Prudential-Bache Securities, Inc. v. Sawyer (In Re Sawyer)

Citations: 112 B.R. 386; 1990 U.S. Dist. LEXIS 3339; 1990 WL 34991Docket: Civ. A. No. 88-K-308, Bankruptcy No. 86 B 11451 E, Adv. No. 87 E 202

Court: District Court, D. Colorado; March 22, 1990; Federal District Court

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An appeal was made by Bruce A. Sawyer from the bankruptcy court's decision denying the discharge of his debt to Prudential-Bache Securities, Inc. The court's ruling was based on 11 U.S.C. § 523(a)(2)(A), which Sawyer contested on three grounds: (1) he did not gain any money or property from unauthorized purchases of cattle futures contracts; (2) he lacked intent to deceive his creditors; and (3) the burden of proof for Prudential-Bache should have been clear and convincing evidence rather than a preponderance of the evidence. The facts established that Sawyer, while employed as an account executive, placed unauthorized orders for 110 cattle futures contracts for Webster Feedlots, Inc., with only 26 authorized. He intended to transfer these contracts to prospective clients, which did not happen, and did not liquidate the positions as the market declined. Prudential-Bache financed these purchases using a margin account, which led to a significant cash loss when a margin call was issued. Despite repeated warnings from Prudential-Bache regarding the margin shortfall, Sawyer misled the firm about the account's status and improperly facilitated a transfer of funds without authorization from Webster. Ultimately, Prudential-Bache compensated Webster for the losses incurred from Sawyer's unauthorized trades, amounting to approximately $165,835.60. The court concluded that Sawyer's debt was non-dischargeable, albeit on a different statutory basis than the bankruptcy court.

Webster assigned its rights against Sawyer to Prudential-Bache. On February 26, 1985, Sawyer admitted to unauthorized trades amounting to $119,500.00 and executed a promissory note for that amount, but later defaulted. Prudential-Bache filed a state court action to enforce the note and recover additional amounts related to Sawyer's unauthorized trades, resulting in judgments totaling $179,280.28 against Sawyer, who subsequently declared bankruptcy. Prudential-Bache objected to the discharge of Sawyer's debt under 11 U.S.C. 523(a)(2)(A) and (6). During a hearing on December 10, 1986, the bankruptcy court determined that Prudential-Bache bore the burden of proof to deny discharge by clear and convincing evidence.

Regarding the claim under 523(a)(6), the court found no evidence of Sawyer's intent to cause willful and malicious injury, as required by Tenth Circuit law. For the 523(a)(4) claim, the court noted that while a fiduciary relationship exists between stockbrokers and their clients, it must arise from an express trust, which was not the case with Sawyer and Prudential-Bache. Ultimately, the court concluded that Sawyer's unauthorized trades constituted fraud under 523(a)(2)(A), establishing a debt resulting from fraudulent conduct. However, Prudential-Bache was denied recovery due to its failure to prove damages with certainty. After Prudential-Bache's motion for reconsideration, the court awarded it $77,416. Sawyer appealed, arguing that 523(a)(2) did not apply to his case.

Sawyer contends that his unauthorized purchases did not result in him acquiring any "money, property, services, or an extension, renewal or refinance of credit." Prudential-Bache counters this claim, referencing the bankruptcy court's finding that Sawyer became obligated for the cattle futures contracts upon their unauthorized purchase. While Prudential-Bache elaborates on commodities futures contracts, it fails to cite any legal authority supporting the claim that a broker who makes unauthorized purchases holds them for personal benefit rather than on behalf of the client. The law defines a broker as someone who negotiates contracts for others, without entitlement to possession or ownership of the property involved. As such, a broker does not gain title or benefits from unauthorized contracts, and the principal retains title. The principal may seek damages for unauthorized acts, but title to the unauthorized contracts remains with them. Prudential-Bache's argument that Sawyer has a proprietary interest in the unauthorized contracts only when their value declines is deemed illogical. Furthermore, there is no precedent for applying 523(a)(2) of the Bankruptcy Code to unauthorized broker purchases, with relevant cases instead focusing on 523(a)(4) concerning fraud or defalcation in a fiduciary role. Consequently, Prudential-Bache did not provide clear and convincing evidence that Sawyer obtained any benefits through fraud. Therefore, Sawyer's argument regarding his lack of intent to deceive is not addressed. Regarding the discharge of debt under 523(a)(4), this section specifies that debts for fraud or defalcation while in a fiduciary capacity are not dischargeable. The federal definition of "fiduciary" differs significantly from common law definitions, which are considered too broad for the purposes of this section.

The term "fiduciary capacity" under federal law and 11 U.S.C. § 523(a)(4) is limited to technical trusts, express trusts, or statutorily imposed trusts, excluding fiduciary relationships from equitable, implied, or constructive trusts, as well as ordinary commercial relationships such as principal/agent or debtor/creditor. A fiduciary duty must exist prior to the act creating the debt, meaning the debtor must have been a fiduciary before the misconduct occurred. The bankruptcy court determined that Sawyer was not acting in a fiduciary capacity, aligning with Tenth Circuit law, particularly the case of Hill v. Bache Halsey Stuart Shields, Inc., where a broker was found not to have a fiduciary duty under the Commodity Exchange Act (CEA). In Hill, the appellate court criticized the inclusion of fiduciary duty in the context of 4b of the CEA, asserting that it misinterpreted the anti-fraud intent underlying the provision. Conversely, in In re Smith, the court held that a broker was acting in a fiduciary capacity due to specific regulations under the CEA that restricted broker actions regarding customer funds, ultimately determining that the broker’s unauthorized trades constituted "defalcation."

In re Smith has not been cited by other courts, and the parties involved have not discussed it in their briefs, likely because they accepted the bankruptcy court's conclusion that 11 U.S.C. § 523(a)(4) was inapplicable. The rationale in In re Smith and related cases indicates that the Tenth Circuit's ruling in Hill does not prevent the conclusion that the Commodity Exchange Act establishes a technical trust for commodities purchasers. This trust is based on provisions concerning fund segregation and the prohibition against brokers trading without customer consent under 17 C.F.R. § 166.2 (1989), rather than the prohibitions interpreted in Hill.

Tenth Circuit precedent supports the notion that a statutory framework can create an express trust and fiduciary duty relevant to dischargeability under bankruptcy law. In Allen v. Romero (In re Romero, 535 F.2d 618 (10th Cir. 1976)), the court found that New Mexico's licensing laws created a fiduciary relationship for contractors, which existed independently of any agreement with clients regarding the handling of advanced funds. The court affirmed the bankruptcy court's determination that Romero acted in a fiduciary capacity under § 523(a)(4).

Although Romero has faced criticism, it has been applied in various contexts, such as in In re Currin and In re Peterson, where state licensing statutes similarly imposed fiduciary duties. In contrast, In re Choisnard ruled that a statutory trust did not arise under the Securities Exchange Act due to the nature of the broker's activities.

In the current case, while provisions of § 6b of the Commodity Exchange Act alone may not impose a fiduciary duty on brokers, other provisions can be interpreted to do so. The bankruptcy court concluded that § 523(a)(4) is applicable, and the stipulated facts demonstrate that Sawyer committed defalcation while in a fiduciary role. Consequently, the bankruptcy court's decision to deny the dischargeability of Sawyer’s debt to Prudential-Bache was affirmed. The court also noted that the fiduciary relationship was between Sawyer and Webster, not Sawyer and Prudential-Bache, and that the evidence of Prudential-Bache's damages met the clear and convincing standard, rendering any confusion regarding the standard of proof a harmless error.