On paper the new more demanding standard for defalcation should result in fewer non-dischargeable judgments for violations of the mechanic’s lien trust fund statute. However, it is unclear whether the new standard will be a get-out-of-jail-free card. The new Bullock standard for “defalcation” is likely to raise a number of new issues that, as a practical matter, may attenuate the impact of Bullock.
Colorado’s mechanic’s lien trust fund statute requires contractors to hold all funds received on a project for the payment of subcontractors and material suppliers who have performed work or who may be anticipated to perform work. Colo. Rev. Stat. § 38-22-127. Until recently, a violation of Colorado’s mechanic’s lien trust fund statute was almost certain to result in a non-dischargeable debt under 11 U.S.C. 523(a)(4). See, e.g., In re Helmke, 398 B.R. 38 (Bankr. D. Colo. 2008). Prior to Bullock v. Bankchampaign, N.A., a “defalcation” in the Tenth Circuit required only a breach of a fiduciary duty, even if the breach was innocent. Fowler Bros. v. Young, 91 F.3d 1367, 1371-72 (10th Cir. 1996). Thus, almost every unpaid subcontractor or material supplier was likely to have a non-dischargeable debt against a “defalcating” contractor.
In Bullock v. Bankchampaign, N.A., the Supreme Court interpreted “defalcation” to require “reckless conduct,” or that the debtor “consciously disregards a substantial and unjustifiable risk” that his conduct will violate a fiduciary duty. Id. at 1760. The Court held that because § 523(a)(4) places defalcation with larceny and embezzlement, the intent for defalcation should be similar to larceny and embezzlement. In Bullock, the debtor was a trustee of a trust for the debtor and his siblings. On multiple occasions, the debtor used the trust assets for his personal benefit, such as by making loans to himself and using trust assets to buy property for his own benefit. The Supreme Court did not determine whether the debtor’s conduct constituted defalcation under the test enunciated by the Court Once the case made it back to the bankruptcy court, the parties stipulated to dismiss the case.
ROBBING PETER TO PAY PAUL
Prior to Bullock, a common scenario in nondischargeability cases based on the trust fund statute is that the contractor has robbed Peter to pay Paul by using money from one project on another project. When the contractor’s next job doesn’t pay or doesn’t pay quickly enough, one of the projects is likely to be left with unpaid contractors. In the context of a trust fund case, the question is whether the contractor’s belief that the contractor would, should or might be able to pay from non-trust sources (for example the next job) defeats a finding of defalcation. Prior to Bullock the answer was “no;” the intent to repay was not relevant to whether a defalcation occurred. See, e.g., In re Helmke, 398 B.R. 38 (Bankr. D. Colo. 2008); In re Gamboa, 400 B.R. 784 (Bankr. D. Colo. 2008).
One of the few post-Bullock trust fund cases to be decided is In re Emberton, 501 B.R. 392 (Bankr. D. Colo. 2013). In Emberton, at the time the debtor’s business failed, subcontractors were owed approximately $377,000 for work performed on a single project. The debtor could not account for how the trust funds were used, but there was evidence that the debtor had paid himself regularly and even gave himself a $4,500 bonus while subcontractors were not paid. However, the bankruptcy court held that the only “gross deviation” from an acceptable standard of conduct occurred when the debtor paid himself a lump sum of approximately $34,000 out of the ordinary course. That payment left the debtor’s company with almost nothing in its bank account. The court found only the $34,000 payment to be a “defalcation” within § 523(a)(4).
Another post-Bullock trust fund case is In re Mayhew, 2014 Bankr. LEXIS 792, (Bankr. D. Colo. Feb. 27, 2014). In Mayhew, the debtor was building a “dream home,” in part with a loan secured by the real estate, but the debtor ran out of money. There was no dispute that the debtor caused some of the money to be used for non-trust fund purposes. However, the debtor used personal funds and other borrowed money to pay for part of the construction. At the point that the debtor knew it would be impossible to complete and pay for the construction of the house, the debtor put the house on the market. The court determined that a trust fund violation occurred, but that there was no defalcation. Two facts that the court relied on in reaching its conclusion were that the debtor put in her own money and attempted to sell the house.
If Emberton and Mayhew are indications, robbing Peter to pay Paul may not result in a defalcation for at least two reasons. First, like the debtor in Bullock, contractors are “nonprofessional” trustees who may lack any actual knowledge of the requirements of the trust fund statute. Second, in both Emberton and Mayhew, there was the possibility of receiving money after the trust funds were used, which funds might have been used to pay for trust fund work. On the second point, the trust fund statute itself even provides some flexibility to contractors because the statute does not prohibit comingling of funds from different projects. Colo. Rev. Stat. § 38-22-127(4). Money in a bank account is fungible and even applying the lowest intermediate balance rule won’t help determine whose trust funds are in the account—the lowest intermediate balance rule will likely only show that a breach of the trust fund statute occurred because there wasn’t enough money to pay all the subcontractors.
THEFT RESULTING FROM A TRUST FUND VIOLATION AFTER BULLOCK
Another significant post-Bullock question is whether a violation of the trust fund statute constitutes theft that would be an independent grounds to find nondischargeability under 11 U.S.C. § 523(a)(4) regardless of whether a “defalcation” occurred. Under Colorado law, theft in the context of the mechanic’s lien trust fund statute in Colorado requires that the contractor “knowingly” use the funds in a manner that is “practically certain” to deprive the owner of the funds. See, e.g., In re Helmke, 398 B.R. 38 (Bankr. D. Colo. 2008). Among the remedies for theft is an award of treble damages and attorneys’ fees.
Robbing Peter to pay Paul may not create a defalcation after Bullock, but Bullock did not expressly change the theft standard. To the extent that the trust fund statute creates a true trust such that the funds received by a contractor do not belong to the contractor until all subcontractors and material suppliers are paid in full, the mental culpability standard for theft may turn out to be easier to satisfy than the new defalcation standard. At least one pre-Bullock court has held that using the actual trust funds for anything other than trust purposes is certain to deprive the owner of those funds. In re Helmke, 398 B.R. 38 (Bankr. D. Colo. 2008).
In Bullock, the Supreme Court noted that the debtor was a “nonprofessional” trustee. The Court did not explain the significance of being a nonprofessional v. a professional trustee, but an important distinction is that a professional trustee actually knows the fiduciary obligations of being a trustee. Thus, Bullock may raise an important question for the theft analysis—must the debtor actually know there is a trust and that the money subject to the trust is not actually the debtor’s for the intent element of theft to be satisfied? In addition, larceny under 11 U.S.C. § 523(a)(4) is determined under federal law, not state law, and federal common law requires “an intent to steal.” A mistake of fact—“I thought the umbrella I took was mine”—can prevent a person from forming the necessary intent to take someone else’s property under federal common law. United States v. Nicholson, 721 F.3d 1236, 1253 (10th Cir. 2013). Is the same true for a contractor: “I thought the money was mine?”
How the Bullock defalcation standard for non-dischargeability will be applied to the mechanic’s lien trust fund statute remains to be determined. Courts will have to decide if the expectation of paying claimants on one job from the proceeds of another is sufficient to avoid a defalcation under the Bullock test will likely be a focus of the litigation, and whether the debt will be non-dischargeable as theft even if the failure to pay is not a “defalcation.”