Adversary proceedings objecting to the discharge of certain debts sometimes arise in the context of bankruptcy cases.  One such type of adversary proceeding, one based on “fraud or defalcation while acting in a fiduciary capacity,” is based on Section 523(a)(4) of the Bankruptcy Code.  But to prevail under this section requires that certain conditions must exist.  A recent case illustrated how such conditions may in fact exist.  The case was a 10^th Circuit B.A.P. case, NM-12-017, Hawks Holding LLC v. Kalinowski, decided in 2012.

In 2008, Hawks Holdings, LLC (“Hawks”) contracted with K2 Construction Company, LLC (“K2”) to build three homes on property Hawks owned near Santa Fe, New Mexico, for a contract price of more than $3.6 million. K2 was formed in 2007 as a New Mexico limited liability company, and held a general contractor’s license issued under the New Mexico Construction Industries Licensing Act (the “Contractors Act”). K2 neither completed the construction 1 called for by the Hawks contract, nor paid all of the subcontractors and material suppliers that had contributed to the project.

The Kalinowskis filed bankruptcy in 2009.  Hawks then filed an adversary proceeding against them, claiming that their debts could not be discharged under §523(a)(4).

Karen was listed as K2’s “sole manager” in its operating agreement and organizational minutes. William was not listed as a member or manager of K2, but was authorized to sign checks on its behalf. William also was not a licensed New Mexico contractor, but admitted that he was “significantly involved in the management of the day-to-day affairs of K2.”

In fact, William negotiated the Hawks contract on K2’s behalf, and represented to Hawks that he “was personally responsible for getting the projects built and paid for through K2.”

Karen and William routinely claimed to be co-owners and partners in several construction companies, and admitted that they consulted with each other and made joint decisions regarding K2’s operation and management.

Hawks paid an initial deposit of nearly $364,000 to K2 pursuant to the parties’ contract. Significantly, some of the money that Hawks paid to K2 was then “pooled” into an account held by Fourteen Pueblos Construction Co., LLC, a company that William in fact controlled. Hawks periodically received and paid draw requests from K2 for work done on the project, but some of its payments were not used to pay for the work specified in the draw requests. Ultimately, K2 ceased work on the Hawks project.

At that time, Hawks had paid a total of approximately $1,458,000 to K2. In addition, liens filed on Hawks’ property by subcontractors and suppliers that K2 had failed to pay totaled nearly $587,000.

The bankruptcy trial court ruled against the Kalinowskis.  The basis for the bankruptcy court’s ruling of non-dischargeability was that Hawks’ funds were required by statute to be held in trust by K2, and the trust had been mismanaged.

Following a subsequently held evidentiary hearing on Hawks’ damages, the bankruptcy court entered final judgments against both Karen and William in the amount of $775,895.21 plus attorneys’ fees and determined they were nondischargeable pursuant to §523(a)(4).  The Kalinowskis appealed.

Exceptions to discharge under Section 523(a)(4) are not normally easy to prove.  This is because there must exist a fiduciary relationship between the parties.  The fiduciary defalcation exception in § 523(a)(4) has been particularly constrained, and it is well settled in the Tenth Circuit that a  qualifying fiduciary relationship “exists only where a debtor has been entrusted with money pursuant to an express or technical trust.”

In addition, “the fiduciary relationship must be shown to exist prior to the creation of the debt in controversy.” Finally, the existence of a fiduciary relationship under §523(a)(4) is ultimately a question of federal law, though state law obligations are certainly relevant to the inquiry.

In this case, however, there was an actual trust in existence that was created by state statute.  No express trust was alleged, so the question turned on the existence of a “technical trust.”  And one did indeed exist, arising from state law.  Technical trusts are typically created by statute and, in this case, Hawks relied upon § 60-13-23(F) of the Contractors Act of the State of New Mexico for the existence of a trust.  The statute read:

Any [contractor’s] license issued by the division shall be revoked or suspended by the commission for any of the following causes:

…conversion of funds or property received for prosecution or completion of a specific contract or for a specified purpose in the prosecution or completion of any contract, obligation or purpose, as determined by a court of competent jurisdiction.

In other words, the statute clearly imposes a fiduciary duty upon contractors who have been advanced money pursuant to construction contracts. The court found that the debtor was bound by the statutorily imposed technical trust, had violated that trust, and the debt incurred was therefore non-dischargeable under the Bankruptcy Code.  At the end of the day, Hawks placed money in trust with K2, which was mismanaged by the de facto manager of K2.

Hawks was fortunate here in that they had a specific statute to rely on.  The Debtors had argued that they did not qualify as “contractors” under New Mexico law; they also argued that they were not the actual responsible parties, and should not be held liable. The court was not persuaded by these arguments.

The Debtors were found to be exercising de facto control over operations, and that their business operations fell within the statute.  This was, therefore, one of those uncommon examples where the nondischargeability requirements of Section 532(a)(4) were satisfied.

Read More:  Bankruptcy Adversary Proceedings Under Section 523