Misuse of Construction Trust Funds May Prevent a Contractor From Discharging Its Liability in Bankruptcy

In a recent bankruptcy case in Texas, the court rejected a contractor’s attempt to discharge its liability for violation of a construction trust-fund statute. Tag Invs., Ltd. v. Monaco (In re Monaco), 514 B.R. 477, 2014 Bankr. LEXIS 3276 (Bankr. W.D. Tex. 2014). The trust-fund violation established that the contractor had breached its fiduciary duties to the trust beneficiaries with either actual knowledge of wrongdoing or reckless disregard to the risk that the conduct would violate the contractor’s duties. This was sufficient to reject a discharge under § 523(a)(4) of the Bankruptcy Code.

In many states, funds paid by an owner to a contractor to pay for subcontractors’ work are considered statutory “trust funds.” See, e.g., Tex. Prop. Code §§ 162.001, et seq. The contractor is deemed to be a “trustee” with certain fiduciary duties to the “beneficiaries” of the trust funds, including the subcontractors. Violation of the statute occurs when the contractor intentionally or knowingly does not apply the funds in the manner required under the statute. This can lead to civil liability and, depending on the statute, potential criminal prosecution. Such liability applies not only to the contractor, but to any officers, directors, or agents who control or direct the trust funds.

If such violations occur, the contractor may attempt to discharge its liability to the owner for the misapplied payments through bankruptcy proceedings. If the subcontractors have perfected liens against the owner’s property, the owner faces the risk of paying twice for the subcontractors’ work without any possibility of collecting reimbursement from the contractor.  

To reduce this risk, the owner has the option to challenge the discharge of the debtor’s liability. Section 523 of the Bankruptcy Code prohibits discharge of a debt “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” 11 U.S.C. 523(a)(4). If successful, the owner may then seek to recover the misapplied funds from the debtor (which could be the contractor, its officers, its directors, and/or its agents).

In the Monaco case, a contractor and several individual officers sought to discharge debts in bankruptcy that included claims asserted by an owner based on the debtors’ misapplication of trust funds. The contractor failed to pay several subcontractors despite receiving the funds to do so from the owner. The bankruptcy court found that the debts were not dischargeable, as the owner had shown that the debtors misapplied funds with sufficient knowledge to meet the requirements of § 523(a)(4) of the Bankruptcy Code. In particular, this finding was based on evidence that one of the officers submitted written certifications that all subcontractors and suppliers had been paid, when he knew they had not. These false certifications were intended to obtain payment from the owner and conceal the misapplication of the trust funds. Thus, the discharge was denied as to the officer who had signed the certifications. Another officer evidently was permitted a discharge because, though she likely knew the subcontractors had not been paid, she did not sign false certifications or engage in other conduct suggesting intentional violation of the trust-fund statute.

Bankruptcy proceedings can impose significant obstacles to the successful pursuit of claims against the debtors. Statutory fiduciary duties can serve as an important tool to owners seeking to overcome these obstacles.