT OF MASSACHUSETTS

[Hon. Nathaniel M. Gorton, U.S. District Judge]

Before

Lynch, Circuit Judge,
Stahl, Senior Circuit Judge, and
Howard, Circuit Judge.

David M. Nickless with whom Nickless and Phillips was on
brief for appellant.
 Katherine A. Robertson with whom Robert A. Gelinas and
Bulkley, Richardson and Gelinas, LLP were on brief for appellees.

December 10, 2002

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 LYNCH, Circuit Judge. This case addresses the rules that

should be applied in determining when a fiduciary of a trust is in

"defalcation while acting in a fiduciary capacity," and so may not

be discharged from those debts in bankruptcy under 11 U.S.C.

§ 523(a)(4) (2000). The issue is one of first impression for this

court.

I.

We describe the facts as they are set forth in the

decision of the Massachusetts Supreme Judicial Court (SJC), as

supplemented by the state probate court findings, in the underlying

state litigation which gives rise to the judgment debt against Carl

Baylis, the bankrupt debtor.

In 1969, Antonia Quevillon, the settlor of the Antonia

Quevillon Trust, consulted Baylis, an attorney, regarding the

disposition of the apartment buildings she owned and operated. At

that time, she was seventy years old and in poor health. She had no

prior relationship with Baylis. Baylis drafted the trust into

which she transferred her property. The property consisted of

eight apartment buildings in Massachusetts: six in Southbridge and

two in Worcester. Baylis also drafted an exculpatory clause into

the trust which stated that "[e]ach trustee shall be liable only

for his own willful misconduct or omissions in bad faith."

Quevillon died on May 10, 1971. After her death, the

trust was to provide income to her children for a period of twenty

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years at which point it would terminate, and the trust property was

to be divided equally among the children of Marcel Quevillon, a son

of the settlor. (It did so terminate on May 10, 1991.)

Baylis and Estelle Ballard, daughter of the settlor and

one of the income beneficiaries, were appointed co-trustees; they

served from May 1971 to May 1991. Ballard agreed to manage the

property for $50 per week, and was paid from December 1973 through

May 1991, for a total of $45,100. Not only did Ballard derive her

income from managing the buildings, but she also lived in one unit,

and the trust paid her utilities and provided items such as cable

television and a washing machine. Baylis did not discuss any

management fees with the settlor. By his own admission, he almost

entirely abdicated his responsibilities as trustee to Ballard, who

alone actively managed the property.

The property appreciated substantially in value from

$256,000 in 1971 to $1.3 million in 1986, but paid the income

beneficiaries only $48,813 between 1971 and 1985. The trustees had

discretion to sell the trust property, and the trust did pay taxes

and other expenses from the estate out of income derived from

profits and the sale of a building in 1971. The trust sold another

building in 1984.

The income beneficiaries were taxed on the capital gains

but did not receive any actual distribution of money. Concerned,

the income beneficiaries met in 1985 with the co-trustees to

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discuss the lack of income from the trust property. The trustees

acknowledged that each of the income beneficiaries was owed

$82,000. This represented the amount, with interest, of the

difference between the actual distributions received and the amount

on which each of the beneficiaries had been taxed since May 10,

1971. Baylis told the beneficiaries that the trust was broke. At

that meeting, it was decided that the property would be sold and

the proceeds invested in government bonds. Ballard did not object

to selling the properties.

In late 1985, the trustees began accepting offers on the

remaining six buildings. By January 1986, they had received an

offer of $215,000 from Mr. and Mrs. Young for two of the

Southbridge properties. The Ramshorn Realty Trust, in the business

of purchasing and selling apartment buildings since 1986, made

another offer, subject to the availability of financing, of $1.425

million for the other four properties. Ramshorn had recently sold

substantial assets and had cash on hand to make a down payment.

Both purchasers paid deposits of $1,000. The six properties were

later appraised for only $1.3 million, significantly below the

offers received of $1.64 million.

Ballard, however, desired to own the properties herself.

