Opinion
Case No. A98-01271-HAR, ADV PROC NO A98-01271-003-HAR (BANCAP No. 99-3025) Chapter 7
Date: January 4, 2000
MEMORANDUM DECISION DISMISSING NONDISCHARGEABILITY CLAIM UNDER 11 U.S.C. § 523(a)(4)
1. INTRODUCTION 291
2. FACTS AND PROCEDURE 291
3. ISSUES 293
4. LEGAL ANALYSIS 293
4.1. AS 34.35.062(f),(g) Can Impose a Trust Relationship for the Purposes of 11 U.S.C. § 523(a)(4) 293
4.2. Where the Construction Lender Did Not Make Debtor Identify the Prime Contractors and Amount They Were to be Paid as Required by AS 34.35.062(f), a Trust Relationship is Not Created for the Purposes of § 523(a)(4) 301
5. CONCLUSION 302
INTRODUCTION
A company owned by the debtor Scott received construction loan draws, but did not pay a supplier for some of the materials included in the draw estimates.
The Alaska Statutes provide that:
AS 34.35.062(f),(g).
a draw on a construction loan may be made only after the owner has filed a certificate identifying the "prime contractors" whose labor and materials are unpaid, and stating what amount it intends to pay them; and,
AS 34.35.120(15).
the owner shall use each draw as indicated in the certificates given to the lender.
Nonetheless, the lender allowed the draws without requiring that the prime contractors and the amount to be paid them be identified.
The supplier seeks to avoid discharge of its claim based on 11 U.S.C. § 524(a) for Scott's defalcation while acting as a fiduciary. Does the statute create an express or technical trust, necessary to hold Scott liable as a fiduciary?
Although the state statutes might impose a trust obligation, where the prime contractors were not identified, no trust obligation to them exists.
FACTS AND PROCEDURE
Aaron F. Scott, one of the debtors, owned A.F. Scott, Inc. (AFSI), a home builder. AFSI bought materials for some homes it was building on speculation from Spenard Builders Supply, Inc. (SBS).
The construction financing for the homes was procured by AFSI from Key Bank of Alaska. AFSI requested interim construction draws from Key Bank, which, according to SBS, included funds to cover the material it supplied on the various jobs. AFSI did not, however, pay SBS the full amount it drew from Key Bank, although those funds were included in AFSI's interim draws. As a result, SBS is owed over $83,000.
Each draw request was made by AFSI on a Key Bank form entitled Cost Breakdown/Draw Request, which contained a statement:
We hereby certify and guarantee that the requested disbursement will be paid to the subcontractors and/or suppliers as they are listed on reverse side of this draw request, and that the funds shall be used in accordance with this draw request only. . . .
See, Exhibit C to Defendant's Motion for Summary Judgment to Establish Dischargeability Under Sections 523(a)(2)(A) and 523(a)(4) and to Establish Non-Liability of Barbara Haverfield. Docket Entry 12, filed October 27, 1999.
The draw requests generally appear to have been signed by Scott on behalf of AFSI as both owner and contractor. Notwithstanding the wording of the form, the construction lender did not require or ask AFSI to list the names of the subs and material suppliers on the reverse side of the form, or the amount it intended to pay them. This information was not supplied.
After Scott filed a chapter 7 bankruptcy, SBS started this adversary proceeding to avoid Scott's discharge. One of the counts is based on defalcation while acting in a fiduciary capacity. SBS alleges that the funds paid to AFSI by Key Bank were held in trust by AFSI, in part for SBS to cover its charges for materials. The claim is based on the statutory framework covering construction financing in Alaska, discussed in more detail in Part 4.
Scott filed a motion for summary judgment to the various counts of the complaint. This Memorandum only deals with the legal issue of whether the Alaska statutes upon which SBS relies create the type of trust necessary to prevail under § 523(a)(4).
ISSUES
Does AS 34.35.062(f),(g) allow creation of an express or technical trust for which the debtor is liable for fraud or defalcation while acting in a fiduciary capacity under 11 U.S.C. § 523(a)(4)? If so, does the fact that SBS was not listed as one of the intended recipients of the construction draws negate such a trust?
