Contractor’s “Deliberately Cultivated Ignorance” Supports Finding of Defalcation Sufficient to Except Debt Owed to Subcontractors from Discharge under 11 U.S.C. § 523(a)(4)

Section 727(b) of title 11 of the United States Code (the “Bankruptcy Code”) grants an individual debtor a discharge from all debts that arose before the filing of the debtor’s bankruptcy case. 11 U.S.C. § 727(b).  Certain debts, however, are excepted from this discharge, pursuant to Section 523 of the Bankruptcy Code, including any debt “for fraud or defalcation while acting in a fiduciary capacity . . .”.  11 U.S.C. § 523(a)(4).

In a recent case addressing the scienter requirements of Bankruptcy Code section 523(a)(4), Bullock v. BankChampaign, N.A., 133 S. Ct. 1754 (2013), the United States Supreme Court held that defalcation “requires an intentional wrong”, which includes “not only conduct that the fiduciary knows is improper but also reckless conduct of the kind that the criminal law often treats as the equivalent.”  Id.

This so-called willful blindness standard was construed further in a new case out of the United States District Court for the Western District of Wisconsin – Sveum v. Stoughton Lumber Co., 3:13-cv-00788-wmc, ____ F.3d _____ (W.D. Wis. 2015).  In Sveum, the District Court affirmed the decision of the United States Bankruptcy Court for the Western District of Wisconsin (the “Bankruptcy Court”) and held that a general contractor’s debt to a certain subcontractor would not be discharged, pursuant to Section 523(a)(4) of the Bankruptcy Code, where the general contractor failed to ensure that certain funds received from construction loan draws were held in an express trust to pay subcontractors, as required by Wisconsin’s “Theft-By-Contractor Statute”.  Wis. Stat § 779.02(5).  In Sveum, appellant Phillip A. Sveum, along with his brother, Peter Sveum, was an officer and owner of Kegonsa Builders, Inc. (“KBI”).  The Sveums obtained supplies for KBI’s home construction business from various subcontractors, including Stoughton Lumber, but rather than segregate a proportionate share of funds KBI received from construction draws to pay those subcontractors as required by both contract and statute, KBI instead deposited the funds into a general operating account to be used for operating expenses, payroll and other bills.  In the midst of litigation instituted by Stoughton Lumber against KBI, the Sveums filed for bankruptcy protection under chapter 7; in the bankruptcy cases, Stoughton Lumber filed adversary complaints, arguing that KBI’s debt was non-dischargeable because it arose of out of their fraud or defalcation while acting in a fiduciary capacity under Bankruptcy Code section 523(a)(4).

In order to establish that a debt is non-dischargeable under Section 523(a)(4) of the Bankruptcy Code, a plaintiff-creditor must establish  “(1) a trust existed; (2) the debtor was a fiduciary of the trust; and (3) the debtor committed ‘fraud or defalcation . . .while acting as a fiduciary of the trust.’”  Sveum at __ (citing In re Polus, 455 B.R. 705, 708 (Bankr. W.D.Wis. 2011)).  In Sveum, it was undisputed that Wisconsin’s “Theft-By-Contractor Statute” established an express trust, and the debtor-contractor, as an officer of his construction company, was a fiduciary of such trust.  The only issue before the Court in Sveum, therefore, was the “fraud or defalcation” element.

In affirming the Bankruptcy Court’s ruling that the debtor-contractor engaged in defalcation, the court in Sveum stated that the debtor-contractor’s “failure to make any inquiry into [the company’s] practices and to take any steps to ensure it was complying with its trust obligations constituted a conscious disregard of the substantial, unjustifiable likelihood that [the company] was out of trust.”  Sveum at __ (emphasis in original).  The Court in Sveum went on to state that:

[The debtor-contractor] knew he was obligated . . . to ensure segregation and eventual payment of construction draws held in trust for particular subcontractors, and he knew at least at the time [his company was being] . . . infus[ed] with new money that some subcontractors had not been paid.  In light of that knowledge, [the debtor-contractor’s] failure to take any action to ensure [the company] was complying with its trust fund obligations is deeply troubling.

Sveum at __ (emphasis in the original).  Accordingly, the Court in Sveum held that the Bankruptcy Court was correct in ruling that the debtor-contractor engaged in defalcation, as the Bankruptcy Court did not clearly err in finding that the debtor-contractor’s “deliberately cultivated ignorance of his company’s financial undertakings . . . involved a ‘gross deviation from the standard of conduct that a law-abiding person would observe in [his] situation.’” Sveum (citing Bullock at 1760).

Recent trends, as evidenced by Bullock and Sveum, suggest that principals of construction companies that file for bankruptcy protection will be deemed to possess the intent necessary to support a finding of fraud or defalcation while acting in a fiduciary capacity, when they act with deliberately cultivated ignorance of the company’s financial undertakings, even if the conduct falls short of “intentional wrongdoing.”