In financial and legal usage, defalcation may involve misappropriation of funds by a person trusted with their charge; also, the act of misappropriation, or an instance thereof. A common example of defalcation would be skimming.
The United States Bankruptcy Code specifically uses the term defalcation to describe a category of acts that taint a particular debt such that it cannot be discharged in bankruptcy.[1] The United States Supreme Court addressed the issue in 2013,[2] holding that "defalcation" in the context of the U.S. Bankruptcy Code [3] requires proof of "a culpable state of mind… involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior."[4]
In accounting terminology, especially with respect to the area of audit, defalcation means a misappropriation of assets or theft of assets by employees or officers of a corporation.
Defalcation occurs when a debtor commits a bad act while acting in a fiduciary capacity.[5] The classic example of defalcation occurs when a trustee recklessly invests in trust funds and loses the money. If the beneficiary wins a judgment against the trustee, and the trustee files for bankruptcy, the debt (the judgment) cannot be discharged in bankruptcy because the debt was the result of a defalcation.
Defalcation also applies when a debtor is acting in a fiduciary capacity. To constitute a defalcation, the conduct involves a degree of culpability that is greater than negligence, but the act does not need to rise to the level of a "fraud" under common law. Defalcation requires showing of conscious behavior or extreme recklessness.[6]
The term is used in legal proceedings other than bankruptcy to refer more generally to embezzlement; it is often used in the context of the title insurance business. A title agent who misuses funds intended to be used to close insured transactions is said to be involved in a defalcation. Many[citation needed] title insurers have their own "defalcation units".
Sometimes defalcation has been pronounced for very small amounts, as under 2 £ and cents, even if it was claimed to be an error in handling change.
The term is from Latin, and is analyzed as de- "off" + falx "sickle" + -atio "act of", hence literally "cutting off with a sickle". There is also a verb form, "defalcate".
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