Some companies have strategically entered into contracts knowing that bankruptcy was on the horizon and expecting that any debt or a resulting judgment would be discharged by the Bankruptcy Court. However, creditors are fighting back by using the “trust” exception to discharge to maintain claims against both companies and individuals who breached fiduciary duties to the creditor.
On May 12, 2009, the Sixth Circuit Court of Appeals ruled that debts that arise from a fiduciary relationship are not dischargeable in a bankruptcy proceeding. In the matter of Patel v Shamrock Floorcovering Services, Inc., affirming the decision of U.S. District Court Nancy Edmunds, the Court of Appeals expounded on the fact that if debts arise from the embezzlement, misappropriation, or failure to account by a fiduciary, while acting in a fiduciary capacity, then those debts are not dischargeable in bankruptcy. The exception to discharging this type of debt comes from Congress’ desire to protect trust relationships.
When the bankrupt individual or company is a trustee and the creditor a trust beneficiary, the Bankruptcy Code imposes higher standards of loyalty and care on trustees. A pre-existing fiduciary relationship is required for a creditor’s debt not to be discharged. The “fiduciary capacity” requirement of the exception is only satisfied if the trust is an express or technical trust. A “constructive trust” would not meet the criteria because the debtor has to be a trustee before the wrong was committed, and not as a result of the wrong.
Establishing an “express” trust is basic. The creditor must demonstrate an intent to create a trust, a trustee, a trust asset, and a definite beneficiary. This does not often happen in the business context.
In Patel, the Court held that there was a “technical trust” between the parties, based on a law designed to protect the beneficiary. For example, when a contract is made between a general contractor and a sub-contractor, a fiduciary relationship is automatically created between the parties as a result of the Michigan Builder’s Trust Fund Statute. The general contractor is a fiduciary for funds paid to it on the project, and is obligated to pay sub-contractors before the general contractor uses the money for other purposes. Liability also extends to the corporate officers of the general contractor who control the funds. Thus, as a result of the statute, a debt owing from a contractor to a subcontractor would not be dischargeable in bankruptcy by either the company or the responsible officers because of the trust imposed by statutes when the parties executed their contract.
In this economy, as corporate bankruptcies become more prevalent, subcontractors and other trust beneficiaries have more protections from bankruptcy.
Click here to download a PDF of the Opinion from the Courts Website.
This article was written by , Senior Associate at Demorest Law Firm. Click here to view his professional resume.
