Using Bankruptcy to Avoid Responsibility for Embezzled Funds

Churches need to have safeguards against embezzlement.

Magpusao v. Magpusao, 265 B.R. 492 (M.D. Fla. 2001)

Background. Unfortunately, church employees and volunteers sometimes embezzle church funds. Consider a recent case. A woman ("Amy") was hired by a church as a bookkeeper. Her responsibilities included managing the church's bank account, maintaining financial records, and handling the church's finances. She also operated a home interior business. A few years after she started working at the church, Amy began to misappropriate church funds by issuing unauthorized checks to herself, her personal creditors, and other individuals. According to the church's investigation, she embezzled nearly $560,000 over an eight-year period. She deposited approximately $162,000 of the embezzled funds into a joint account with her husband, Eric.

Amy's embezzlement was ultimately discovered in 1998 by her supervisor. Amy was arrested and charged with grand theft. She pled guilty to misappropriating the funds and was convicted of grand theft and sentenced to a ten-year prison term. A year later, her husband Eric filed for bankruptcy and listed the church as an unsecured creditor in the amount of $560,000. The church asked the court to exempt this debt from being discharged in bankruptcy pursuant to section 523(a)(6) of the bankruptcy code, which state that a discharge of debts as a result of bankruptcy "does not discharge an individual debtor from any debt … (4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement or larceny [or] (6) for willful and malicious injury by the debtor to another entity or to the property of another entity."

The court's ruling. The bankruptcy court noted that "exceptions to discharge prevent a debtor from avoiding the consequences of wrongful conduct by filing a bankruptcy case." However, it pointed out that "courts narrowly construe the exceptions to discharge against a creditor and liberally in favor of a debtor in order to ensure that the 'honest but unfortunate debtor' is afforded a fresh start."

Fraud or defalcation while acting in a fiduciary capacity

The court concluded that Eric did not occupy a fiduciary capacity with respect to the church, and therefore he could not have committed fraud or defalcation while acting in a fiduciary capacity. The court also concluded that Eric had not committed embezzlement or larceny. It defined embezzlement as "the fraudulent appropriation of property by a person to whom such property has been entrusted or into whose hands it has lawfully come." Although proof of a fiduciary relationship is unnecessary to prevail on an embezzlement claim, the creditor must show evidence of fraud or fraudulent intent. The court concluded that "the evidence does not demonstrate that [Eric] was either entrusted with or lawfully received the property of the [church]. Accordingly, the court does not find that [he] committed embezzlement." Similarly, the court defined larceny as the fraudulent taking and carrying away of the property of another with intent to convert such property to his use without the consent of another." It concluded that Eric had not fraudulently taken away the church's assets.

Willful and malicious injury

Section 523(a)(6) of the bankruptcy code exempts from discharge any debt "for willful and malicious injury by the debtor to another entity or to the property of another entity." In order to be successful in exempting the $560,000 debt from discharge under this section, the church had to prove the following elements: (1) an intentional action by Eric; (2) done with the intent to harm; (3) which caused damage (economic or physical) to the church; and (4) the injury is the result of Eric's action. The church insisted that since Amy and Eric shared a joint bank account, knowledge of activity in the account should be imputed to him. On this basis, the church claimed that Eric should be presumed to have known that his wife deposited approximately $162,000 of misappropriated funds into the joint account and should be held accountable for the church's loss in that amount.

The bankruptcy court observed that "courts have generally held that fraudulent intent may not be imputed from one spouse to another based simply on the marital relationship of the parties. Even knowledge of a spouse's misconduct is insufficient to confer liability. Rather, knowledge must be concurrent with participation in the use or enjoyment of the stolen property in order for liability to attach."