She also intended that the properties not be sold out of the

family. Baylis, knowing this, presented the offers to her by

letter dated February 5, 1986 and gave her an opportunity to match

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them, but it was soon evident that she could not finance the

purchase. Baylis tried to cajole her into agreeing to sell to the

offerors. She then refused to sell the property and later

testified that she had not considered the interests of either the

income beneficiaries or the remaindermen in making that decision.

Even though Ballard had refused to sell the property,

Baylis forwarded purchase and sale agreements to the prospective

buyers on May 20, 1986. The buyers signed the agreements by June

3, 1986 and put down additional deposits. Baylis hoped to close on

December 31, 1986, thinking that date would be advantageous for

capital gains treatment. Baylis signed the agreement; Ballard

refused to sign. Baylis did not go to probate court for

instructions.

Baylis instead responded to Ballard on July 22, 1986 by

proposing that Ballard would receive the two properties for which

$215,000 had been offered, and would allow the other sale, to

Ramshorn, to proceed. He did this although the Youngs had signed

a Purchase and Sale Agreement that he himself had prepared.

Ballard agreed to this proposal, subject to conditions. Baylis did

not inform the Youngs of this development. He had appraisals done

in anticipation of a license to sell the properties. The Youngs

learned of this proposed sale to Ballard and sued the trust, the

trustees, and Baylis in his individual capacity. The lawsuit

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sought specific performance of the Purchase and Sale Agreement, and

it alleged that Baylis had committed fraud.

The trustees were served with the suit on December 13,

1986; after being served, Ballard then decided that she would not

sell at all. As she put it, a sale would have left her "out in the

cold with nothing." The trust settled the case with the Youngs and

paid the legal expenses associated with the suit. The Youngs' case

continued against Baylis individually for fraud. The trust paid

$7,000 for defense of the case against Baylis and $15,000 to settle

it.

Baylis had prepared and filed a petition in Probate and

Family Court for a license to sell the property in December 1986.

The SJC later found, however, that Baylis did not disclose to the

court Ballard's refusal to consent to the sale:

Baylis's complaint, however, did not challenge Ballard's
refusal at all. Instead the complaint he presented to
the court stated that Ballard had submitted her
resignation to Baylis and that he had accepted it. The
judge, not knowing that Ballard was wrongfully refusing
to consent, deferred judgment subject to obtaining
Ballard's signature. Baylis never followed up by
informing Ballard that she might be in breach of her
fiduciary duty by not signing nor did he ask the judge to
compel Ballard to agree to the sale. Because Baylis did
not file a petition explaining to the judge that the sale
would be in the best interests of the beneficiaries and
that Ballard was improperly blocking the sale, he did not
take the steps reasonably necessary to prevent Ballard
from breaching her duty.

Rutanen v. Ballard, 678 N.E.2d 133, 140 (Mass. 1997).

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 The income beneficiaries filed suit in probate court

against the trustees on May 23, 1988. The trust terminated on May

10, 1991, and the property was transferred to the remaindermen, who

intervened in the suit. At that time, the estimated value of the

property was $1.081 million. The probate court found that the

Youngs and Ramshorn were ready, willing and able to purchase the

trust properties, and Ballard and Baylis breached their fiduciary

duties by failing to sell the properties in 1986. It also found

that Baylis "knowingly allow[ed] Ms. Ballard to breach her

fiduciary duties without taking any action."

Baylis claimed that the exculpatory clause he had drafted

protected him. The probate court found that these breaches of

fiduciary duty were in bad faith and therefore beyond the

protection of the clause, and that even if the breaches were not in

bad faith, the exculpatory clause was not enforceable because

Baylis, a co-trustee, drafted the language, and the settlor was of

ill health and had not been advised to seek the advice of outside

counsel.

The probate court awarded judgments of $330,079.95 to the

beneficiaries and $607,900.27 to the remaindermen on findings that

the co-trustees had violated their fiduciary duties.1 The damages

1
The probate court judgment in favor of the income
beneficiaries included damages of $244,493.75 for failure to
sell, $27,322.90 for trust expenditures in the defense and
settlement of the Young suit and $58,263.30 in pre-judgment
interest. The judgment in favor of the remaindermen comprised

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included both the net proceeds from the sales and the profits

resulting from the planned investment in six-month Treasury bills.

