Can debts arising from misapplied construction funds be discharged in bankruptcy?

Recently, a case out of the Federal Sixth Circuit Court of Appeals made headlines, holding that a contractor in Michigan receiving funds from the owner on a job could not use bankruptcy to discharge its debts to a subcontractor (or probably a laborer or material supplier) to whom the contractor should have passed along the funds. Patel v. Floorcovering Services, Inc. This holding extended not only to the contractor (a corporation) but to the licensed contractor who guaranteed its debts. The cardinal bankruptcy concept is that the debtor receives a fresh start, with all debts being paid or wiped away by the bankruptcy process. The narrow exceptions to this "discharge" of debts are enumerated in Section 523 of the bankruptcy code. They include certain types of debts (such as student loans, to the chagrin of certain of my law school classmates) and debts resulting from wrongdoing such as "fraud or defalcation while acting in a fiduciary capacity, embezzlement, or larceny." In Michigan, at least, the misapplication of construction funds received from the owner falls into this category.

A trustee acts in a fiduciary capacity. Under Michigan law, funds paid by an owner for the benefit of subs, laborers or material supplieres are considered trust funds, and the contractor or subcontractor is considered the trustee of the funds. Because the basic rule is that trustees act in a fiduciary capacity, the debts of the contractor (or sub) to his subs, laborers and material suppliers cannot be removed by bankruptcy.

As mentioned in a previous post, bankruptcy courts must make decisions involving both federal and state law. Obviously, the question facing Florida construction professionals is whether Florida law would intersect with federal law in the same way such that Florida contractors would not be able to discharge debts in bankruptcy resulting from the misapplication of funds. In contrast to the recent ruling interpreting Michigan law, when deciding In re Gropp, 153 B.R. 350(Bkrtcy.M.D.Fla.1993), a Florida bankruptcy court reiterated its position that even though Florida law makes misapplication of construction funds a crime, it does not create a "fiduciary" duty such that the debt would be immune to bankruptcy discharge. Although Florida's Section 713.345 (outlawing misapplication of funds) seems to have much in common with Michigan's law at 570.151-153, MCL (outlawing misapplication of funds), the Michigan law can be distinguished because it specifically states that money paid under a construction contract to a contractor (or sub) is considered a trust fund and the contractor or sub receiving the fund "shall be considered the trustee of all funds so paid to him for building construction purposes."

Despite the subtle differences in various state statutes, the Sixth Circuit will have some persuasive authority nationwide. It will be interesting to see if attorneys in jurisdictions outside Michigan (including Florida) attempt to use the Patel v. Floorcovering Services, Inc. decision to expand the scope of debts resulting from wrongdoing that cannot be wiped clean by bankruptcy.