Construction Trust Funds: Does Failure to Pay Give Rise to a Non-Dischargeable Debt?

Reshetar Systems, Inc. v. Thompson, 686 F.3d 940 (8th Cir. 2012)

Scott Thompson, the owner and manager of a construction company, signed a confession of judgment accepting liability for the company’s failure to pay its subcontractor sums received from an owner for a construction job.  After Thompson filed bankruptcy, the subcontractor sought to have its debt declared non-dischargeable on several grounds, including for “fraud or defalcation while acting in the fiduciary capacity.”  The 8th Circuit considered this issue in light of a Minnesota statute requiring that payments be held in trust for the benefit of subcontractors.

As discussed in a prior blog post (see Some Lies Matter More Than Others), Section 523(a)(4) of the Bankruptcy Code bars discharge for fraud or defalcation while acting in a fiduciary capacity.  According to the 8th Circuit, the threshold question of whether the debtor was acting in a fiduciary capacity is a matter of federal law, and the term is used in a “strict and narrow sense.”

The Minnesota statute provides (emphasis in original):

Proceeds of payments received by a person contributing to an improvement to real estate … shall be held in trust by that person for the benefit of those persons who furnished the labor, skill, material, or machinery contributing to the improvement. … Nothing contained in the subdivision shall require money to be placed in a separate account and not comingled with other money of the person receiving payment or create a fiduciary liability or tort liability on the part of any person receiving payment …

To meet the requirements of Section 523(a)(4), the trust must include a definable res and there must be “trust-like” duties.  That was not the case here.  Further the statute expressly states that no fiduciary relationship is created.  Accordingly, the court found that the statute did not create an express trust as required for application of Section 523(a)(4).

The subcontractor also argued under Minnesota common law that when a corporation is insolvent, its directors and officers become fiduciaries of the corporation’s assets for the benefit of creditors.  However, the court concluded, among other things, that this is not a technical trust of the type required by Section 523.

Next, the subcontractor tried alleging embezzlement (which is an alternate ground under Section 523(a)(4)).  However, although the subcontractor had a contractual right to be paid for its work, it did not have any specific property rights in the payments the contractor received from the owner so that they remained the property of the general contractor.  The general contractor’s use of its own property did not qualify as embezzlement.  Similarly, the general contractor’s possession of the payments from the owner was not larceny (yet another basis for non-dischargeability).

Not to be deterred, the subcontractor also contended that Section 523(a)(6), which bars discharge for “willful and malicious injury,” was applicable.  However, this requires intentional or deliberate injury that is targeted at the creditor and certain (or almost certain) to cause financial harm.  Again the court was not persuaded.

So, the court affirmed the lower court decision that the debtor’s liability for the failure to pay to the subcontractor sums the general contractor received from the owner of the project was dischargeable.

This is another case where key parts of the decision turned on Minnesota state law.  Although the court concluded that the Minnesota statute did not create a trust that would give rise to fiduciary obligations subject to Section 523(a)(4), it noted that other states have provisions that differ in the extent to which they create express trusts and impose trust-like duties.  An evaluation of how claims will play out in bankruptcy often requires an evaluation of the specific state law that is applicable – which may be generally similar to the law in other states while including nuances sufficient to produce different results.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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