Rutanen v. Ballard, No. 88E0072-G1, slip op. at 22-23 (Prob. Ct.

Mass. Apr. 15, 1993); Rutanen v. Ballard, No. 88E0072-G1, slip op.

at 1-2 (Prob. Ct. Mass. Nov. 4, 1993) (supplemental judgment).

On appeal, the Massachusetts Supreme Judicial Court

affirmed the probate court's decision, but solely on the ground

that Baylis acted negligently and was not shielded by the

exculpatory clause. Rutanen, 678 N.E.2d at 136, 140. As to the

probate court's finding of bad faith, the SJC found that "the

evidence is more questionable" and declined to rely on it in

affirming the decision. Id. at 140.

II.

Faced with the judgments against him, Baylis filed for

bankruptcy. The trust's income beneficiaries, as creditors, took

the position that their judgment against Baylis was non-

dischargeable because the debt resulted from Baylis's "defalcation

while acting in a fiduciary capacity" under 11 U.S.C. § 523(a)(4).

In addition, they asserted the debts resulted from "willful and

malicious injury by the debtor . . . to the property of another."

Id. § 523(a)(6). The parties stipulated that the state probate

court's findings of fact were binding, except for the finding that

Baylis acted in bad faith.

$544,767 in damages and $63,133.27 in pre-judgment interest.

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 Both sides moved for summary judgment. Although styled

as summary judgment, it is evident they expected the court to

resolve the case on the stipulated record. The bankruptcy court

held that the probate court's finding that Baylis had acted in bad

faith had no preclusive effect because it was not essential to the

judgment and had not been ruled on by the Supreme Judicial Court.

Rutanen v. Baylis, 222 B.R. 1, 7 (Bankr. D. Mass. 1998). It also

found Baylis's conduct did not amount to defalcation. Id. at 5.

The district court disagreed, holding that Baylis was bound by the

probate court's bad faith finding, and as such had committed

defalcation. Rutanen v. Baylis, No. 98-30174-NMG, slip op. at 12

(D. Mass. Oct. 29, 1999). This court found that the bad faith

finding did not have a preclusive effect because the SJC had

refused to affirm on that ground, and remanded the case to the

district court. Rutanen v. Baylis (In re Baylis), 217 F.3d 66, 71

(1st Cir. 2000). On remand, on cross-motions for summary judgment,

the district court found that Baylis's conduct amounted to

defalcation under § 523(a)(4), and that § 523(a)(6) was

inapplicable. Rutanen v. Baylis, 275 B.R. 145, 153-54 (D. Mass.

2002). Baylis appeals the § 523(a)(4) determination against him;

the plaintiffs cross-appeal the § 523(a)(6) finding.

III.

Because this case was decided on cross-motions for

summary judgment, our review of the bankruptcy court decision is de

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novo. See Piccicuto v. Dwyer, 39 F.3d 37, 40 (1st Cir. 1994). The

standard by which to measure "defalcation" of a fiduciary duty for

purposes of § 523(a)(4) is a legal question, in any event, to which

we give de novo review. The parties have agreed that they are

bound by the probate court's findings of fact.

A. Meaning of Defalcation of a Fiduciary Duty, 11 U.S.C.
§ 523(a)(4)

Section 523 of the Bankruptcy Code contains a number of

exceptions to discharge of debt. Section 523(a) provides that:

(a) A discharge . . . does not discharge an individual
debtor from any debt . . .
(4) for fraud or defalcation while acting in a fiduciary
capacity, embezzlement, or larceny.

(emphasis added). This provision has been part of the Bankruptcy

Act since 1867. See An act to establish a uniform system of

bankruptcy through the United States, ch. CLXXVI, § 33, 14 Stat.

517, 533 (1867) (repealed 1878); cf. An act to establish a uniform

system of bankruptcy throughout the United States, ch. IX, § 1, 5

Stat. 440, 441 (1841) (repealed 1843) (excepting only debts arising

from "defalcation as a public officer"). An exception to discharge

should be strictly construed. Gleason v. Thaw, 236 U.S. 558, 562

(1915). "Exceptions to discharge are narrowly construed in

furtherance of the Bankruptcy Code's 'fresh start' policy . . . ."

