Pursuing Misallocated Contract Funds in Bankruptcy: Recent Developments Regarding Non-Dischargeability and Fraudulent Misrepresentations

September 12, 2013

Adam C. Harrison Construction Law


           The United States Court of Appeals for the 4th Circuit issued an interesting opinion this past summer titled SG Homes Associates, LP v. Marinucci, 2013 U.S. App. LEXIS 11176.  The opinion examines the pursuit of a general contractor’s president / shareholder by a project owner through the bankruptcy court for misallocated project funds, and whether the bankruptcy debt of the general contractor’s president / shareholder can be deemed non-dischargeable based on fraud pursuant to section 11 U.S.C. § 523(a)(2)(A) of the bankruptcy code.

           In SG Homes, the project owner sued the general contractor and its president / shareholder in Maryland state court for breach of contract, fraud, and a violation of the Maryland Construction Trust Fund Statute.  While the case was pending, the president / shareholder individually filed for Chapter 7 bankruptcy protection.  Thereafter, the project owner filed an adversary proceeding against the president / shareholder in the bankruptcy court, seeking a declaration that the underlying debt was non-dischargeable based on fraud.  Particularly interesting was the project owner’s argument that the president / shareholder falsely certified in the monthly payment applications that the general contractor was paying its subcontractors and suppliers on the project.  The bankruptcy court found from the “totality of the evidence” that the certifications at the bottom of each monthly payment application constituted false representations that monies received from the project owner were used to pay subcontractors and suppliers connected with the project.  As such, the bankruptcy court determined that the underlying debt of the president / shareholder was non-dischargeable under 11 U.S.C. § 523(a)(2)(A), which disallows the discharge of a bankruptcy debt obtained by fraud.  The decision of the bankruptcy court was appealed to the United States Court of Appeals for the 4th Circuit.

           On appeal, the 4th Circuit held that 11 U.S.C. § 523(a)(2)(A) of the bankruptcy code requires a showing of fraud as an underlying basis for non-dischargeability.  To succeed on the fraud claim, the project owner had to prove that one or more false representations had been made, the president / shareholder had to know that the representation was false, the president / shareholder had to intend to deceive, the project owner had to justifiably rely on the representation, and the fraud had to be the proximate cause of damages.

           The payment application certifications became a central focus of the trial and appeal because the president / shareholder expressly indicated the project funds would be used to pay the project’s subcontractors and suppliers.  The court found that the president / shareholder knew these representations were false and intended to deceive the project owner to obtain payments.  The court further agreed that the owner had relied on the representations and incurred damages when it was discovered that the general contractor had not paid subcontractors and suppliers.  As such, the court found that the project owner satisfied all of the elements of fraud and the debt was deemed non-dischargeable with respect to the president / shareholder’s personal bankruptcy.

            This appellate decision provides guidance when chasing companies or individuals into a bankruptcy court based on improperly allocated contract funds.  In such a situation, fraud is a basis for non-dischargeability.  To satisfy the justifiable reliance element to prove fraud, a plaintiff must show that it actually relied on the debtor's misrepresentations and was justified in doing so because of “the circumstances of the particular case.”  Further, a plaintiff “is justified in relying on a representation although he might have ascertained the falsity of the representation had he made an investigation.”  In SG Homes, the 4th Circuit held that the bankruptcy court was entitled to find, and did find, that the project owner justifiably relied on the president / shareholder’s false certifications in the monthly payment applications that the general contractor was paying its subcontractors and suppliers.  Otherwise, the project owner would not have continued to pay the general contractor had it known the general contractor was making false certifications, and instead would have paid the subcontractors directly.  As a result, the finding of fraud on the basis of justifiable reliance was allowed.

           It bears noting that, in SG Homes, the pursuit of bankruptcy non-dischargeability against the general contractor’s president / shareholder came ‘from above’, i.e., via the project owner.  This is not to say that unpaid subcontractors and suppliers cannot likewise pursue non-dischargeability claims ‘from below’ based on fraud.  The benefit of SG Homes is the guidance offered by the appellate court to define the elements of proof, specifically (1) a false representation, (2) knowledge that the representation was false, (3) intent to deceive, (4) justifiable reliance on the representation, and (5) proximate cause of damages.  The facts of each specific case will dictate whether the pursuit will ultimately be successful.