Under bankruptcy law proceeds obtained by fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny are not dischargeable. Section 523(a)(4) clearly states this but note that the word defalcation has an “l”. Bankruptcy law does not involve bodily functions. What happens when the contractor of your house does a lousy job? You sue him for damages; he pays you $100,000 to settle the lawsuit. You use $50,000 to pay your lawyer, and then you gamble the rest of the money in Pechanga. You then file for bankruptcy to get rid of your credit card debt of $60,000 after you lose your house to foreclosure. In your bankruptcy, Chase files an adversarial proceeding to object to the discharge of the balance of the first trust deed alleging that the $100,000 you received as settlement were trust funds that should have been given to Chase. Since you did not give the money to Chase, you breached your fiduciary duty making the $100,000 a non dischargeable debt pursuant to Section 523(a)(4). Is Chase correct?

In Re Nail, the debtor discovered significant structural defects with her newly constructed home soon after she moved in. She sued the builder for constructive fraud, breach of warranty, and breach of contract. While this litigation was pong on, Arvest Mortgage Co. granted her 12 months loan forbearance. When the forbearance period ended, debtor did not resume making mortgage payments. She defaulted on the mortgage and filed for Chapter 13 relief. Arvest obtained stay relief, and then foreclosed on the debtor’s house for substantially less than the amount owed by debtor. At debtor’s deposition in the foreclosure lawsuit, Arvest found out that the builder had paid $65,000 to settle her state court lawsuit. Debtor used some of the money to invest in a new home, to pay her attorney’s fees, and to pay bills.

Arvest filed an adversary proceeding, seeking a judgment declaring the mortgage debt nondischargeable under Section 523(a)(2) and (4). The mortgage agreement assigned to Arvest all “Miscellaneous Proceeds,” a term defined by the mortgage to include “any…settlement…paid by any third part…for…damage to, or destruction of, the property.” The bankruptcy court found that the $65,000 settlement proceeds were Miscellaneous Proceeds, and that the assignment provision created an express trust under the relevant sections of the Arkansas Code. Therefore, the court concluded that the debtor’s failure to pay the proceeds to Arvest was a breach of her fiduciary duty, and entered a judgment in favor of Arvest for $46,016 after giving her credit for her attorney’s fees. Debtor appealed.