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Funds to Pay Subs Misspent; Executive of General Contractor Denied Protection in Bankruptcy
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February 15, 2010
By Laura Kent
A federal appeals court has refused to allow an executive of a failed general contractor to discharge in bankruptcy debts owed to a subcontractor.
Sameer Patel was president and 50 percent shareholder in a general contractor and was responsible for its day-to-day operations, including payment to subcontractors. The general contractor’s principal customer was a new home builder owned by Patel’s father. The home builder experienced financial reverses, and its borrowing against a line of credit was restricted.
As the general contractor’s financial problems grew, it failed to pay a subcontractor, Shamrock Floorcovering, for work performed. The subcontractor waived some of the sums owed it in exchange for payment guarantees from the general contractor and Patel personally. The subcontractor never was paid what it was owed, including the amounts personally guaranteed by Patel personally. The subcontractor sued the general contractor and Patel personally in Michigan state court and obtained a default judgment against both for all amounts owed, plus interest.
Patel then filed for personal Chapter 7 bankruptcy and listed the subcontractor’s state court judgment as a debt to be discharged. The subcontractor contested discharge of the debt. Patel moved for summary judgment, and the Bankruptcy Court held that the debt was dischargeable. The District Court reversed on grounds that Patel breached his fiduciary duties to the subcontractor “by failing to account for and pay funds – a ‘defalcation.’ ” Patel appealed to the U.S. Court of Appeals for the 6th Circuit, and it held that the debt was non-dischargeable. In re Patel, 565 F.3d 963 (6th Cir. 2009).
The appeals court first summarized the purpose and effect of the bankruptcy law:
Bankruptcy is designed to give debtors a “fresh start.” Ordinarily, whatever assets a debtor has are allocated among his creditors and, even though they rarely cover all liabilities, he emerges with no outstanding debts. But, there are exceptions: some debts are not dischargeable, and among those are debts arising from a “defalcation while acting in a fiduciary capacity.” 1/
It explained that the issue was whether Patel was a fiduciary and whether the debts arose from “fraud or defalcation while acting in a fiduciary capacity.”
To establish that a debt is non-dischargeable as a result of defalcation, the court wrote, the creditor must prove a pre-existing fiduciary relationship, breach of that relationship and resulting loss. The appeals court noted that the U.S. Supreme Court has held that the non-dischargeability provisions in 11 USC §523 apply only to express trusts and technical trusts and not to constructive trusts arising from the very act of wrongdoing.
The subcontractor alleged that a technical trust existed based on duties imposed on Patel by the Michigan Builders Trust Fund Act (Michigan Complied Laws §570.151). In a previous case involving a sole proprietor, the 6th Circuit held that the act created a technical trust. But, the Bankruptcy Court held that Patel could not be held personally liable unless the corporate veil of the general contractor were pierced. The District Court held that such a showing was not needed, finding that Patel was a “contractor” within the meaning of the act and thus was directly liable to the subcontractor.
The act provides that “appropriation by contractors” of money “paid to [them] for building operations before the payment by [them] of all moneys due or so to become due laborers, subcontractors, materialmen or others entitled to payment, shall be evidence of intent to defraud.”
This, the appeals court wrote, makes the contractor “a trustee of project funds and imposes on him the duty to pay the beneficiaries – the subcontractors – before himself and his employees and before paying any expenses.”
Under Michigan state cases applying the act, the appeals court held, Patel, as a corporate officer and a participant in misappropriation of the funds, was a contractor within the meaning of the act. Further, the appeals court found that the fact Patel was found personally liable for the debt in state court and listed the state court default judgment as a debt in his bankruptcy action further indicated the debt was his.
Then, the appeals court explained that “defalcation in the… context [of the act] occurs when evidence supports ‘the objective fact that monies paid into the building contract fund were used for purposes other than to pay laborers, subcontractors, or materialmen first… so long as the use was not the result of mere negligence or mistake of fact.’ ” That is, the debtor “must have been objectively reckless in failing to properly account for or allocate funds.”
Because “Patel testified that he paid his own operating expenses – including payroll, utilities, taxes, and wages to himself for services rendered as president – before he sent any money to Shamrock” and because he admitted that his accounting was sloppy, the appeals court found that Patel had committed a defalcation and that the debt was not dischargeable in bankruptcy.
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ENDNOTES
| 1/ | The appeal courts noted that some debts are non-dischargeable because of their type and others are non-dischargeable because of public policy. As examples of types of debts that are non-dischargeable, the appeals court listed taxes, customs duties, alimony and child support. The court noted that public policy forbids discharge of debts resulting from obtaining money, goods or services by fraud or falsehood; willful or malicious injury; death or injury caused by driving under the influence of alcohol or drugs; and embezzlement or larceny.
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