Theft by Contractor Claims and Dischargeability

Posted by Attorney David J. Espin in Theft by Contactor / Comments

One of the industries hit hardest by the financial crisis was the construction industry, which includes many prime contractors and subcontractors. In addition to the effects of the slowdown in housing construction, contractors are particularly vulnerable to recessions due to their reliance on payments from other contractors up and down the construction chain. When one contractor goes under, they will often drag others down with them. This leads to contractors “robbing Peter to pay Paul," which, after the dust settles and individual bankruptcies for the owners are filed, can lead to thorny issues regarding the dischargeability of “theft by contractor" claims.

Wisconsin's theft by contractor law is codified in Wisconsin Statute 779.02(5), which creates a trust for funds paid by an owner to a contractor for the benefit of the subcontractors who provide it with labor and materials. The statute makes a contractor a trustee of funds received from an owner until the laborers, material suppliers, or subcontractors are paid for work or materials put into the specific improvement for which the payment was made.

The Bankruptcy Code provision most often used to attack the dischargeability of these claims is section 523(a)(4), which states that the party bringing the claim must establish (1) that a trust existed; (2) that the debtors were fiduciaries of that trust; and (3) that the debtors committed fraud or defalcation while acting as fiduciaries of the trust.

While the first two prongs are ordinarily easily met, the third prong is often difficult to prove. Defalcation refers to the misappropriation of funds entrusted to someone—a form of embezzlement. It's different from fraud in that it does not require a false statement, and different from conversion in that it doesn't require the taking of another's property.

Recently, the U.S. Supreme Court resolved a split in authority as to the proper standard for defalcation, holding that defalcation “requires an intentional wrong." This not only includes conduct that the debtor knows is improper, it also includes reckless conduct of the kind that criminal law would treat as its equivalent. In general, a fiduciary cannot consciously disregard a risk that his or her conduct would violate a fiduciary duty.

Two recent decisions illustrate the difficulty in applying these principles to the fact intensive situations that arise in these cases. In Stoughton Lumber v. Sveum, Judge Posner upheld decision by the Western District of Wisconsin Bankruptcy Court denying a discharge to the co-owner of a homebuilder that failed to pay one of its suppliers.

The factual issue that the bankruptcy court wrestled with was whether or not the debtor was aware of the trust fund statute, or at the very least recklessly or intentionally failed to apprise himself of it. The Bankruptcy Court, in this case the sole trier of fact, did not find the debtor's testimony pleading ignorance of the law to be credible. The Bankruptcy Court made it decision based on the following factors:

• The debtor was an educated person with a college degree in business administration.
• He had been in the construction business for forty years, and had supervised the construction of hundreds of homes.
• Credible evidence was presented indicating that the trust-fund requirement was well known in the home building industry.
• The Court found it inconceivable that the debtor did not understand that the proceeds of a sale of a home have to be held in trust for subcontractors, since a subcontractor that is not paid can sue the owner, who in turn can sue the prime contractor (this is why prime contractors insist on lien waivers).
• Judge Posner found that the Bankruptcy Court made a permissible inference that the debtor either knew of the trust fund laws, or was “playing ostrich," and intentionally avoided confirming his suspicion in order to preserve an appearance of ignorance.

In a case with a similar set of facts, the Eastern District of Wisconsin Bankruptcy Court came to a different conclusion. In re St. Antoine also involved a contractor, in this case a home remodeler, which failed to pay a supplier. However, in analyzing the defalcation issue, the court decided that the debtors should receive a discharge based on the following findings:

• The debtors did not have any business training or education beyond high school, and they credibly testified that had never heard of the trust fund statute prior to the bankruptcy proceedings.
• The supplier had never mentioned the statute before, and the debtors credibly testified that the supplier had consistently allowed the debtor's company to make late payments during the course of doing business together.
• The debtors did not hold licenses or take CLE courses where they would have learned of their trust fund duties.
• In contrast to Stoughton Lumber, there was no credible testimony that the trust fund statute was common knowledge in the home remodeling industry.
• On multiple occasions the Bankruptcy Court's decision mentions the debtors' demeanor while testifying; in short, the judge found them to be credible witnesses, where the judge in the Stoughton Lumber case came to the opposite conclusion.

While pleading ignorance may in certain circumstances lead to a court finding that a claim against a debtor for violation of the theft by contractor statute is dischargeable, it is certainly a dangerous game to play. As a contractor, the only way to be certain that in the event of an individual bankruptcy filing your debts will be dischargeable is to educate yourself on and comply with the Wisconsin theft by contractor laws.