June 2003
By ALEXANDER A. MIUCCIO, CIC Legal Counsel
Certain debts are not dischargeable in a bankruptcy proceeding and will remain the continuing obligations of the debtor. The debts, which are not dischargeable, are described in the Bankruptcy Code and arise out of specific wrongdoing by the debtor. A mere breach of contract and the consequential damages arising from the breach do not result in a bar to the discharge of the debt. However, the Bankruptcy Code specifically provides that a debt for money, property or services obtained by false pretenses, a false representation or actual fraud shall not be discharged. Similarly, a debt arising out of a "defalcation while acting in a fiduciary capacity" will also prevent the discharge of the debt.
Under Article 3-A of the New York Lien Law, monies received by an owner, contractor or subcontractor for a construction project are trust funds to be used to pay the claims of subcontractors, material suppliers or laborers. The diversion of trust funds for purposes other than paying the claims of unpaid suppliers, laborers, subcontractors or other trust beneficiaries is a fiduciary defalcation (misuse) that will bar the discharge of the debts. An owner who pays the outstanding debts to trust beneficiaries after the general contractor's defalcation may also seek an exception from the discharge of the general contractor's debts, as illustrated by the recent case of Sandak v. Dobrayel.
Background
David Sandak, a dentist, leased space in White Plains, NY and then contracted with Elias Dobrayel, a contractor, for the construction of a dental office. The contract provided that the contractor was to complete the work in accordance with existing plans for a price of $118,000. The contractor was to receive an initial payment of $39,000 and nine weekly payments of $8,777. The construction was to have been completed within 10 weeks starting the day after "plan and permit approval." The plans were filed on March 4, 1998 and the building permit was issued on March 23, 1998.
The contractor commenced work, but was delayed because of certain modifications in the building that were the landlord's obligation. All of the delaying work was completed before the end of August 1998. By the beginning of September 1998, the contractor had been paid the full $118,000 but had only completed about 60 percent of the work. The contractor also demanded, and received, payment of an additional $58,505 for alleged changes or extra work.
After more than a year of inattention by the contractor, Mr. Sandak demanded, in October of 1999, that Mr. Dobrayel finish the work. The contractor refused unless he was paid an additional $18,600. Mr. Sandak finally concluded that the contractor was never going to complete the work. He hired another contractor to complete the work for $35,630 and paid three subcontractors who had been hired by Mr. Dobrayel, but not fully paid, a total of $13,060.
The contractor filed for bankruptcy and Mr. Sandak brought an adversary proceeding in the Bankruptcy Court to establish the contractor's liability for the $13,060 that Mr. Sandak paid to the subcontractors, for the overpayment for the alleged "extras" on grounds of fraud, for the cost to complete the work and for the additional costs and damages arising from the delay of more than a year in completing the dental office.
The contractor sought a discharge of all of his debts. Mr. Sandak sought a determination that all, or at least part, of the liabilities arising from the construction contract were non- dischargeable.
Decision
The Bankruptcy Court determined that the contractor had breached his contract by failing to complete the work and by failing to complete it within the time set forth, even allowing for delay that was not the fault of either party. The court stated that although Mr. Sandak was entitled to a judgment against the contractor for his costs to complete the construction and might be entitled to a judgment for certain consequential damages, such as the rental and storage costs of certain dental equipment, those obligations were dischargeable as mere breach of contract damages.
The court found that with respect to the approximately $58,000 of alleged "extras" involving the HVAC system, ceiling tiles, electrical fire boxes, electric lighting and certain flooring, the contractor had made material misrepresentations regarding alleged changes in building code requirements and the cost of the materials. Because these payments were induced by fraud, the contractor's liability to the owner arising from the so-called "extras" would not be discharged.
With respect to the owner's payment of $13,060 to the subcontractors that had not been paid in full by the contractor, the court determined that the contractor had failed to pay over trust funds received from the owner. The contractor had not only been paid the full contract price of $118,000 but also more than $58,000 for the alleged "extras" while representing to the owner that the subcontractors had been paid in full. According to the court, the owner was "entitled to a judgment of liability and non-dischargeability" against the contractor because of his defalcation of subcontractor trust funds "which Mr. Sandak became obligated to, and did, pay."
Comment
Although the court came to the right conclusion, its reasoning with respect to the contractor's defalcation is not as clear as it should have been. The court's conclusion that the owner was obligated to pay the subcontractors is incorrect. An owner is not required to pay more than the contract price, and having already paid the contractor more than the contract price, he was not obligated to pay the unpaid subcontractors. The unpaid subcontractors would have had a right to assert their Article 3-A trust beneficiary status in the Bankruptcy Court and the debts to them would not have been dischargeable for the reasons set forth by the court regarding the defalcation of a fiduciary.
Although the subcontractors might have filed liens against the property, the liens would have been ultimately unenforceable because no monies were due from the owner (Mr. Sandak) to the contractor. Weighing the costs to obtain either a temporary discharge of such liens by bonding or a final discharge by demanding a lien foreclosure action against the $13,060 due to the subcontractors, it may have made economic sense to pay the subcontractors, even though there was no legal obligation to do so. Because the owner paid the subcontractors, who had legitimate trust fund claims against the contractor, he effectively stepped into the subcontractors' shoes and had the right to assert the same claims against the contractor that the subcontractors could have asserted. Therefore, the court was right to declare the obligation of the contractor, arising from the monies paid to the subcontractors by the owner, was non-dischargeable.
Conclusion
The trust fund provisions of the Lien Law are meant to protect claimants, such as suppliers and subcontractors, who have provided materials and labor which made the actual construction possible. Such claimants are, and should be the beneficiaries of the trust funds received by the owner, contractor or subcontractor. Any payments made by a trustee to a party other than a beneficiary is a diversion of the trust that subjects the debtor to civil and criminal liability. The Bankruptcy Code offers further protection to trust beneficiaries by rendering a debt, which arises from a defalcation of the debtor while acting in a fiduciary capacity, non-dischargeable. As this case demonstrates, an owner who pays the contractor's trust fund obligations may also assert the non-dischargeability of the contractor's debt.
About the author: Mr. Miuccio is a partner in the New York City-based law firm Altieri, Kushner & Miuccio, P.C. and legal counsel to the Construction Industry Council of Westchester and Hudson Valley, Inc. Robert Mark Wasko, senior associate with the firm, assisted in the preparation of this article.