S & S Food Corp. v. Sherali (In re Sherali)
490 B.R. 104 (2013)
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Rule of Law:
Debts arising from a corporate officer's defalcation of fiduciary duty or larceny—including unlawful corporate distributions made while the corporation is insolvent and conversion of corporate assets—are nondischargeable in bankruptcy under 11 U.S.C. § 523(a)(4), and bankruptcy courts retain the constitutional authority to liquidate such state law claims when doing so is integral to determining dischargeability.
Facts:
- Sa-druddin Sherali (Sherali) was the sole officer, director, and shareholder of S & S Food Corporation (S & S) from January 1, 2006, until December 9, 2011 (the "Relevant Period").
- During the Relevant Period, Sherali caused S & S to make distributions totaling $670,356 to himself, which were recorded as stock distributions, not compensation, for tax reasons.
- Throughout the Relevant Period, S & S was insolvent (unable to pay its debts as they became due) and had a negative net worth and a negative surplus under Texas corporation law.
- Sherali wrongfully possessed and claimed ownership of S & S's 2003 Honda Element after December 9, 2011, despite S & S consistently listing it as an asset on its balance sheets and bankruptcy schedules since 2004.
- From December 1-9, 2011, Sherali failed to account for and converted $21,225.48 of S & S's net cash sales.
- S & S was unable to pay its debts to at least two creditors, Zipco, Inc., a gasoline supplier, and Wilshire State Bank, during the Relevant Period.
Procedural Posture:
- Sa-druddin Sherali (Debtor) filed for Chapter 7 bankruptcy (Case No. 12-34480-bjh-7).
- S & S Food Corporation (S & S) filed an adversary proceeding (Adversary No. 12-03185-bjh) in the U.S. Bankruptcy Court for the Northern District of Texas against Sherali, seeking to determine a debt owed and its dischargeability under 11 U.S.C. § 523.
- Sherali filed an Answer to the Complaint.
- The parties submitted a Joint Pretrial Order, which the court entered.
- Sherali's counsel filed a Motion for Leave to File Amended Answer shortly before trial, which the Bankruptcy Court denied at the outset of the trial due to untimeliness, lack of legitimate reason, and prejudice to S & S.
- The adversary proceeding proceeded to trial, where the court heard testimony from witnesses and subsequently requested and received post-trial briefs from the parties.
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Issue:
Does a bankruptcy court have the constitutional authority to liquidate state law claims and determine their dischargeability under 11 U.S.C. § 523(a)(4) when the debtor, a corporate officer, breached fiduciary duties and committed larceny by making unlawful distributions and converting corporate assets?
Opinions:
Majority - Houser, Bankruptcy Judge
Yes, a bankruptcy court has the constitutional authority to liquidate state law claims and determine their dischargeability under 11 U.S.C. § 523(a)(4) when the debtor, a corporate officer, breached fiduciary duties and committed larceny by making unlawful distributions and converting corporate assets. The court rejected Sherali's argument that Stern v. Marshall stripped bankruptcy courts of their constitutional power to finally determine such issues. The court clarified that Stern focused on a debtor's common-law counterclaim to a proof of claim, not a creditor's claim against a debtor for dischargeability. It held that determining dischargeability, even if it requires liquidating an underlying state law claim, is integral to the bankruptcy process and falls under the "public rights exception" as outlined in Thomas v. Union Carbide. The court also cited controlling Fifth Circuit precedent (In re Morrison) and other circuit court decisions affirming bankruptcy courts' authority to liquidate state law claims and enter monetary judgments in dischargeability actions. On the merits, the court found Sherali liable for $670,356 for causing unlawful distributions to himself while S & S was insolvent and had a negative surplus, in violation of Texas corporation law, and for breach of fiduciary duty. The court also found Sherali liable for $24,000 for converting S & S's 2003 Honda Element and $21,225.48 of cash sales. These actions constituted defalcation while acting in a fiduciary capacity and larceny under 11 U.S.C. § 523(a)(4). The court reasoned that Sherali, as a corporate officer/director, owed S & S a fiduciary duty and was presumed to know S & S's financial condition and the law. His actions constituted a "willful neglect of duty," meeting the recklessness standard for defalcation. His appropriation of property without consent constituted larceny. Furthermore, attorney's fees ($15,000) and exemplary damages ($500,000) awarded for the breach of fiduciary duty and malicious conversion were also found to be nondischargeable, consistent with Supreme Court and Fifth Circuit precedent.
Analysis:
This case is significant for several reasons. First, it clarifies and reinforces the scope of bankruptcy court authority post-Stern v. Marshall, holding that bankruptcy courts can constitutionally liquidate state law claims when necessary to determine dischargeability. This prevents debtors from using Stern to avoid adjudication of claims related to their discharge. Second, it robustly applies 11 U.S.C. § 523(a)(4), emphasizing that a corporate insider's "willful neglect of duty" (recklessness) can constitute defalcation, making debts arising from unlawful self-dealing or asset misappropriation nondischargeable. This provides a strong tool for corporate creditors to pursue claims against fiduciaries who exploit their position while a company is in financial distress.
