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3-A Trust Fund Diversion Not Automatically Nondischargeable in Bankruptcy

In re Barksdale
2010 WL 3895498 (9/29/10 Bkrtcy.N.D.N.Y.)

The plaintiff lumber company brought an adversary proceeding in the contractor’s bankruptcy seeking a determination that the debt owed to it by the debtor-contractor was nondischargeable solely by reason of a trust fund diversion on the part of the contractor.

The plaintiff argued that the contractor’s failure to maintain detailed books and records required by Art 3-A of the NY Lien Law gave rise to a presumption of diversion under Art. 3-A, that this diversion amounted to a “defalcation” under the Bankruptcy Code, and therefore the debt owed to the plaintiff should be held non-dischargeable.

The court disagreed holding that the contractor’s conduct in this case did not rise to the level of “culpable mental state” required to find a defalcation and nondischargeability under the holding of the 2d Circuit in In re Hyman (2007) which is controlling in bankruptcy cases in NY.

Noting that there is a three-way split on this issue among the various Circuits around the country, the 2d Circuit has adopted the strictest rule which requires “conscious misbehavior or extreme recklessness” for a debt to be nondischargeable. The court did not find those facts present here.

As the court noted “unfortunately this debate will not be settled in the near future given the Supreme Court’s recent denial of certiorari on this issue.” Thus it appears that the strict standard for nondischargeability in Hyman will be the law in NY for the foreseeable future.


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