Century 21 Balfour Real Estate v. Menna (In re Menna), 16 F.3d 7,

9 (1st Cir. 1994); see Grogan v. Garner, 498 U.S. 279, 286 (1991)

(endorsing the "fresh start" policy).

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 Within this context, certain rules are clear about the

availability of the exception:

1) The burden of proof to establish defalcation is on the creditor,

given the "fresh start" policy. In re Menna, 16 F.3d at 9 (a

claimant must prove that his "claim comes squarely within an

exception enumerated in Bankruptcy Code § 523(a)"); see also

Palmacci v. Umpierrez, 121 F.3d 781, 786 (1st Cir. 1997).2

2) The creditor must show defalcation by a preponderance of the

evidence. Grogan, 498 U.S. at 286-87.

3) The exception to discharge applies to fiduciaries only while they

are acting in a fiduciary capacity.3

4) Inherent in "defalcation" is the requirement that there be a

breach of fiduciary duty; if there is no breach, there is no

defalcation.

2
But see In re Niles, 106 F.3d 1456, 1462 (9th Cir. 1997)
(shifting the burden to the debtor under the defalcation exception
once the creditor demonstrates that the debtor was a fiduciary).
3
Some years ago, the Supreme Court noted that under
§ 523(a)(4), the exception for fiduciary capacity applies only to
express trusts, and not to equitable trusts created by the debtor's
conduct. Davis v. Aetna Acceptance Co., 293 U.S. 328, 333 (1934).
Whether this continues to be so is in doubt. See, e.g., Republic
of Rwanda v. Uwinama (In re Uwimana), 274 F.3d 806, 811 (4th Cir.
2001) (ambassadors are fiduciaries for countries they represent).
It is undisputed that Baylis is a fiduciary for purposes of
§ 523(a)(4) and so this case does not present the question of when
else a fiduciary capacity arises.

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5) In order to avoid redundancy, defalcation must mean something

other than fraud and different from "willful and malicious injury,"

11 U.S.C. § 523(a)(6).

6) Defalcation is to be measured objectively. Cent. Hanover Bank

& Trust Co. v. Herbst, 93 F.2d 510, 512 (2d Cir. 1937).

That then leaves the question of the standard to measure

when a fiduciary breach is a "defalcation." The dictionary

definitions of defalcation are of limited assistance. Black's Law

Dictionary (7th ed. 1999) defines defalcation as, "Loosely, the

failure to meet an obligation; a nonfraudulent default." Id. at

427. The Oxford English Dictionary (2d ed. 1989) defines

defalcation as, "A monetary deficiency through breach of trust by

one who has the management or charge of funds; a fraudulent

deficiency in money matters." 4 id. at 369. The Oxford Dictionary

of English Etymology (C.T. Onuns ed., 1966) tells us that the word

derives from the "earlier defalk which survives in U.S. legal use.

See - ation [is] diminution, reduction, curtailment. . . ,

defective, failure; fraudulent monetary deficiency." Id. at 250.

The etymology of the word thus shows the term historically has

covered both fraudulent and non-fraudulent acts.4 Our view is that

not every breach of a fiduciary duty amounts to defalcation.

4
By contrast, A Dictionary of Modern American Usage (B.
Garner ed., 1998) says that it is only by slipshod extension
that "some writers have misused defalcation when referring to
a non-fraudulent default," a view contrary to other authors of
other dictionaries. Id. at 191.

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 The case law in this area is far from a seamless whole.

More than sixty years ago, Judge Learned Hand's carefully equivocal

opinion in Herbst held that there could be defalcation even in the

absence of deliberate wrongdoing. Recognizing the ambiguities in

the term, he noted:

All we decide is that when a fiduciary takes money upon
a conditional authority which may be revoked and knows at
the time that it may, he is guilty of a "defalcation"
though it may not be a "fraud," or an "embezzlement," or
perhaps not even a "misappropriation."

Herbst, 93 F.2d at 512.