LEGAL ANALYSIS
AS 34.35.062(f),(g) Can Impose a Trust Relationship for the Purposes of 11 U.S.C. § 523(a)(4) — The discharge of an individual debtor's debt may be denied under 11 U.S.C. § 523(a)(4) "for fraud or defalcation while acting in a fiduciary capacity, . . ." The basis of SBS's claim is that Scott, as principal owner of AFSI, allowed AFSI to receive construction draws from Key Bank without paying for the cost of the SBS materials used as a basis for those draws. SBS argues that the "fiduciary capacity" element is supplied by Alaska statutes, AS 34.35.062(f), (g), (h):
(f) A draw against construction financing may be made only after certification of job progress is delivered to the lender by the owner. The form of the certification may be prescribed by the lender and must include
(1) a statement of the progress of the project, including the percentage of completion of the project;
(2) the name, address, and telephone number of each prime contractor who has furnished labor, material, service, or equipment for the project;
(3) the amount owed by the owner to each listed prime contractor; and
(4) the portion of the draw that the owner will pay to each listed prime contractor. (g) The owner shall use each draw as indicated in the certificates given by the owner to the lender under (f) of this section. The lender may not be required to verify the information in a certificate and is not liable for an error in a certificate.
(h) An owner who intentionally fails to apply construction financing proceeds as indicated by the certificate required under (f) of this section is guilty of a class A misdemeanor. The penalty provided under this subsection does not replace any other penalty that may be provided for by law for the same conduct.
There are a number of decisions discussing the application of § 523(a)(4) in relation to state statutes enacted to protect contractors and material suppliers from loss for failure of an owner or prime contractor to pay funds received and passing them through to the contractors or material suppliers whose labor or materials provided the basis for the owner or prime contractor receiving payment. In re Baird is one of those cases from the 9th Circuit BAP. Baird laid out the black letter law governing the interpretation of the words "fiduciary capacity" in § 523(a)(4):
See, 3 Norton Bankruptcy Law Practice 2nd, § 47:25 at fn 4-7(1999).
Woodworking Enterprises, Inc. v. Baird (In re Baird), 114 B.R. 198 (9th Cir BAP 1990).
In re Baird at 201-02.
• the meaning of "fiduciary capacity" is a question of federal law, which limits the term to express or technical trust relationships;
In re Baird, citing Ragsdale v. Haller, 780 F.2d 794, 796 (9th Cir. 1986).
• a broad definition of a fiduciary relationship (one involving confidence, trust and good faith) is not applicable to § 523(a)(4);
In re Baird, citing Ragsdale at 796.
• the nondischargeable debt must arise from a breach of trust separate from any breach of contract;
In re Baird, citing Carlisle Cashway, Inc. v Johnson (In re Johnson), 691 F.2d 249, 251 (6th Cir. 1982), decided under § 17(a)(4) of the Bankruptcy Act, the predecessor of 11 U.S.C. § 523(a)(4).
• the trust must exist prior and without reference to the act of wrongdoing (i.e., the trust must not arise from the breach itself, called a trust ex maleficio );
In re Baird, citing Ragsdale at 796; see, also, Carey Lumber Co. v. Bell, 615 F.2d 370, 374 (5th Cir. 1980), a § 17(a)(4) case.
• although the concept of who is a "fiduciary" under § 523(a)(4) is a question of federal law and narrowly defined, courts look at state law to determine whether the elements of a trust relationship exist, and if state law creates an express or technical trust relationship between the debtor and a third party, and imposes a trustee status on a debtor, a fiduciary relationship will exist for § 523(a)(4) purposes;
In re Baird, citing Ragsdale at 796-97.
• for a state statute to create a fiduciary relationship qualifying as an express or technical trust, it must: (a) define a trust res; (b) spell out the trustee's fiduciary duties; and (c) impose a trust prior to and without reference to the wrong which created the debt.
