Defalcation

This article is about the financial crime. For the bodily process, see Defecation.

A defalcation is an amount of funds misappropriated by a person trusted with its charge; also, the act of misappropriation, or an instance thereof. The term is more specifically used by the United States Bankruptcy Code to describe a category of bad acts that taint a particular debt such that it cannot be discharged in bankruptcy.

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. The classic example of defalcation is when a trustee recklessly invests 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, for example, 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 a showing of conscious behavior or extreme recklessness.

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 title insurers have their own "defalcation units."

Etymology

Defalcation literally means "cutting off (with a falx "sickle").

The term is from Latin, and is analyzed as de- "off" + falx "sickle" + -tion "act of", hence literally "cutting off with a sickle". There is also a verb form, "defalcate" – see Wiktionary for further details.