Roughly, three interpretive camps have been established

as to the standard for measuring defalcation. The first is that an

innocent mistake can constitute defalcation. See Republic of Rwanda

v. Uwinama (In re Uwimana), 274 F.3d 806, 811 (4th Cir. 2001) (self-

dealing); Tudor Oaks Ltd. P'ship v. Cochrane (In re Cochrane), 124

F.3d 978, 984 (8th Cir. 1997) (same); Lewis v. Scott (In re Lewis),

97 F.3d 1182, 1186 (9th Cir. 1996) (failure to account fully for

money received). The second is that negligence by the fiduciary is

required but no more. See Antlers Roof-Truss & Builders Supply v.

Storie (In re Storie), 216 B.R. 283, 288 (B.A.P. 10th Cir. 1997)

(failure to account). The third is that at least recklessness by

the fiduciary is required. See Schwager v. Fallas (In re Schwager),

121 F.3d 177, 185 (5th Cir. 1997) (breach of duty to manage);

Meyer v. Rigdon, 36 F.3d 1375, 1384-85 (7th Cir. 1994) (same);

Carlisle Cashway, Inc. v. Johnson (In re Johnson), 691 F.2d 249, 257

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(6th Cir. 1982) (failure to account); Herbst, 93 F.2d at 512 (for

a failure to account, defalcation must be "due to a known breach of

the duty, and not to mere negligence or mistake"). The different

camps not only exist between the different circuits, but sometimes

within the bankruptcy courts of the same circuit, including this

one. Compare M-R Sullivan Mfg. Co. v. Sullivan (In re Sullivan),

238 B.R. 230, 237-38 (Bankr. D. Mass. 1999) (recklessness required,

considering breach of duty to manage), with Hoff v. Carroll (In re

Carroll), 140 B.R. 313, 316 (Bankr. D. Mass. 1992) (negligence or

ignorance enough for failure to account). The types of duty which

the fiduciary has violated appear to influence the choice of

standard regardless of the broad language sometimes used.

The present range of interpretations of "defalcation"

among the circuits, from innocent mistake to a civil recklessness

standard, does not, in our view, adequately capture Congress's

intended meaning of the term in § 523(a)(4). Instead, we find that

a defalcation requires some degree of fault, closer to fraud,

without the necessity of meeting a strict specific intent

requirement. Our view is based on both the structure of 11 U.S.C.

§ 523(a) and the "fresh start" policy.

A reading of § 523 as a whole indicates that most of the

exceptions to discharge in bankruptcy are in place for one of two

basic reasons. First, bankruptcy may not be used to avoid the

payment of certain types of debts, the repayment of which are

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important for policy reasons. Exceptions to discharge falling in

this category include debts for: taxes or customs duties, id.

§ 523(a)(1), or debts incurred to pay tax, id. § 523(a)(14); alimony

and child support payments, id. § 523(a)(5); fines, penalties or

forfeitures to the government, id. § 523(a)(7); educational loans

made or insured by the government or a nonprofit institution, id.

§ 523(a)(8); orders of restitution, id. § 523(a)(13); court fees,

id. § 523(a)(17); and support owed under state law and enforceable

under the Social Security Act, id. § 523(a)(18). The level of fault

of the debtor has no bearing on these exceptions; the exception

turns on the type of debt.

It is arguable that defalcation by a fiduciary fits into

this "type of debt" category -- that is, that Congress intended to

reinforce the high standard of care owed by fiduciaries by making

debts for defalcation non-dischargeable. That reading is, we think,

an unlikely one, and we see no strong federal interest in making

every debt from breach of a fiduciary duty non-dischargeable.

The other large category of bankruptcy exceptions relies

on fault. These exceptions define not the type of debt itself, but

the type of fault that caused the debt. Such exceptions include

debts generated by: money, goods or services obtained by fraud or

falsehood, id. § 523(a)(2); willful and malicious injury, id.

§ 523(a)(6); death or injury caused by driving under the influence

of alcohol or drugs, id. § 523(a)(9); and the exception we interpret

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here, "fraud or defalcation while acting in a fiduciary capacity,

embezzlement, or larceny," id. § 523(a)(4).