The court found that Eric "was not as ignorant of his wife's malfeasance as he claims." It concluded:

Although the bankruptcy code does not permit attribution of intent from one spouse to another, fraudulent intent may be inferred from the totality of the circumstances and the conduct of the person accused. Eric's demeanor at trial showed him to be an intelligent and astute individual, despite his attempt to appear ignorant of financial matters. He appeared well-informed regarding the nature and operation of mortgages and consignment shops. He showed surprising familiarity and control over an old bank account. In fact, he was even able to recite the account number by memory. The court also noticed that he had sufficient knowledge of the family's income to determine what expenditures were beyond their means, as evidenced by his objections to [various purchases and gifts]. His testimony revealed that his wife solicited his advice regarding certain expenses and that they discussed mortgages on their home. Yet when asked how the family afforded a new car or rent payments for [Amy's home interior business] Eric simply professed ignorance and insisted that his wife handled all financial matters. His selective knowledge and summary denials hamper his credibility. Eric claims that he did not witness any unusual or extravagant expenditures. However, the evidence shows there was quite a bit of money expended on behalf of the family in the form of trips, allowances to the children, a new automobile, and various credit card purchases.

The court concluded that by the time of his wife's arrest, Eric "was abundantly aware of his wife's embezzlement, he knew she had used their joint account to hide some of the money, and he knew that there was a great likelihood that the remaining money in the account rightfully belonged to the church. Nevertheless, he proceeded to use it for his own purposes. Where the specter of suspicion is present, there is a duty to be cautious in the use of tainted funds. The court holds Eric in abrogation of this duty. In the absence of an explanation accounting for the source of these funds, the court finds that this money was derived from the embezzled funds."

While the court was convinced that "the evidence demonstrated numerous instances of Eric's knowledge and participation in the use or enjoyment of church property," the evidence also demonstrated that Eric was unaware of his wife's illegal conduct. He testified that in accordance with his own cultural (Filipino) tradition, it was his wife who managed the family's finances. This assertion was supported by the fact that it was Amy who signed all but one of the checks drawn from the joint account. The court observed, "Given that Amy was a bookkeeper and skilled in account management, it is likely that Eric did not regularly, if ever, monitor the bank account." When Amy's supervisor confronted her with evidence of embezzlement, Amy pleaded with her not to tell her husband fearing that he might kill her. Such evidence "suggests that Amy intended to hide her criminality from her husband," and that Eric did not participate in the use and enjoyment of church funds to the extent the church claimed.

The court concluded that Eric did not know of the degree to which his wife was stealing from her employer. However, he was aware that his wife was receiving money from an unexplained source, even though he did not actively participate in her ill-gotten gains. Instead, he accepted only those benefits that she herself conferred upon him. Based upon these findings, the court "cannot hold Eric liable for all of the embezzled funds that his wife deposited in the joint account. He can only be held accountable for items that he knew were acquired illegally and which he nevertheless accepted." After carefully reviewing items purchased or financed through funds stolen from the church, the court concluded that debts amounting to $25,000 were nondischargeable in bankruptcy on the basis of section 523(a)(6).

What this means for churches

Consider the following points:

1. Many church leaders consider embezzlement to be a problem that couldn't happen in their church. Yet, it is this very attitude that contributes to poor or nonexistent "internal controls" over cash handling and payment of expenses that makes embezzlement a real threat. In this case, the bookkeeper (Amy) was able to embezzle $560,000 over an 8-year period before her deeds were detected.

2. How was Amy able to embezzle more than half a million dollars? By issuing unauthorized checks to herself as well as to her personal creditors and other individuals. Had the church implemented the most basic "internal controls," Amy could not have engaged in her acts of embezzlement. Here are two internal controls that would have worked: (1) Require at least two signatures for all checks above a nominal amount. (2) Have monthly bank statements reviewed by a church official or employee having no responsibility for handling cash or writing checks.

3. It could be said that church leaders are not discharging their fiduciary duties when they fail to implement basic internal controls over cash handling and the payment of expenses. Such a failure can result in a host of negative consequences, including the following: (1) Criminal liability to the embezzler. In this case, Amy was sentenced to ten years in a state penitentiary. (2) Financial hardship to the church. Think of the impact to most churches of having over a half million dollars embezzled over an 8-year period. (3) As this case illustrates, embezzlers who do not pay back embezzled funds to their former employer have a continuing legal duty to do so that cannot be discharged through bankruptcy. (4) The court concluded that Amy's husband was legally responsible for repaying at least some of the embezzled funds.

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