Arvest Mortgage Co. v. Elizabeth Nail

Filing

OPINION FILED - THE COURT: JAMES B. LOKEN, KERMIT E. BYE and MICHAEL J. MELLOY. James B. Loken, Authoring Judge (PUBLISHED) [3918429] [11-2018]

United States Court of Appeals
FOR THE EIGHTH CIRCUIT

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No. 11-2018
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In re: Elizabeth E. Nail,

*
*
Debtor.
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Arvest Mortgage Company,
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* Appeal from the United States
Appellant,
* Bankruptcy Appellate Panel
* for the Eighth Circuit.
v.
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Elizabeth E. Nail,
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Appellee.
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Submitted: February 14, 2012
Filed: June 5, 2012
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Before LOKEN, BYE, and MELLOY, Circuit Judges.
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LOKEN, Circuit Judge.
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 nondischargeable under

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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 nondischargeable 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

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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);1 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 nondischargeable 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 nondischargeable under

1

§ 4-58-105(b)(2) provides: “In any case where, acting without knowledge of
the assignment . . . the debtor in good faith pays all or part of such account to the
assignor . . . the assignor . . . shall be a trustee of any sums so paid and shall be
accountable and liable to the prior assignee thereof.”

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§ 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
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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 nondischargeable;
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,2
instead urging, as the bankruptcy court concluded, that Ark. Code § 4-58-105(b)(2)
created the requisite fiduciary relationship by declaring that Ms. Nail “became the
trustee of the funds upon receipt of the Settlement Proceeds,” and then committed a
defalcation by spending the proceeds instead of remitting them to Arvest.
It is now well settled that a state statute may create the fiduciary relationship
required by § 523(a)(4). See In re Long, 774 F.2d at 878. Determining whether a
particular statute has done so can be difficult. “It is not enough [] that a statute
purports to create a trust: A state cannot magically transform ordinary agents,
contractors, or sellers into fiduciaries by the simple incantation of the terms ‘trust’ or
‘fiduciary.’ Rather, to meet the requirements of § 523(a)(4), a statutory trust must (1)

2

Arvest’s brief casually likens its assignment provisions to the insurance agency
contract that we held created an express trust in Morgan v. Amer. Fid. Fire Ins. Co.,
210 F.2d 53, 55-56 (8th Cir. 1954). The suggestion is beyond Arvest’s statement of
issues presented for review; it also lacks the slightest factual merit. The contract in
Morgan expressly provided that “[a]ll premiums received by agent shall be held by
agent in a fiduciary capacity as trustee for Company until delivered to Company or its
managers.” Id. at 54 (quotation omitted).
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include a definable res and (2) impose ‘trust-like’ duties.” Matter of Tran, 151 F.3d
339, 342-43 (5th Cir. 1998).
In Matter of Dloogoff, 600 F.2d 166, 169-70 (8th Cir. 1979), we held that a
statute making it unlawful for a construction contractor to fail to apply payments owed
to labor and material lienholders did not create a § 523(a)(4) fiduciary relationship
because the Supreme Court of Nebraska had held that the statute did not create an
express trust. Similarly careful analyses of other state lienholder protection statutes
have produced differing § 523(a)(4) outcomes. Compare In re Nicholas, 956 F.2d 110
(5th Cir. 1992) (Tex. Construction Trust Fund Statute), and Matter of Angelle, 610
F.2d 1335 (5th Cir. 1980) (La. law), with Carey Lumber Co. v. Bell, 615 F.2d 370,
374-76 (5th Cir. 1980) (Okla. Lien Trust Statutes), In re Baird, 114 B.R. 198 (9th Cir.
BAP 1990) (Ariz. Construction Trust Fund Statute), and Matter of Kawczynski, 442
F. Supp. 413 (W.D.N.Y. 1977) (N.Y. Lien Law).
In Matter of Marchiando, 13 F.3d 1111, 1113 (7th Cir. 1994), the Seventh
Circuit concluded that the Illinois Lottery Law proviso that “the proceeds of sales of
lottery tickets ‘shall constitute a trust fund until paid to the [State]’” did not create a
§ 523(a)(4) fiduciary relationship:
The key to knitting the cases into a harmonious whole is the
distinction stressed in Davis . . . between a trust . . . that has an existence
independent of the debtor’s wrong and a trust . . . that has no existence
before the wrong is committed. A lawyer’s fiduciary duty to his client
. . . pre-exists any breach of that duty, while in the case of a constructive
. . . trust there is no fiduciary duty until a wrong is committed. [In this
case, the trust] has a purely nominal existence until the wrong is
committed. Technically, Marchiando became a trustee as soon as she
received her license to sell lottery tickets. Realistically, the trust did not
begin until she failed to remit ticket receipts.