There is also one exception that spans both categories:

the exception "for malicious or reckless failure" to maintain

capital of an insured depository institution to the extent required

by federal regulatory agencies. Id. § 523(a)(12). This exception

combines a level of fault with a type of debt important for reasons

of federal financial policy.

As is evident from the above listings, those exceptions

that rely exclusively on a level of fault concern extremely serious

actions done knowingly or with great risk of harm to others. A

charge of driving under the influence of alcohol or drugs requires

knowing ingestion of those substances with at least the attributed

knowledge of consequent great risk that others will be injured. The

exception for willful and malicious injury we discuss below also

requires some form of intent. Kawaauhau v. Geiger, 523 U.S. 57,

61-62 (1998). Obtaining money, goods or services by criminal fraud

or false pretenses also requires knowledge and more: a specific

intent to defraud. E.g., 18 U.S.C. § 1341 (2000) (mail fraud);

United States v. Sawyer, 239 F.3d 31, 40 (1st Cir. 2001). Specific

intent requires that the accused have the intent to accomplish the

precise criminal act with which he is charged. See Black's Law

Dictionary, supra, at 814. The structure of 11 U.S.C. § 523 as a

whole, then, suggests that for an act to fall under the

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"defalcation" exception to discharge, it must be a serious one

indeed, and some fault must be involved. The defalcation by a

fiduciary, in our view, belongs in this category.

This interpretation is buttressed by the structure of

§ 523(a)(4) itself. First, the same line contains exceptions to

discharge for fraud and defalcation while acting as a fiduciary, and

embezzlement and larceny generally. Id. § 523(a)(4). Fraud,

embezzlement, and larceny are all serious crimes requiring specific

intent. To the extent that the term covers civil actions for fraud,

such as a fraudulent misrepresentation, the maker of the statement

must know or believe the statement is untrue or that he has no basis

to make the statement. See Restatement (Second) of Torts § 526

(1976). Moreover, it is telling that in § 523(a)(4) fraud and

defalcation are listed together.

Reading "defalcation" as akin to the other actions

constituting fault-based exceptions to discharge is also consistent

with the "fresh start" policy undergirding the bankruptcy system.

The bankruptcy system is designed and used to obtain a fresh start

for those owing debts of many kinds, including civil damages awards.

Were this not so, the narrow exceptions in § 523(a) would make

little sense.

Of course, the term "defalcation" must mean something

different than the other terms listed. "In construing a statute we

are obliged to give effect, if possible, to every word Congress

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used." Reiter v. Sonotone Corp., 442 U.S. 330, 339 (1979). We

believe that defalcation lessens the threshold required from one of

criminal or civil fraud to something less. To show defalcation, a

creditor need not prove that a debtor acted knowingly or willfully,

in the sense of specific intent. However, a creditor must be able

to show that a debtor's actions were so egregious that they come

close to the level that would be required to prove fraud,

embezzlement, or larceny.

A debtor fiduciary may not escape the exclusion from

discharge of his debt arising out of defalcation by saying he had

no specific intent. As in other areas of the law, circumstances

will provide the level of wrongdoing needed to constitute a

defalcation. One useful analogy is to the law of securities, which

requires "scienter." Scienter, in the context of securities fraud,

is "a mental state embracing intent to deceive, manipulate, or

defraud." Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 n.12

(1976). A form of recklessness can meet the requirement of

scienter, but it is "more like a lesser form of intent." Rizek v.

SEC, 215 F.3d 157, 162 (1st Cir. 2000). This form of recklessness

is "an extreme departure from the standards of ordinary care."

Greebel v. FTP Software, Inc., 194 F.3d 185, 198 (1st Cir. 1999)

(quoting Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045

(7th Cir. 1977)). The mental state required for defalcation is akin

to the level of recklessness required for scienter. It is more than

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the mere conscious taking of risk associated with the usual torts

standard of recklessness. See Black's Law Dictionary, supra, at

1276-77. Instead, defalcation requires something close to a showing

of extreme recklessness.

