In re: Bertha M C Gee

In the
United States Court of Appeals
For the Seventh Circuit
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No. 03-2297
In the Matter of:
B ERTHA M C G EE ,
Debtor-Appellant.
G LORIA N ELSON and L INDA M ITCHELL ,
Creditors-Appellees.
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Appeal from the United States District Court for the
Northern District of Illinois, Eastern Division.
No. 03 C 2061—Milton I. Shadur, Judge.
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S UBMITTED D ECEMBER 3, 2003—D ECIDED D ECEMBER 23, 2003
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Before B AUER , E ASTERBROOK , and DIANE P. W OOD , Circuit
Judges.
E ASTERBROOK , Circuit Judge. Gloria Nelson and her
mother Linda Mitchell rented a single-family house in
Chicago from Bertha McGee. The lease called for a security
deposit of $2,500, which Nelson and Mitchell (collectively
“the tenants”) paid in cash. McGee put the money in a
strongbox—a misstep, as an ordinance requires landlords to
invest security deposits in segregated, interest-bearing
accounts. When a dispute arose about the condition of the
premises, McGee launched an eviction proceeding in state

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2 No. 03-2297
court; the tenants moved out and filed a counterclaim
seeking return of the security deposit. McGee’s lawyer in
that action counseled her to bank the security deposit in
compliance with the ordinance, and she did. Before the
state court had resolved the litigation, however, McGee
withdrew and spent the money. McGee says that she
anticipated that the state court would rule in her favor, so
that there was no need to wait for “her” money. The state
judge saw things otherwise, determining that the tenants
had complied with all of their obligations and that McGee
owed double damages plus interest (a total of $5,207.50) for
failing to return the security deposit after the tenants quit
the premises. Unable (or at least unwilling) to pay this
judgment, McGee filed a federal bankruptcy proceeding and
sought a discharge. Bankruptcy Judge Squires ruled in
McGee’s favor, but District Judge Shadur reversed. See
2003 U.S. Dist. L EXIS 7208 (N.D. Ill. Apr. 29, 2003). He
found that withdrawal of the security deposit while the
state litigation was pending amounted to “defalcation while
acting in a fiduciary capacity” and foreclosed the debt’s
discharge. See 11 U.S.C. §523(a)(4).
As far as we can determine, neither this circuit nor any
other has addressed the question whether a landlord’s im-
proper retention of a security deposit amounts to “defalca-
tion while acting in a fiduciary capacity” for purposes of
§523(a)(4). Perhaps no general answer is possible, for some
jurisdictions (or leases) may treat the landlord’s position as
“fiduciary” while others do not. (There can be no doubt that,
if McGee was the tenants’ fiduciary, withdrawal and
spending the money during the eviction litigation was an
act of defalcation. See Meyer v. Rigdon, 36 F.3d 1375, 1383-
85 (7th Cir. 1994).) It is not hard to imagine arrangements
that entitle landlords to treat security deposits as their own
while tenancy continues, much as insurance companies may
commingle prepaid premiums with general corporate funds

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No. 03-2297 3
even though they must repay any unearned premium to an
insured who cancels the policy before the end of its term. If
the lease or governing statute treats the deposit as a form
of loan to the landlord in order to create the possibility of a
setoff if the tenant later incurs a debt to the landlord, then
the tenant becomes an unsecured creditor in bankruptcy.
On this understanding, each side’s obligation—the tenant’s
to pay rent and cover any damage, and the landlord’s to
repay the deposit—is unsecured, which makes the debts
“mutual” and readily offset. Likewise, however, it is easy to
imagine arrangements, created by contract or statute, that
require landlords to treat security deposits as trust funds
and thus create fiduciary duties. That is how the district
judge read Chicago’s ordinance. (As the ordinance super-
sedes inconsistent terms of any lease, we confine attention
to the legislative language.)
Chicago Municipal Code §5-12-080(a) provides:
A landlord shall hold all security deposits . . . in a
federally insured interest-bearing account in a
bank, savings and loan association or other finan-
cial institution . . . . A security deposit and interest
due thereon shall continue to be the property of the
tenant making such deposit, shall not be commin-
gled 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.
Subsection (c) adds that the interest paid into the inter-
est-bearing account belongs to the tenant. Subsection (d)
requires the landlord to provide an accounting and return
the deposit (less deductions for unpaid rent and damage to
the premises) promptly after the tenant vacates.
Subsection (a) contains five distinct rules: (1) the money
must be deposited in an insured account in a financial

