Subcontractors: Construction Trust Statute Held to Protect Debts Owed to Subcontractors Despite General Contractor’s Bankruptcy
Kegler Brown Construction Alert June 11, 2009
In a victory for subcontractors, the 6th Circuit U.S. Court of Appeals held recently that because a general contractor and its president were fiduciaries of their subcontractors under a state construction trust fund (the Michigan Builders Trust Fund Act), debts owed to a subcontractor could not be discharged in bankruptcy. This ruling, in a case titled Patel v. Shamrock Floorcovering Services, Inc, 2009 FED App. 0167P (6th Cir.); 51 Bankr. Ct. Dec. 166, is welcome news to subcontractors in not only Michigan but in other states with similar construction trust fund statutes, or those who supply labor or materials under contract documents that make the general contractor a trustee of payments received for their lower-tier's work or materials.
In Shamrock Floorcovering, the 6th Circuit —a circuit that includes Ohio, Michigan, Kentucky, Tennesse, and Indiana— addressed the question of whether a debt owed to a subcontractor may be discharged in bankruptcy if (a) the general contractor was a fiduciary of its subcontractor and (b) the debt arose in violation of those fiduciary duties. Though federal law generally governs bankruptcy proceedings, the applicable state construction trust fund act was at issue because it made general contractors "fiduciaries" of their subcontractors and suppliers. This was important because, under the federal bankruptcy code, a debt is not dischargeable if it arises from a "defalcation while acting in a fiduciary capacity." (When a debt is "discharged" in bankruptcy, it is no longer enforceable against the debtor.) The 6th Circuit defined 'defalcation' for these purposes as, basically, bad acts without a subjective, deliberate wrongdoing.
The underlying dispute arose out of a large home construction project. Months into the project, the project lender imposed new borrowing restrictions on the line of credit the general contractor was using to pay its subcontractors. The general contractor struggled to meet the new requirements and fell behind in payments. About one year into the project, Shamrock Flooring, the general contractor's flooring subcontractor, obtained a personal guaranty of corporate debts from the general contractor and its president/50% owner (the "President"). Shortly thereafter, the lender pulled its line of credit and the general contractor collapsed. The project was abandoned.
The flooring subcontractor obtained an $81,171.79 default judgment against the general contractor and President. The general contractor had no assets, so the subcontractor looked to the President to pay the judgment. The President, though, filed for personal bankruptcy. He listed in his bankruptcy filing the $81,171.79 state court judgment as a debt to be discharged.
The subcontractor objected that the monies owed to it were not dischargeable because the debt arose from a "defalcation" while acting in a fiduciary capacity. The subcontractor asserted that Michigan's construction trust fund act established a "technical trust" under which both the contractor and its President were "contractors" and thus fiduciaries. The 6th Circuit reviewed the trust fund act and noted that it made the general contractor a trustee of project funds and imposed on it "the duty to pay the beneficiaries —the subcontractors— before himself and his employees and before paying any other expenses." Because the President handled the general contractor's day-to-day operations, the 6th Circuit concluded that he "must have 'participated'" in any misappropriation of funds, and was a contractor for purposes of the trust fund statute.
The Court held that the "objective fact" that the general contractor used monies it received for the building contract "for purposes other than to pay laborers, subcontractors, or materialmen first is sufficient to constitute a defalcation … so long as the use was not the result of mere negligence or a mistake of fact." The Court determined that the President had "recklessly misallocated" funds and failed to pay his subcontractors first, as required by the trust fund act. Though the 6th Circuit felt that this misallocation was the result of "woefully inadequate" accounting practices, and not deliberate wrongdoing, it held that the failure to pay its subs first was not a result of mere negligence or mistake, and thus was defalcation that prevented the debt from being discharged in bankruptcy.
Shamrock Flooring represents a welcome development to subcontractors and suppliers in states with construction trust fund statutes that make the general contractor a fiduciary of their subcontractors and suppliers. While Ohio unfortunately lacks such a trust statute, the decision would appear to provide guidance for bankruptcy courts even in states without a construction trust fund act —or those with trust acts that are not as clear or comprehensive as Michigan's— if the relevant contract documents require the contractor to hold such payments in trust. In these troubled economic times, as bankruptcies climb, subcontractors and suppliers should view contractual or statutory trust language as a vital and useful collections tool that may provide relief, even in cases where the debtor goes bankrupt.