In evaluating whether there is a defalcation of a

fiduciary duty, there must be reference to the duty involved. Of

the various duties, the duty of loyalty is "[t]he most fundamental

duty owed . . . the duty of a trustee to administer the trust solely

in the interest of the beneficiaries." 2A A. Scott, The Law of

Trusts § 170 (W.F. Fratcher ed., 4th ed. 2001).

Defalcation may be presumed from breach of the duty of

loyalty, the duty not to act in the fiduciary's own interest when

that interest comes or may come into conflict with the

beneficiaries' interest:

A trustee occupies a position in which the courts have
fixed a very high and very strict standard for his
conduct whenever his personal interest comes or may come
into conflict with his duty to the beneficiaries. As
long as he is not acting in his own interest the standard
fixed for his behavior is only that of a reasonable
degree of care, skill, and caution. But when the trustee
acts in his own interest in connection with the
performance of his duties as trustee, the standard of
behavior becomes more rigorous. In such a case his
interest must yield to that of the beneficiaries.

2A id. § 170.25. As with the other fault-based exceptions, fault

may be presumed from the circumstances, here a violation of the duty

of loyalty.

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B. Application of Defalcation Standard to Facts

There is no dispute as to the material facts and we are

assisted by the probate court findings.5

The bankruptcy court granted Baylis's summary judgment

motion because it found mere negligence in Baylis's actions:

The Debtor did not stand by and do nothing. And he did
more than merely ask Ballard to agree to the sales. He
put pressure on her in two ways, first by presenting her
with agreements signed by the buyers and later by filing
a petition in court to sell the properties. Although he
was adjudicated to have been negligent in not going
further and requesting a court order against her, he
surely was not in reckless disregard of his obligations
concerning Ballard's fiduciary defaults.

Rutanen, 222 B.R. at 5. Ignoring the probate court's contrary

finding, the bankruptcy court found nothing improper in the Trust's

payment of the expenses of the suit against Baylis for fraud.

The district court overturned the grant of summary

judgment to Baylis and entered summary judgment for the creditors.

It found that Baylis, by executing purchase and sale agreements even

though Ballard refused to agree to a sale, "practically assured a

lawsuit." Rutanen, 275 B.R. at 152. Baylis also used trust funds

in a resulting lawsuit brought against him personally, not only to

pay attorneys' fees, but also to settle the lawsuit. Id. at 153.

Finally, the district court noted that "Baylis is an attorney who

5
As a practical matter these cases will usually come up on
appeal with the result determined by the findings of fact made by
the bankruptcy court. Those findings will be binding unless they
are clearly erroneous.

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specializes in the law of trusts and estates. He was well aware of

the duties required of a fiduciary under trust law." Id.

Both courts treated the question of the dischargeability

of the debt as a unitary one. We think it more helpful to consider

the different components of the judgment debt. The judgment debt

comprises three elements: $27,322.90 for the trust expenditures for

Baylis's benefit on the Youngs' lawsuit against him; over $937,000

for the loss in value of the property due to the failure to sell;

and the pre-judgment interest.

We start with the $27,322 payment for Baylis's benefit in

the lawsuit against him by the Youngs and the associated interest.

Of course, not all payments from a trust to trustees are

inappropriate. Trustees may receive fees and be reimbursed for

expenses. They may be defended and indemnified in lawsuits.

Nevertheless, the impropriety of those payments here was resolved

by the state courts, and that is a binding ruling. See Rutanen, No.

88E0072-G1, slip op. at 22 (Apr. 15, 1993). The probate court found

that although the trust had no obligation to defend Baylis on the

fraud charges brought against him personally or to indemnify him,

Baylis caused fees for his defense to be paid by the Trust. That

wrongdoing was compounded by Baylis having the trust pay the $15,000

it took to settle the Youngs' claims of fraud against him

personally. Baylis is bound by the probate court's holding,

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affirmed by the SJC, that these payments were inappropriate. See

Montana v. United States, 440 U.S. 147, 153 (1979).

Baylis's actions as to this component of the debt do

constitute defalcation. Baylis's actions were in violation of his

duty of loyalty. He used trust monies to pay the attorney's fees

and settle the lawsuit brought by the Youngs. His breach of the

duty of loyalty is exacerbated by the fact that Baylis, in breach

of various fiduciary duties, brought about the conditions that led

to the lawsuit.

