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.
