Creditors May Find Recourse with Bankruptcy Code's Defalcation Provision By D. Hiatt Collins hcollins@gsrm.com

Imagine you are a subcontractor at work on a large construction project under a general contractor. The general contractor has not paid you for some time, and you then learn that the general contractor has filed for bankruptcy. You may resign yourself to accepting pennies on the dollar for what you are owed. There is a provision in the Bankruptcy Code, however, that may allow you to recover more than you originally believed you would.

Section 523 of the Bankruptcy Code contains a provision preventing a debtor from discharging a debt that is due to “fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” Fraud, embezzlement, and larceny may all be familiar wrongdoings, but defalcation is a term that is unfamiliar to many people. Defalcation has been defined slightly differently at different times and by different courts, but it generally includes misappropriation of funds or failure to account for such funds resulting from reckless handling of those funds. A finding of defalcation does not require proof of the level of intent found in theft or fraud, but requires a creditor to prove more than that the debtor was merely negligent in handling the money (at least within the Sixth Circuit).

In order to prove that a debtor has engaged in defalcation, a creditor must prove the following three elements:

1. the presence of a pre-existing fiduciary relationship between creditor and debtor where the debtor holds funds due the creditor;
2. a breach of that fiduciary relationship; and
3. a loss from the breach, resulting from misappropriation of mishandling of funds held in trust for the creditor.

In other words, the debtor must have an existing relationship with the creditor where the debtor holds money on behalf of the creditor, but then misappropriates or mishandles the money in such a fashion that the creditor suffers a loss of the money. The money in this situation is held “in trust” for the creditor. This trust relationship can arise through a contract, where the parties agree at the outset that one party will hold funds on behalf of the other. The trust relationship can arise by operation of a statute, such as statutes enacted by some states which create a trust where a contractor holds money for a subcontractor. A trust relationship may also arise out of the relationship between the parties and the placing of money in the hands of the debtor, with the understanding that the debtor will dispose of the property according to the creditor’s wishes.

In the case of the subcontractor example, the contractor would have the proper relationship with the subcontractor to find defalcation if the contractor accepted payment for the entire construction job, part of which was due the subcontractor for the work it performed. The breach of the relationship would occur when the contractor recklessly misappropriated or mishandled the money due to the subcontractor. If the subcontractor then suffers a loss from the misappropriation or mishandling, i.e. does not get paid due to the actions of the contractor, then the third element necessary to find defalcation is present.

If the contractor files bankruptcy, it will not be able to discharge the claim in bankruptcy if defalcation is present. Normally, a creditor’s claim in bankruptcy will be paid a portion of the debtor’s assets, in a proportion determined by that creditor’s claim compared to all claims filed against the debtor. In some bankruptcies the creditor will get paid the full amount; in others the creditor may only receive 10% of its total claim. At the end of the bankruptcy, the creditor’s claim is discharged and may not be pursued further, even if the creditor only received 10% of what it was owed. If the creditor successfully proves defalcation, the claim is not discharged in the bankruptcy and the creditor may pursue the debtor for the full amount even after the end of the bankruptcy case.

It should be noted that the defalcation provisions of Section 523 are not self-executing. A creditor must file a complaint in order to object to the discharge of the debt, and demonstrate that defalcation is present, before the deadline, which is 60 days after the first date set for the meeting of creditors under Section 341(a).

If you have any questions regarding the information contained in this article, please contact Hiatt Collins at 615.244.4994 or any of the other insolvency attorneys at GSRM.  More information can be found at www.gsrm.com.