In re Baird, citing Butler v. Weedman (In re Weedman), 65 B.R. 288, 291 (Bankr WD Ky 1986).
While a trust created by statute is not an "express" or "technical" trust according to some authorities, the 9th Circuit, as well as other circuits, skip over this nicety and hold that a fiduciary capacity sufficient for § 523(a)(4) purposes can be created by statute.
76 AmJur2d § 159; CRL of Maryland, Inc. v Holmes (In re Holmes), 117 B.R. 848, 853-55 (Bankr D Md 1990).
Lewis v. Short (In re Short), 818 F.2d 693, 695 (9th Cir. 1987) (applying Washington partnership statute), citing Hartford Acc. Indemn. Co. v. McCraney (Matter of McCraney), 63 B.R. 64, 65 fn 3 (Bankr ND Ala 1986) as listing cases from seven other circuits; Ragsdale v. Haller, 780 F.2d 794, 795-96 (9th Cir. 1986); Runnion v. Pedrazzini (In re Pedrazzini), 644 F.2d 756, 758 (9th Cir. 1981).
Although it seems to fly in the face of the fresh start policy of the bankruptcy code for honest debtors when construing nondischargeability sections relating to "bad actors," 11 U.S.C. § 523(a)(2),(4),(6), the 9th Circuit holds that an innocent (i.e., one where there is no fraud or only ordinary negligence) failure to account for or turn over entrusted funds may be a defalcation. In re Baird involved a § 523(a)(4) action with facts analogous to the case at bar. It arose in Arizona which has a statute which provided that money paid by an owner to a contractor as payment for labor or materials "shall be deemed for all purposes to be paid in trust and shall be held by the contractor for the benefit of the person or persons" furnishing the labor or materials and not "diverted nor used for any purpose other than to satisfy the claims of those for whom the trust is created . . ."
Lewis v. Scott (In re Lewis), 97 F.3d 1182, 1186-87 (9th Cir. 1996); contra, Schwager v. Fallas (Matter of Schwager), 121 F.3d 177, 185 (5th Cir. 1997); Moreno v. Ashworth (Matter of Moreno), 892 F.2d 417, 421 (5th Cir. 1990); Carlisle Cashway, Inc. v. Johnson (In re Johnson), 691 F.2d 249, 254-57 (6th Cir. 1982); Meyer v. Rigdon, 36 F.3d 1375, 1384-85 (7th Cir. 1994).
The BAP held that the Arizona statute was sufficient to create an express or technical trust. It noted three schools of opinion in cases involving similar construction contractor statutes promulgated to protect subcontractors' rights as to whether they created express trust obligations under § 523(a)(4):
• "At one end of the spectrum, courts hold that statutes which only impose criminal or other penalties for the failure of a contractor to make a certain disposition of construction funds do not create fiduciary capacity for dischargeability purposes. . . . These courts reason that any trust relationship that is created by such statutes does not arise prior to and independently of the wrong."
In re Baird at 202, citing Runnion v Pedrazzini (In re Pedrazzini), 644 F.2d 756 (9th Cir. 1981) (a case decided under § 17(a)(4), and analyzing California law governing construction contractors); other citations omitted.
• "At the other end of the spectrum, courts hold that statutes which expressly designate the funds received by the contractor as trust funds and which explicitly impose specific and detailed duties on the contractor regarding the funds create a fiduciary relationship for dischargeability purposes."
In re Baird at 202-03, citing Besroi Construction Corp. v. Kawczynski (In re Kawczynski), 442 F. Supp. 413 (WDNY 1977) (cited with approval in Pedrazzini, supra).
• "Between the two ends of the spectrum are cases, such as this one, dealing with statutes which refer to the funds as trust funds but which do not explicitly impose specific and detailed duties upon the contractor with respect to those funds."
In re Baird at 203.
