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Arkansas Contractor's Diversion of Progress Payment Is Breach of Fiduciary Duty to Surety, Precluding Discharge of Debt in Bankruptcy


September 23, 2002


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(A revised version of this article appears in The Construction Lawyer, Volume 22, No. 4, Fall 2002, published by the American Bar Association's Forum on the Construction Industry.)


By John W. Ralls
Howrey LLP

A financially troubled contractor (organized as a limited liability company) purchased piping materials on credit for a water line project. The contractor received a $55,000 progress payment, approximately $50,000 of which was for the piping materials. When the water line project was cancelled, the contractor did not pay the supplier but instead used the money to meet obligations on another project.

The contractor had supplied a performance and payment bond in connection with the water line project. The unpaid supplier made a claim against the bond, which was paid by the surety.

The president of the contractor (who had agreed to indemnify the surety) filed for personal bankruptcy protection. The surety filed a complaint against the Debtor alleging that his debt to the surety was nondischargeable under 11 USC §523 (a) (4). That statute excepts from discharge in bankruptcy "debts which are for… defalcation while acting in a fiduciary capacity...."

A term in the indemnity agreement provided: "[I]t is expressly understood and declared that all monies due and to become due under any contract or contracts covered by the Bonds are trust funds, whether in the possession of the Contractor or Indemnitors or otherwise, for the benefit of and for payment of all such obligations in connection with any such contract or contracts for which the Surety would be liable under any of said Bonds…."

The matter proceeded to trial before the Bankruptcy Court, where the primary issue was legal: Did the indemnity agreement impose a fiduciary duty on the Debtor in favor of the surety, the breach of which triggered the nondischargability rule set forth in 11 USC §523 (a) (4)?

The court concluded the indemnity agreement did create such a duty. International Fidelity Insurance Co. v. Herndon, 277 B.R. 765 (Bankr. E.D. Ark. 2002). "Federal courts construing [11 USC §523 (a) (4)] generally agree that the requisite fiduciary capacity must arise from an express or technical trust created prior to the defalcation and without reference to it." The court found these factors to be present. The court also relied on prior bankruptcy cases that held a trust may arise from an indemnity agreement.

The court easily found that the other elements of the defalcation rule had been met, noting that the Debtor was personally involved in the contractor's accounts payable and receivable. "[The construction company] and Debtor as a fiduciary agreed that the trust money would be used to pay expenses incurred on the [water line] Project, and this agreement was violated when the money was diverted to pay expenses for another job. A failure to apply funds entrusted to a fiduciary in accordance with the terms of the trust is a defalcation whether intentional or not." Therefore, because the Debtor violated his express trust by using the money to pay debts incurred on another project, "he committed a defalcation by a fiduciary within the meaning of 11 USC §523 (a) (4) and the debt to plaintiff [surety] is determined to be nondischargeable."


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For more information about the issues covered in this report, please contact John Ralls in our San Francisco office at 415-848-3362 or at rallsj@howrey.com or contact your Howrey attorney. For more information about Howrey's Construction Practice Group, click here.


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©2002 Howrey LLP

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