Creating a Subcontractor Fiduciary Relationship
When a subcontractor files bankruptcy, any attempt to recover funds that have been paid, but not applied to pay off obligations, is stayed. It is possible to petition the court to lift the stay to allow a state court action to proceed against the subcontractor-debtor, but it is unlikely the court will do that. Instead, an adversary proceeding must be filed in the Bankruptcy Court and it must allege that certain of the subcontractor-debtor’s obligations should not be discharged in the bankruptcy order.
There are two arguments for non-dischargeability that are typically used: 1- fraud by the debtor, and 2- that there was a fiduciary duty that the debtor breached. Both arguments depend on the successful proof of alter ego if the debtor-subcontractor is a corporation, but if this is established, or if the debtor is an individual, the debtor may be required to repay certain obligations despite the discharge of its other debts through the bankruptcy.
Fraud is a tough argument in the bankruptcy world. You must show that there was justifiable reliance on the representations of the debtor. If the debtor’s progress payment included line items for supplies and wages, it might be justifiable for you to rely on that representation. It might not be justifiable if the union had previously informed you of delinquent contributions, or a supplier filed a Stop Notice.
Even more problematic is that at the time the debtor’s representations are made, i.e. when the pay app is submitted, there must be no intention to perform. If the billings are submitted and the sub intended at the time to pay its bills, but thereafter did not, then the necessary showing of a “present intention” to defraud is not made. In short, fraud is difficult to prove in a bankruptcy proceeding.
Conversely, establishing that there was a fiduciary relationship is relatively easy, and can be accomplished by including a provision in the subcontract that creates that relationship. It’s not a guarantee that the court will find certain debts non-dischargeable, but the threshold showing is a lot easier to meet.
A fiduciary relationship can be contractually established by including language in the subcontract to the effect that any payments that are made to the subcontractor for materials, labor and/or supplies are made in trust and that those payments shall be held in trust for the benefit of the materialmen, suppliers and laborers for that project.
The provision would read something like the following:
“All sums received by subcontractor under this agreement will be held in trust for the express use of (1) paying in full for all labor, material, equipment, and appliances furnished to subcontractor in performing this agreement, and (2) if required, making payments to labor union trust funds established under a collective bargaining agreement. No title to any payment or any part of it shall vest in subcontractor or to be used for any other purpose until
subcontractor has first paid in full for all such labor, material, equipment, and appliances furnished by that date to subcontractor.”
In this arrangement, the sub does not have any immediate right to the funds, but only holds them as a trustee until all of the bills are paid, and then only if there is something left after those bills are paid can it keep those funds. As a fiduciary, there is a trust relationship established, and the violation of that trust/fiduciary obligation is grounds for making that
particular debt non-dischargeable in bankruptcy. If nothing else, this provision gives you another argument if you find that you have been scammed by an unprincipled sub.
There are two arguments for non-dischargeability that are typically used: 1- fraud by the debtor, and 2- that there was a fiduciary duty that the debtor breached. Both arguments depend on the successful proof of alter ego if the debtor-subcontractor is a corporation, but if this is established, or if the debtor is an individual, the debtor may be required to repay certain obligations despite the discharge of its other debts through the bankruptcy.
Fraud is a tough argument in the bankruptcy world. You must show that there was justifiable reliance on the representations of the debtor. If the debtor’s progress payment included line items for supplies and wages, it might be justifiable for you to rely on that representation. It might not be justifiable if the union had previously informed you of delinquent contributions, or a supplier filed a Stop Notice.
Even more problematic is that at the time the debtor’s representations are made, i.e. when the pay app is submitted, there must be no intention to perform. If the billings are submitted and the sub intended at the time to pay its bills, but thereafter did not, then the necessary showing of a “present intention” to defraud is not made. In short, fraud is difficult to prove in a bankruptcy proceeding.
Conversely, establishing that there was a fiduciary relationship is relatively easy, and can be accomplished by including a provision in the subcontract that creates that relationship. It’s not a guarantee that the court will find certain debts non-dischargeable, but the threshold showing is a lot easier to meet.
A fiduciary relationship can be contractually established by including language in the subcontract to the effect that any payments that are made to the subcontractor for materials, labor and/or supplies are made in trust and that those payments shall be held in trust for the benefit of the materialmen, suppliers and laborers for that project.
The provision would read something like the following:
“All sums received by subcontractor under this agreement will be held in trust for the express use of (1) paying in full for all labor, material, equipment, and appliances furnished to subcontractor in performing this agreement, and (2) if required, making payments to labor union trust funds established under a collective bargaining agreement. No title to any payment or any part of it shall vest in subcontractor or to be used for any other purpose until
subcontractor has first paid in full for all such labor, material, equipment, and appliances furnished by that date to subcontractor.”
In this arrangement, the sub does not have any immediate right to the funds, but only holds them as a trustee until all of the bills are paid, and then only if there is something left after those bills are paid can it keep those funds. As a fiduciary, there is a trust relationship established, and the violation of that trust/fiduciary obligation is grounds for making that
particular debt non-dischargeable in bankruptcy. If nothing else, this provision gives you another argument if you find that you have been scammed by an unprincipled sub.