Mechanics' Lien Trust Fund Debts Not Dischargeable in Bankruptcy – What Were You Thinking?


In a recent unanimous decision, the United States Supreme Court made it more difficult to avoid a bankruptcy debtor discharging a debt tied to "defalcation while acting in a fiduciary capacity." [1] In Bullock, the Court stated that a defalcation, or misappropriation of funds, requires a culpable state of mind "involving knowledge of, or gross recklessness in respect to, the improper nature of the relevant fiduciary behavior."   Id.  This heightened mental culpability requirement will impact non-dischargeability litigation in the bankruptcy court, including, importantly for the construction industry, claims based on violations of the Colorado Mechanics Lien Trust Fund Statute[2].

Section 523(a)(4) of the Bankruptcy Code excepts from discharge any debt "for fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny."[3] Prior to Bullock, courts construing defalcation under Section 523(a)(4) of the Bankruptcy Code had reached conflicting conclusions concerning the mental state necessary to prove a defalcation.  Some courts required recklessness; others required negligence, gross negligence, or objective recklessness; and yet others, including federal courts in Colorado, required no culpable state of mind at all.  This meant that, prior to Bullock, any violation of the Colorado Mechanics Lien Trust Fund Statute would suffice to establish a non-dischargeable debt under Section 523(a)(4) and it was relatively easy to preserve such claims through a bankruptcy. 

In Bullock, a trustee had taken loans from a family trust to purchase property for his own benefit.  The trustee paid the loans back to the trust in full, with interest.  Prior to the bankruptcy filing, the trustee's brother, a beneficiary of the trust, sued the trustee for using the money.  The state court had concluded that the trustee did not have a "malicious motive" but was involved in self-dealing, which was a breach of fiduciary duty.  After he could not satisfy the state court judgment, the trustee filed for bankruptcy and the creditor objected to the discharge of the debt.  The bankruptcy court said the debt was non-dischargeable because the debtor had engaged in a known breach of fiduciary duty and his conduct was "objectively reckless." 

Before the Supreme Court, the debtor argued there could not be a defalcation under Section 523(a)(4) absent a specific finding of ill intent.  The Supreme Court essentially agreed, holding that, absent bad faith, moral turpitude, or other immoral conduct, defalcation requires an intentional wrong.  The Court further held that intentional conduct includes not just conduct that the fiduciary knows is improper, but also reckless conduct that the criminal law treats as the equivalent of intentional conduct. 

The Bullock decision may have a significant impact on the non-dischargeability of debts involving funds held under the Trust Fund Statute.[4] Plaintiffs must focus on the debtor's mental culpability, including the debtor's knowledge that the funds were held in trust.  Defendants will argue that the use of trust funds to pay other legitimate business expenses, albeit a violation of the Colorado Mechanics Lien Trust Fund Statute, is not a defalcation for purposes of Section 523(a)(4) of the Bankruptcy Code because there was no intentional wrongdoing. 

It remains to be seen how the bankruptcy courts will rule under such circumstances, but if they accept this argument, contractors facing trust fund claims may be successful in discharging debts owed to subcontractors and suppliers through bankruptcy, even though they should have been holding the funds to pay those debts in trust.  Subcontractors and suppliers will then likely look to owners to pay those debts, resulting in potential double payments by project owners. 

[1] See Bullock v. Bankchampaign, N.A., 569 U.S. ____, 2013 WL 1942393 (2013).

[2] C.R.S. § 38-22-127.

[3] 11 U.S.C. § 523(a)(4). 

[4] It is important to note that the Bullock decision does not impact state law litigation based on violations of the Colorado Mechanics Lien Trust Fund Statute.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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