The BAP observed that, in the last category (cases imposing a trust, even though the state statute gave little detail as to the trustee's duties), there was a split of authority. Some cases, such as the Carey case from the 5th Circuit (interpreting an Oklahoma law) and the Johnson case from the 6th Circuit (interpreting Michigan law), with statutes similar to Arizona's, found a technical trust existed. Other courts have not.
Carey Lumber Co. v. Bell, 615 F.2d 370, 374 (5th Cir. 1980).
Carlisle Cashway, Inc. v. Johnson (In re Johnson), 691 F.2d 249 (6th Cir. 1982).
Boyle v. Abilene Lumber, Inc. (In re Boyle), 819 F.2d 583 (5th Cir. 1997), interpreting Texas law.
The Michigan statutes in Johnson bear some similarity to the ones in Alaska, and some differences. They specifically make the contractor a trustee of funds paid to it for the benefit of subcontractors and materialmen. The Alaska statutes do not specifically identify an owner who receives funds from a construction lender as a "trustee" or provide that the funds are to be "held in trust," but do say the owner shall use the draws "as indicated" in the owner's certification (which requires the owner to identify prime contractors, the amount owed to each, and the amount to be paid to each from the draw).
Mich. Comp Laws Ann §§ 570.151-.153.
In re Johnson, 691 F.2d at 252 fn 3-5.
AS 34.35.062(g).
AS 34.35.062(f).
The Michigan statutes in Johnson, like the Alaska statutes, mix the fiduciary obligation with a penal statute for failure to comply. Yet the BAP in Baird found Johnson strong authority for its holding in finding that the Arizona statute established a fiduciary relationship.
Mich. Comp Laws Ann §§ 152-153 and AS 34.35.062(h).
The Oklahoma statutes in Carey, a case followed by the BAP inBaird, were straight forward. They said the funds received under a mortgage for construction or remodeling shall be held in trust for the payment of any lienable claims and applied to the payment of those lienable claims until they were satisfied. They are analogous in many respects to the Alaska statutes.
Carey Lumber Co. v. Bell, 615 F.2d at 373 fn2 (42 OS §§ 152, 153 (1971)).
Two questions should be addressed: (a) does the failure of the Alaska statutes to use the specific words "trust" and "trustee" matter; and, (b) does the imposition of a criminal penalty make a difference?
Failure to use specific words to create the trust does not defeat the creation of a trust relationship. The important points in establishing a statutory trust are that the state statutes must: (a) define a trust res; (b) spell out the trustee's fiduciary duties; and (c) impose a trust prior to and without reference to the wrong which created the debt. AS 34.35.062(f),(g) identifies the res (the construction draw), and AS 34.35.062(g) spells out the fiduciary duties (the obligation to pay the draw over to the listed "prime contractors" [i.e., those providing labor, material, and services to the "owner"] in the amount stated in the certificate).
76 AmJur2d, Trusts, § 77, Use of Express or Particular Words or Phrases; In re Elrod, 42 B.R. 468, 473 (Bankr ED Tenn 1984).
In re Baird, 114 BR at 202.
As defined in AS 34.35.120(15).
As defined in AS 34.35.120(13).
The 9th Circuit BAP, in In re Schneider, held that a debtor operated in a fiduciary capacity despite the apparent lack of any explicit reference to a "trust" or "trustee." The court found the debtor, a minister, who agreed to assist a widow in his congregation (who became his lover), to preserve her inheritance, and then used it in a risk venture with his brother, operated in a fiduciary capacity.
Schneider v. Davis (In re Schneider), 99 B.R. 974 (9th Cir BAP 1989).
Scott argues that this case is closer to the 9th Circuit case of In re Pedrazzini than to the Johnson or Carey cases. But, the trust in the case at bar is imposed without regard to the possible sanctions imposed for noncompliance spelled out in AS 34.35.062(h). That section could be left out altogether without impairing the trust duties created by AS 34.35.062(f),(g).
Runnion v. Pedrazzini (In re Pedrazzini), 644 F.2d 756 (9th Cir. 1981).