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4 No. 03-2297
institution; (2) the account must earn interest; (3) the funds
remain the tenant’s property while on deposit; (4) every
tenant’s deposit must not be commingled with other assets;
and (5) the funds “shall not be subject to the claims of any
creditor of the landlord”. The second requirement— that
each account earn interest—is not relevant to analysis
under the Bankruptcy Code. Nor is the fifth requirement.
Federal law preempts any effort by state and local govern-
ments to determine which assets may be reached, for what
purposes, by particular creditors. See, e.g., Perez v. Camp-
bell, 402 U.S. 637 (1971). The meaning of the words in
§523(a)(4) is a question of federal law, see In re Frain, 230
F.3d 1014, 1017 (7th Cir. 2000), which state and local
governments cannot influence by attaching the word “trust”
or any equivalent label to arrangements that lack the
normal attributes of those devices. That is why we held in
In re Marchiando, 13 F.3d 1111 (7th Cir. 1994), that a state
law calling the proceeds of lottery-ticket sales “trust funds”
had no effect in bankruptcy, for the state had not required
retailers to use normal trust devices. The law at issue in
Marchiando amounted to little more than an effort by the
state to prefer its claims as a creditor over those of the
retailer’s other creditors. Bankruptcy law depends on, and
implements, entitlements defined by state law, see, e.g.,
Butner v. United States, 440 U.S. 48, 54 (1979); In re Wayco,
947 F.2d 1330, 1332 (7th Cir. 1991) (applying this principle
to ascertaining whether a trust had been created), but
which of these entitlements is subject to discharge or a
trustee’s avoiding power is beyond state control. (Unless, of
course, Congress decides to recognize local rules, as it has
done in providing that debtors may choose between the
exemptions provided by federal and state law. See 11 U.S.C.
§522(b).)
Chicago Municipal Code §5-12-080(a) does not attempt to
give the City a higher place in the priority queue. It is
neutral rather than self-preferring legislation. And rules

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No. 03-2297 5
(1), (3), and (4) do create a trust-like relation between
landlord and tenant, the sort of relation that federal law
labels “fiduciary.” Segregation of funds, management by
financial intermediaries, and recognition that the entity in
control of the assets has at most “bare” legal title to them,
are hallmarks of the trust. These real attributes, not the
labels applied by the ordinance, bring into play a fiduciary
obligation and thus §523(a)(4). See Douglas G. Baird, The
Elements of Bankruptcy 52 (rev. ed. 2001). The ordinance
charges landlords with duties to be carried out on behalf of
tenants, to protect their entitlement to return of deposits
with interest if they keep their part of the bargains.
By virtue of the formal separation and ownership rules,
the economic relation created by Chicago Municipal Code
§5-12-080(a) is more clearly a “fiduciary” one than is the
management of a client’s funds by a lawyer—and Maksym
v. Loesch, 937 F.2d 1237, 1241-42 (7th Cir. 1991), holds that
a lawyer acts as the client’s fiduciary in financial matters
even when neither contract nor statute requires segregation
of the client’s funds. Although we observed in Marchiando
that many fiduciary relations are characterized by dispari-
ties in the knowledge or economic status of the participants,
a condition not met here—neither McGee nor the tenants
are specialists in the housing market—this is not a sine qua
non. A plutocrat who puts an investment account of
$500,000 at the disposal of a recent high-school graduate for
the latter’s discretionary financial management may be
acting foolishly but has created a fiduciary relation (even if
not a formal trust), and if the manager decides to “invest”
the account in No. 28 on a roulette wheel then §523(a)(4)
will prevent discharge of the debt.
Having demanded and received $2,500 under (statutory)
terms designed to ensure that the money would be available
for return to the tenants if they kept their own promises,
McGee was obliged to act as the tenants’ fiduciary in
investing and preserving the funds. Instead she made off

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with the money, an act of defalcation that disqualifies her
from receiving a discharge.
A FFIRMED
A true Copy:
Teste:
________________________________
Clerk of the United States Court of
Appeals for the Seventh Circuit
USCA-02-C-0072—12-23-03

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