Even after it was apparent to him that Ballard, his co-

trustee, had refused to assent to a sale of property to either the

Youngs or to Ramshorn, Baylis forwarded purchase and sale agreements

to both prospective buyers, who signed them and put down deposits.

He thus virtually guaranteed the ensuing litigation with the Youngs,

which led to a wasting of the trust's assets in defending and

settling the litigation.

Given Baylis's active role in creating the conflict over

which the Youngs were suing, he should have requested permission

from the probate court before he used trust assets to defend himself

against the personal aspects of the Youngs' lawsuit. He did not do

so. Instead, he proceeded to use trust assets to defend himself,

an extremely reckless thing to do in light of his duty of loyalty.

Given this combination of the fiduciary breach which

caused the lawsuit and the self-dealing to defend against it, we

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find that Baylis's actions here constitute defalcation under 11

U.S.C. § 523(a)(4). Thus, the $27,322 of the judgment debt relating

to these actions is non-dischargeable.

Whether the remaining damages attributed to the loss in

value of the trust from the failure to sell the property resulted

from defalcation presents a different question. Baylis, as co-

trustee, was obliged to participate in the administration of the

trust and to use reasonable care to prevent a co-trustee from

committing a breach of the trust. Rutanen, 678 N.E. 2d at 140

(citing Restatement (Second) of Trusts § 184 (1959)). Co-trustees

may not acquiesce in the other trustee's refusal to exercise a power

the trustees are obligated to exercise. Id. Should that occur, the

co-trustee must apply to the courts for instructions.

Baylis argues he acted reasonably in compliance with these

obligations when he applied to the probate court in December 1986

to conduct a sale, and so any breach cannot be a defalcation.

"Reasonableness," as we have said, is not the test for whether a

breach is a defalcation, but if the trustee has acted reasonably,

there is no defalcation. For the prior 15 years, Baylis had let

Ballard manage the trust properties, largely ignoring his

obligations, yet during most of those 15 years it was not evident

that Ballard was in breach of her fiduciary obligations. Still,

Ballard's breach of her own duty of loyalty around the time of the

proposed sales was sufficiently egregious as to amount to a

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defalcation. It is a different matter whether her co-trustee's

failure to bring her defalcation to the attention of the probate

court was itself a defalcation.

We are troubled by the fact that when Baylis went to the

probate court for instructions to sell, he failed to disclose

material information to the court. He did not describe the co-

trustee's conflict of interest, her breach of fiduciary duty, or the

facts giving rise to the problem. Nonetheless, it was not

unreasonable for Baylis to think that the matter would be resolved

if the court gave instructions to sell the property. His various

judgments about how best to handle his troublesome co-trustee were

flawed and clearly negligent, but not so reckless as to rise to the

level of fault needed to constitute a defalcation.

C. Section 523(a)(6)

Finally, the income beneficiaries allege that Baylis's

debt is non-dischargeable because it is a "willful and malicious

injury by a debtor to another entity or to the property of another

entity." § 523(a)(6). As interpreted by Kawaauhau, 523 U.S., "the

actor [must] intend the consequences of an act, not simply the act

itself." Id. at 61-62 (emphasis in original); see Roumeliotis v.

Popa (In re Popa), 140 F.3d 317, 318 (1st Cir. 1998).

Neither the bankruptcy nor the district court found

willfulness and intent to injure. Rutanen, 275 B.R. at 154;

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Rutanen, 222 B.R. at 8. Both courts concluded that Baylis's debt

would not be non-dischargeable under this provision. We agree.

D. Conclusion

The judgment of the district court that Baylis's debt is

non-dischargeable under 11 U.S.C. § 523 (a)(4) is affirmed as to the

part of the judgment based on the lawsuit, $27,322.90, and the pre-

judgment interest attached, and reversed as to the award for loss

of property value and consequent pre-judgment interest. The

judgment of the district court that Baylis's debt is not non-

dischargeable under 11 U.S.C. § 523(a)(6) is affirmed. The case is

remanded to the district court for entry of an appropriate judgment.

Costs are awarded against Baylis.

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