Having a debt resulting from the violation of the Colorado’s Mechanic’s Lien Trust Fund Statute, commonly known as the Construction Trust Fund Statute, declared non-dischargeable in bankruptcy may be more difficult due to a 2013 U.S. Supreme Court ruling.

The Construction Trust Fund Statute provides that “all funds disbursed to any contractor or subcontractor under any building, construction or remodeling contract or on any construction project shall be held in trust for the payment of the subcontractors, laborer or material suppliers, or laborers who have furnished laborers, materials, services, or labor, who have a lien, or may have a lien, against the property, or who claim, or may claim, against a principal and surety under the provisions of this article and for which such disbursement was made.” A person who violates this statute is guilty of theft.

Contractors or subcontractors often find themselves in financial difficulties and use money paid to them on one project to cover costs for another project or for other purposes. As financial difficulties worsen, the contractors or subcontractors cannot repay the funds from the first project and, as a result, the people who furnished labor, materials or services for the first job remain unpaid, even though money had been paid to the contractor to cover such costs in violation of the Construction Trust Fund Statute.

In the event the contractor or subcontractor files bankruptcy, the unpaid parties often sue to have the debt to them declared non-dischargeable. The section excepts from discharge debts “for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny.” To prevail, the plaintiff has to show that an express or technical trust exists, that the debtor owed a fiduciary duty arising from the trust and that the debtor breached the duty by “defalcation.”

The Colorado Trust Fund Statute imposes a statutory trust so the technical trust and fiduciary elements necessary to prevail under § 523(a)(4) are satisfied. The third element, defalcation, could be satisfied by merely showing that the debtor failed to account for funds that had been entrusted to it due to any breach of a fiduciary duty, whether intentional, willful, reckless, or negligent; ignorance of the Construction Trust Fund Statute was no defense.

However, this appears to have changed. In 2013, the US Supreme Court in Bullock v Bank Champaign held that a plaintiff now has to prove that an “intentional wrong” was committed. Following the U.S. Supreme Court’s decision, the U.S. Bankruptcy Court for the District of Colorado found that a debtor who did not know about the Construction Trust Fund Statute could not have intentionally violated it. The court found, therefore, that the debt was dischargeable (MacArthur Company v. Cupit, Adv. Pro. No. 13-1185 EEB, July 18, 2014).

In MacArthur, the debtor was using money received from one project to cover the costs of other projects believing that at some point, business would get better, and he would be able to pay the debts of all projects. This did not happen and the debtor eventually filed for bankruptcy protection.  MacArthur sued to have its debt declared non-dischargeable because of the debtor’s violation of the Construction Trust Fund Statute.

The debtor testified that he did not know about the Construction Trust Fund Statute; testimony the Bankruptcy Court found to be credible. As a result, applying the Bullock standard, the Bankruptcy Court found that the debtor did not knowingly violate the statute and therefore, at least a portion of the debt was dischargeable. Once the debtor became aware of the statute, which he did when he was sued by another supplier, any funds subsequently used in violation of the Construction Trust Fund Statute were found to be non-dischargeable.

This Colorado Bankruptcy Court decision could make it more difficult to have debts arising from the violation of the Colorado Construction Trust Fund Statute declared non-dischargeable in Colorado and perhaps other states as well. Parties to a contract may be able to avoid this adverse result at the contracting stage. 

For more information, contact Dave Byassee or Steve Mulligan at Jackson Kelly PLLC at 303-390-0003.