The Long Arm of Construction Trust Fund Law Affects Discharge in Bankruptcy

A corporate manager with control over construction funds, facing personal liability under the NY trust fund law to an unpaid sub and the homeowner for improper diversion of funds, cannot discharge that liability in a personal bankruptcy. Even when the original contracts were with a corporate entity. That is the lesson from the federal bankruptcy court in Manhattan.

Would-be homeowners provided a deposit to Gabrielle Salman, sole owner of one (“Modular”) and 50% owner of a second (“Arch-Mod”) modular building company. The deposit was to be used mostly for payment of modular home components, but was diverted and ultimately never reached the modular home subcontractor. Pursuing claims in the bankruptcy proceeding, the homeowner and modular sub both sought a decision that Salman’s debt to them was non-dischargeable. The court has agreed.

The homeowners’ first payment of $197,454 was to go to Modular, but was instead deposited with Arch-Mod, even though Arch-Mod was not involved with the project. The co-owner of Arch-Mod issued a check the next day for $100,000 for a different project, and later withdrew another $20,000 for his own use. Although Salman told the co-owner of Arch-Mod that the money needed to be returned to the account ASAP, it never was. Nor was the modular building sub paid amounts due for the project.

The bankruptcy judge made three essential findings, to support analysis under Bankruptcy Code § 523(a)(4), which does not allow discharge of a debt arising from “fraud or defalcation while acting in a fiduciary capacity.”

1. The debt was incurred in relation to an express or technical trust. This condition was satisfied by Article 3-A of the New York Lien Law, § 70(1): funds . . . received by a contractor under or in connection with a contract for an improvement of real property . . . shall constitute assets of a trust . . ." Both the modular building sub and the homeowner qualified as beneficiaries of that trust, per the statute.

2. Salman was acting in a fiduciary capacity. This condition was satisfied as Salman was acting as the sole officer of Modular in handling of the funds. Modular became a statutory trustee under the NY law, and Salman as the sole officer “was acting in a fiduciary capacity with respect to the trust beneficiaries.”

3. Whether Salman, as the bankruptcy debtor, breached her fiduciary duty by defalcation. On this point the court pointed to undisputed facts, that Salman admitted to being a fiduciary, that she acknowledged being responsible for seeing to proper disbursement of funds received, and that she “recklessly deposit[ed]” the trust funds into the bank account of an entity not involved with the project.

Thus, in her personal bankruptcy proceeding, Salman could not discharge her duty and debt under the NY construction trust fund law, and would remain liable to the homeowner and modular building sub even after coming out of bankruptcy. A law intended to facilitate flow of funds on construction projects can also affect the outcome of a personal bankruptcy proceeding. The case is In re Salman, 2016 Bankr. LEXIS 3912 (S.D. N.Y., Nov. 7, 2016) (LEXIS subscription required).