Embezzlement Claim Based on Divorce Decree Survives Motion to Dismiss

Posted by NCBRC - October 14, 2022

The plaintiff’s allegations of embezzlement with respect to a business debt the debtor, her ex-husband, owed to her were sufficient to withstand a motion to dismiss, where the plaintiff co-owned the business with the debtor and the debtor failed to comply with the family court’s order to set aside income from the business for the plaintiff. Bailey v. Bailey, No. 22-10013, Adv. Proc. No. 22-1001 (Bankr. E.D. Ky. Sept 26, 2022).

While the debtor and the plaintiff were going through divorce proceedings, the family court ordered the debtor to set aside income from their co-owned roofing business into a separate account (the business debt). The debtor failed to do so. He later filed for chapter 13 bankruptcy and listed the plaintiff as an unsecured creditor. The plaintiff filed an adversary complaint seeking a finding that the business debt, totalling $273,675, was nondischargeable under several paragraphs of section 523. The debtor moved to dismiss the complaint, and the plaintiff moved for partial summary judgment.

Section 523(a)(5) makes nondischargeable any debt that is a domestic support obligation (DSO) “in the nature of alimony, maintenance, or support.” Factors a court will consider to determine whether a debt is a DSO, include: “(1) a label such as alimony, support, or maintenance in the decree or agreement, (2) a direct payment to the former spouse, as opposed to the assumption of a third-party debt, and (3) payments that are contingent upon such events as death, remarriage, or eligibility for Social Security benefits.”

Applying these factors, the court found the business debt did not qualify as a DSO. Significantly, it was not labeled a DSO in the divorce decree, and was not contingent upon any subsequent events. Furthermore, the divorce decree did include an alimony award of $250/month.

The plaintiff next claimed that $160,000 of the business debt, representing income the business generated during the divorce proceeding, should be found to be nondischargeable under section 523(a)(4) as being incurred by “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny[.]”

Finding that the fiduciary component of section 523(a)(4) applies to express trusts, the court began with the question of whether a trust was created by the divorce decree. The court looked at four considerations: “(1) an intent to create a trust; (2) a trustee; (3) a trust res; and (4) a definite beneficiary.” The court found the divorce decree, while ordering the debtor to deposit funds into a separate account, did not create an express trust. The debtor was not a trustee and, because the debtor never actually established the separate account, there was no trust res. Without an express trust for which the debtor was a fiduciary, the plaintiff’s claim alleging fraud or defalcation failed.

The court made quick work of the plaintiff’s claim that the debtor’s conduct was larcenous under section 523(a)(4). Larceny requires wrongful taking of property belonging to another. Here, the funds the debtor was alleged to have stolen, came to him legally through business operations.

Turning to the plaintiff’s claim for embezzlement under section 523(a)(4), the court found a plaintiff must show “(1) that [the plaintiff] entrusted his property to the [d]efendant, (2) the [d]efendant appropriated the property for a use other than that for which it was entrusted, and (3) the circumstances indicate fraud.” In light of the family court’s order to place money in a separate account, the court found that the plaintiff had alleged sufficient facts to support this claim.

The court granted the debtor’s motion to dismiss on all counts except the embezzlement count under section 523(a)(4) for the portion of the income the debtor received during the divorce proceedings.

The court turned to the plaintiff’s motion for summary judgment noting that the only claim surviving the debtor’s motion to dismiss was the claim for embezzlement. The court found the only evidence the plaintiff presented of embezzlement was the divorce decree and that, while it carried the claim past a motion to dismiss, it was insufficient to support summary judgment.

Finally, the court rejected the plaintiff’s request to “impose an equitable lien on the real property deemed Debtor’s nonmarital property by the family court, even though it remains deeded to her.” The claim asked for an equitable lien on the plaintiff’s residence until such time as the debtor complied with his obligation to give the plaintiff her share of the co-owned business.

The court found that equitable liens are typically created under estoppel principles as in cases where a vendor has performed a service on another’s property and may be deemed to have a lien on that property to enforce payment for those services. Here, the lien claim did not accrue out of the same subject matter as the debt obligation, and neither of the party’s obligations was contingent upon the other party’s fulfillment of theirs. Perhaps more importantly, the court was flummoxed by the request to award the plaintiff an equitable lien on property that was currently deeded to her.

The court denied the plaintiff’s motion for summary judgment in full.

Bailey Bankr ED Ky Sept 2022


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