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April 29, 2003


The opinion of the court was delivered by: Milton I. Shadur, Senior United States District Judge.


Gloria Nelson and her mother Linda Mitchell (collectively "Nelson-Mitchell") appeal from the judgment of the Bankruptcy Court that rejected their adversary Complaint against debtor Bertha McGee ("McGee"). In that proceeding Nelson-Mitchell had sought to exclude, from McGee's discharge via her voluntary Chapter 7 bankruptcy petition, the pre-bankruptcy debt that McGee had owed to them. This appeal calls for the application of customary appellate standards of review, requiring examination of the Bankruptcy Court's factual findings for clear error and its conclusions of law de novo (see, e.g., In re UNR Indus., Inc., 986 F.2d 207, 208 (7th Cir. 1993)). This Court has done so, and that review clearly calls for reversal in favor at Nelson-Mitchell.


Because there are really no facts in dispute, the issues posed by the current appeal can be resolved by a de novo legal analysis alone. What follows is a statement of the factual background necessary for that purpose.

Nelson-Mitchell were McGee's tenants in Section 8 housing located at 8159 West Houston, Chicago, Illinois. They delivered a $2,500 security deposit to her in two cash installments. Initially McGee kept the deposit in a strongbox at her own residence, but when she later consulted with a lawyer about possibly evicting Nelson-Mitchell as tenants, he told her that she should have put the security deposit in an interest-bearing account — and she did so.

That was good advice. In the City of Chicago, all landlords obligations with respect to all residential tenants' security deposits are exceedingly stringent, and they are spelled out in detail in Chicago Municipal Code §§ 5-12-080 to 5-12-082 (those sections are part of the Chicago Residential Landlord and Tenant Ordinance).*fn1 Although a photocopy of all of the cited sections is attached as Ex. 1 to this opinion, Code § 080(a) is particularly worth quoting here:

A landlord shall hold all security deposits received by him in a federally insured interest-bearing account in a bank, saving and loan association or other financial institution located in the State of Illinois. A security deposit and interest due thereon shall continue to be the property of the tenant making such deposit, shall not be commingled with the assets of the landlord, and shall not be subject to the claims of any creditor of the landlord or of the landlord's successors in interest, including a foreclosing mortgagee or trustee in bankruptcy.
When in the latter part of 2000 Nelson-Mitchell decided not to renew their lease and to move out instead, McGee preempted that step by filing a forcible detainer action in the Circuit Court of Cook County, seeking to evict them and to collect what she claimed to be unpaid rent. Nelson-Mitchell moved out of the premises and asked McGee for the return of the security deposit. When she refused, Nelson-Mitchell filed not only an Answer but also a multi-count Counterclaim in the Circuit Court lawsuit, with Count TV seeking damages for McGee's failure to return the security deposit (Code § 080(f) provides for damages of twice the amount of the deposit), and with Count V seeking the addition of interest (Code § 080(f) also provides for the tenant's recovery of interest, while Code § 081 specifies the interest rate for that purpose).

While the Circuit Court lawsuit was pending, McGee (who later testified before the Bankruptcy Court in this adversary proceeding that "I didn't think I was going to lose"*fn2) somehow decided that the money had become hers to do with as she wished, so she took the money out of the bank account and put it to her own use in December 2001. At the very beginning of January 2002 Nelson-Mitchell filed a summary judgment motion in the Circuit Court, a motion that the state court judge decided in their favor in all respects in February 2002. Nelson-Mitchell were held to owe nothing whatever to McGee in rent, and judgment on the Counterclaim was entered in their favor and against McGee for $5,000 plus interest of $270.50.

McGee, by then having dissipated all of the funds, proceeded in March 2002 to file a voluntary petition under Chapter 7. That proceeding resulted in her discharge. And as stated earlier, Nelson-Mitchell's adversary Complaint, which sought to challenge the dischargeability of McGee's indebtedness arising out of what has been described here, was turned down by the Bankruptcy Court after an evidentiary hearing. This timely appeal followed.


One of the provisions of 11 U.S.C. § 523 ("Section 523") that specify the exceptions to discharge in bankruptcy is at issue here. Here is Section 523(a)(4):

A discharge under section 727, 1141, 1228(a), 1228(b), or 1328(b) of this title does not discharge an individual debtor from any debt —
(4) for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.
Because no fraud or embezzlement or larceny on McGee's part has been charged by Nelson-Mitchell, the outcome-determinative issues on this appeal hinge on the meaning of "defalcation" and "fiduciary capacity."

Both of those concepts have been addressed by our Court of Appeals in Meyer v. Rigdon, 36 F.3d 1375 (7th Cir. 1994). As for "defalcation," the extended treatment in Meyer, id. at 1382-85 (drawing on the seminal opinion by Judge Learned Hand in Central Hanover Bank & Trust Co. v. Herbst, 93 F.2d 510, 511-12 (2d Cir. 1937)) concluded that the "mere negligent breach of a fiduciary duty is not a `defalcation'" (id. at 1385 (emphasis in original)), but that some added element such as a "willful" or "reckless" failure on the debtor's part to come up with the money is necessary (id.) That poses no difficulty here: There can be no question that McGee's refusal to return her tenants' property, the security deposit, merited such a pejorative characterization.

As for the other necessary component of nondischargeability under Section 523(a)(4), Meyer, id. at 1382 confirms that "[t]he existence of a fiduciary relationship is a question of federal law."*fn3 On that score In re Marchiando, 13 F.3d 1111, 1115 (7th Cir. 1994) (most ...

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