Restructuring

Contributed by Hannah Geller.
Do you serve on your condominium’s board as a fun way to meet your neighbors and test out your governance skills? What seems like a low-commitment diversion can balloon into a stressful time suck – or worse.  You may be held personally liable for breaching fiduciary duties to your condo.  And if you fall into really bad luck and end up in bankruptcy, you may not even be able to discharge debts for such liability, as a recent Fifth Circuit decision reminds us.  
James Robert Whitaker, the subject of the recent Fifth Circuit Court of Appeals’ decision In re Whitaker, was the president and director of his Home Owners’ Association, Moroney Farms subdivision in Richardson, Texas.  When a homeowner requested association documents, Whitaker refused and spent almost $30,000 of the HOA’s money to hire a lawyer and oppose the request.
The HOA sued Whitaker for breach of fiduciary duty, alleging that Whitaker had spent HOA money on frivolous litigation against the tenant, in addition to having improperly accepted money from a contractor who was working for the HOA and reimbursing himself with HOA money for personal expenses.  The District Court in Collin County, Texas found Whitaker liable to the tune of over $30,000.  Whitaker filed for chapter 7 bankruptcy, and the HOA initiated an adversary proceeding to object to the dischargeability of the state court judgment under 11 U.S.C. § 523(a)(4), which excepts “defalcation” (discussed below) from the list of debts that are dischargeable in bankruptcy.
The United States Bankruptcy Court of the Eastern District of Texas denied Whitaker’s requests to relitigate the facts of the state court decision for purposes of the dischargeability proceeding, applying Texas state law’s three-prong collateral estoppel test because the preclusive judgment occurred in state court. Under Texas law, issue preclusion prohibits relitigation when (1) “the facts sought to be litigated in the second action” were “fully and fairly litigated in the prior action,” (2) the facts were “essential to the judgment in the first action,” and (3) the parties in the second action were “adversaries in the first action.”  Finding the prongs met, the court ruled that the state court judgment debt was non-dischargeable
Whitaker appealed to the district court, which affirmed the bankruptcy court’s decision, and appealed further to the Fifth Circuit Court of Appeals.  That court first determined that the bankruptcy court properly applied collateral estoppel. The panel found that the facts had been fully litigated in the Collins County District Court decision, where a multi-day trial complete with witness testimony and exhibits had proceeded.  The second prong was met because the state court made “specific, subordinate, factual findings,” and the third prong was met as Whitaker and the HOA had undoubtedly acted as adversaries in the District Court decision.
The Fifth Circuit continued on to hold that Whitaker’s debt met the 11 U.S.C. § 523(a)(4) requirement for non-dischargeability as a debt stemming from a defalcation while acting in a fiduciary capacity.  First of all, the court held that Whitaker was acting in a fiduciary capacity.  Although under Gupta, the issue of whether Whitaker was a fiduciary was a federal law question, under Fifth Circuit precedent, federal law recognizes fiduciary relationships created under state law.  In re Shcolnik.  Texas state law recognizes a fiduciary relationship between the directors and officers of nonprofit corporations, such as the HOA, which the Fifth Circuit recognized in Whitaker’s case
Secondly, the Fifth Circuit held that Whitaker had committed a defalcation.  Defalcation is a broad term meaning the breach of a fiduciary duty.  Courts of appeals have disagreed about the requisite mental state for defalcation.  In the bankruptcy context, though, the Supreme Court clarified the requisite mental state in the 2013 decision.  Bullock v. BankChampaign, N.A.  For defalcation debts to qualify for the discharge exception, the debtor must have had a mental state of knowledge or gross recklessness that his or her behavior violated his or her fiduciary duties.
Here, the state court had specifically found that Whitaker acted knowingly when he hired the attorney to improperly refuse the homeowner’s request, reimbursed his personal expenses with HOA money, and sought and received money personally from a third party contractor working for the HOA.  Thus, the Fifth Circuit Court of Appeals upheld the lower courts’ judgments, and Whitaker was unable to discharge his bankruptcy debts under the defalcation exception.
The moral of the story?  Be careful if you serve on your condo’s board – not only may you be held personally liable for something that sounds as terrible as “defalcation,” but you may not even be able to get out of such a payment by filing for chapter 7 bankruptcy.