Banking, Bankruptcy, and Creditors' Rights

Damages from Subcontractor’s Misrepresentations Held Non-Dischargeable as to Subcontractor’s Principal in Bankruptcy

Monday, April 20, 2009

Contributed by:   Roger Cox*

As mentioned in another article on this site, construction disputes continue to provide new developments in matters regarding the dischargeability of debts in bankruptcy.

In In re Morrison, 555 F.3d 473 (5th Cir. 2009), the Fifth Circuit Court of Appeals affirmed a non-dischargeable judgment against the principal of a subcontractor that had apparently provided misleading financial information to a general contractor.

Apparently, the subcontractor made written representations about its financial condition to the general contractor on a large construction contract. In short, those representations were apparently false and misleading; moreover, some of the progress payments made to the sub were diverted by the principal who paid off his home equity loan and gave himself a substantial pay raise. Ultimately, the sub abandoned the job; the general contractor paid the outstanding liens; and the general contractor hired a replacement sub, which resulted in over a half million dollar damage claim by the general contractor.

The sub’s principal filed an individual Chapter 7. The general asserted that the damage claim was non-dischargeable as to the principal, asserting the discharge exception under Section 523(a)(2)(B) of the Bankruptcy Code, which can render non-dischargeable a debt incurred based upon a materially false financial statement on which a creditor reasonably relied.

As mentioned, the bankruptcy court entered a judgment for the entire debt, and declared that judgment non-dischargeable. The Fifth Circuit opinion is significant in a number of respects. First, the court found that the bankruptcy court had jurisdiction not only to declare a debt non-dischargeable, but to actually enter a judgment. This had apparently been the case in practice for many years, but the Fifth Circuit had never actually been called upon to determine whether a bankruptcy court had jurisdiction to enter a money judgment. The court held that it did.

Second, the original contract was between the general contractor and the sub, which was a corporate entity. In this case, it was the corporate officer against whom the non-dischargeable judgment was entered. Citing Texas case law, the Fifth Circuit held that “a corporate officer may not escape liability where he had direct, personal participation in the wrongdoing.” In other words, the Fifth Circuit found that the principal, as a corporate agent, could be held “individually liable for fraudulent or tortuous acts committed while in the service of [his] corporation.” In re Morrison,, 555 F.3d at 481.

Finally, the court also found that it could look at the “totality of the circumstances” and infer an intent to deceive when “reckless disregard for the truth or falsity of a statement combined with the sheer magnitude of the resulted misrepresentation may combine” to produce such an inference.

Since the Morrison opinion was handed down, a residential general contractor found himself in a similar situation based upon apparent misrepresentations to homeowners and an alleged diversion of a substantial portion of the funds paid by the homeowners. In In re Blake, 2009 WL 349815 (Bankr. S.D. Tex. 2009), a Houston bankruptcy court found that the principal and sole owner of a residential general contracting entity had committed fraud under Section 523(a)(2)(A). This is a slight variation from Morrison, which dealt with false financial statements. Blake resulted in a similar outcome, although under the general fraud exception to discharge.

There were other issues in the case that were not fully disposed of, but Blake is significant because it was among the first courts to follow Morrison, and it also opened the possibility that fraudulent transfer law might also be a basis for recovery against a contractor who may have improperly diverted construction funds.

  

 

*Roger Cox is Board Certified in Business Bankruptcy Law by the Texas Board of Legal Specialization.

 

This column is published for informational purposes only. It should not be construed as legal advice and is not intended to create an attorney client relationship. The views expressed are those of the author and do not necessarily reflect the views of the author's law firm or its individual partners.