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Id. at 1115-16; accord In re Tran, 151 F.3d at 345 (Tex. lottery sales proceeds statute).
In In re McGee, 353 F.3d 537, 540-41 (7th Cir. 2003), the court, applying
Marchiando, held that a municipal ordinance requiring landlords to hold tenant
security deposits as trust funds did create a § 523(a)(4) fiduciary relationship because
the ordinance imposed trust-like duties, such as requiring segregation of funds in an
interest-bearing financial institution account “to ensure that the money would be
available for return to the tenants if they kept their own promises.”
Viewed in light of these cases, we agree with the BAP that Ark. Code § 4-58105(b)(2) does not create a fiduciary relationship “in the strict and narrow sense”
required by § 523(a)(4). Hunter, 373 F.3d at 876. As the BAP observed, the statute
simply prescribes the legal effect when a party to an assigned account in good faith
pays the assignor rather than the unknown assignee -- payment is an “acquittance” to
the payor (here, the builders), and the assignor (Ms. Nail) is “accountable and liable
to the prior assignee” (Arvest). The statute imposes no trust-like duties such as
segregation of the Miscellaneous Proceeds. And while the statutory “trust” was
created when the settlement proceeds were paid (assuming without deciding those
proceeds were Miscellaneous Proceeds), as in Marchiando the trust had a “purely
nominal existence” until Ms. Nail failed to remit those proceeds to Arvest. In other
words, Ms. Nail was not a trustee “before the wrong and without reference thereto.”
Davis, 293 U.S. at 333. In these circumstances, we agree with the BAP that the mere
use of the word “trustee,” when viewed in the context of the statute as a whole, does
not reflect a legislative intent to create the kind of express or technical trust required
in the strict and narrow sense under § 523(a)(4). Therefore, the $65,000 debt was not
nondischargeable under the fiduciary capacity subpart of § 523(a)(4).3
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The BAP also held that the settlement proceeds were not “Miscellaneous
Proceeds” under the mortgage assignment provision, and that the proceeds in any
event could not be lawfully assigned under Arkansas law. We do not address these
issues because our conclusion that Ms. Nail did not act in a fiduciary capacity resolves
Arvest’s claim under this subpart of § 523(a)(4).
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III. Embezzlement
Alternatively, Arvest argues that the $65,000 debt is nondischargeable under
the embezzlement subpart of § 523(a)(4). “Embezzlement, for purposes of section
523(a)(4), is the fraudulent appropriation of property of another by a person to whom
such property has been entrusted or into whose hands it has lawfully come.” In re
Phillips, 882 F.2d 302, 304 (8th Cir. 1989) (quotation omitted). The bankruptcy court
did not need to reach this issue because it found defalcation while acting in a fiduciary
capacity. Arvest preserved the issue when Ms. Nail appealed and now argues the BAP
erred in failing to address it. But we perceive no error. Arvest contends that Ms. Nail
embezzled settlement proceeds “entrusted” to her by reason of the mortgage
assignment provision and Ark. Code § 4-58-105(b)(2). Thus, when the BAP
concluded the settlement proceeds were not Miscellaneous Proceeds, it decided the
embezzlement issue in Ms. Nail’s favor. Of course, we are not affirming that aspect
of the BAP’s decision, so we must examine the issue more closely.
“One cannot embezzle one’s own property.” In re Belfry, 862 F.2d at 662.
Therefore, documents assigning to a secured creditor proceeds that are part of the
creditor’s collateral are simply agreements in which the debtor retains the funds,
subject to a security interest. In In re Phillips, for example, the borrower went out of
business after spending most of the proceeds. The secured creditor argued that it
“owned” the proceeds and therefore the bankruptcy debtors committed § 523(a)(4)
embezzlement, making the debt nondischargeable. We disagreed:
Although the term “assignment” was used in parts of the documentation,
the parties treated the transaction as the routine granting of a security
interest. . . . [We] conclude that [the borrower] owned the funds from
the check subject to the security interest of the Bank. . . . Because the
funds belonged to [the borrower] subject to [the bank’s] security interest,
the debtors could not have embezzled the funds and the debt is not
nondischargeable under section 523(a)(4). 882 F.2d at 304-05.
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Like the secured lender in Phillips, Arvest loaned Nail money secured by an
interest in her home, including recoveries defined as Miscellaneous Proceeds. The
parties treated the transaction as a mortgage or security interest. The assignment
provision merely served as a collection device for Miscellaneous Proceeds, funds
owned by Ms. Nail that she was contractually obligated to remit to Arvest. Thus, even
if the settlement proceeds were Miscellaneous Proceeds, as we are assuming without
deciding, Ms. Nail’s alleged failure to comply with the assignment provision “was a
dischargeable breach of contract, not a nondischargeable embezzlement.” Werner v.
Hofmann, 5 F.3d 1170, 1172 (8th Cir. 1993); accord In re Mitchell, No. 07-02379,
2008 WL 3992240, *2 (Bankr. S.D. Iowa 2008) (unpublished); In re Moller, No. 0401413S, 2005 WL 1200916, *1-3 (Bankr. N.D. Iowa 2005) (unpublished). The BAP
properly concluded that the $65,000 debt was not nondischargeable under the
embezzlement subpart of § 523(a)(4).
For the foregoing reasons, the judgment of the BAP in this adversary
proceeding is affirmed.
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