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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.
©2002 Howrey LLP
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