In Pedrazzini, decided under § 17(a)(4) of the Bankruptcy Act, the bankrupt was a swimming pool contractor. The California statutes which the creditor sought to use as a basis for establishing fiduciary responsibility were: (a) one which subject a general contractor to disciplinary action by a licensing agency for diverting funds meant to pay subcontractors; and, (b) a penal statute which made it a crime to receive money intended to pay for services, labor, material or equipment incident to construction and to willfully fail to apply it in that manner.
Cal. Bus Prof Code, § 7108, 7108.5 (West 1975 West Supp 1979).
Cal. Penal Code, § 484b (West Supp 1979).
The court stated:
With one exception, all of the courts that have dealt with statutes imposing criminal or other penalties for this kind of diversion of funds have refused to find a trust relationship. The rationale is that even if a trust is created by such a statute, the trust arises only upon the act of misappropriation and cannot be said to exist prior to the wrong and without reference to it.
In re Pedrazzini, 644 F.2d at 759 (citations omitted).
Unlike the statutes in Pedrazzini, the Alaska AS 34.35.062(f),(g) establish a fiduciary responsibility without reference to the criminal sanction in AS 34.35.062(h). In this respect the Alaska statutory framework is similar to the Michigan statutes involved in the Johnson case.
But, even if the Alaska statutory framework can create a fiduciary responsibility which will make a debt subject to nondischargeability under § 523(a)(4), did it in this case where Scott never identified the prime contractors as required by AS 34.35.062(f) because the construction lender did not require it?
Where the Construction Lender Did Not Make Debtor Identify the Prime Contractors and Amount They Were to be Paid as Required by AS 34.35.062(f), a Trust Relationship is Not Created for the Purposes of § 523(a)(4) — AS 34.35.062(f) is addressed to the construction lender, as well as the owner. It provides that a construction financing draw may be made only after a certificate is delivered to the lender containing certain information, including: (a) the name, address and phone number of each prime contractor; (b) the amount owed to each listed prime contractor; and, (c) the amount of the draw to be paid to each listed contractor.
AS 34.35.062(g) says that the owner shall apply the draw proceeds as indicated in the certificate given under AS 34.35.062(f). The lender is not liable for any error in the certificate and does not have to verify the information given by the owner. The teeth are apparently in the criminal sanctions to which an owner is subjected under AS 34.35.062(h) for intentionally not applying the proceeds as certified.
AS 34.35.062 is a 1986 rewrite of construction financing laws from an earlier version in 1979, which apparently was not working. AS 34.35.062(f),(g),(h) were added as new sections. The drafting is not user friendly; the three subsections are plunked down amidst complicated, detailed sections on the new "stop lending" procedure. AS 34.35.062(f),(g),(h) are not completely divorced from the rest of the statute, but, they possibly should have been separated and suitably subtitled for clarity.
See, Notice of Filing Legislative History Information, Docket Entry 26, filed December 9, 1999, by defendants at the request of the court.
The statute says what it says. The owner is to pay the prime contracts listed in the amounts stated. Where the construction lender does not require the information to be listed, what is the effect on the "fiduciary capacity" status of a debtor under § 523(a)(4)? I will resolve this question by interpreting the dischargeability exception strictly and narrowly in favor of the debtor. Where the state statute creates the loophole that exists in this case, a debtor may slip through it.
Houtman v. Mann (In re Houtman), 568 F.2d 651, 656 (9th Cir. 1978); Household Finance Corp. v. Danns (In re Danns), 558 F.2d 114, 116 (2nd Cir. 1977); Cornwell Quality Tools v. Rodgers (In re Rodgers), 115 B.R. 678, 681 (Bankr CD Cal. 1990).
CONCLUSION
The court has issued its oral ruling dismissing other counts of the complaint. As to the § 523(a)(4) count against debtor Scott, it shall be dismissed also. The court will enter a separate order of dismissal.
The decision outlined in Part 4 of this Memorandum alleviates the need to address other issues, such as the fact that the "owner" under AS 34.35.062(f),(g) is not debtor Scott, but AFSI.
Cf, In re Baird, 114 BR at 204-05.