Category: Claims

Principals of General Contractors Should Be Aware: Trustee’s Release of Claims May Not Release Bankrupt GC’s Principals from Trust Fund Violations under NY Law

by David Primack

A subcontractor still retains its right to sue the principals of a bankrupt general contractor for diversion of trust funds under New York law even when a bankruptcy trustee settles and releases causes of action against these same individuals on behalf of the bankruptcy estate. Such is the recent decision by the Bankruptcy Court for the Southern District of New York in In re Lehr Construction Corp., Case No. 11-10723-shl (September 2, 2015 Bankr. S.D.N.Y.) and it provides clarity (at least with regard to New York law) to certain rights of subcontractors when their general contractor files for bankruptcy.

Background

Lehr Construction Corp. (“Lehr”) served as construction manager and general contractor for customers in the New York metropolitan area. Lehr subcontracted electrical work to Robert B. Samuels (“Samuels”) for certain properties. The customers paid Lehr for the construction work that both Lehr and Lehr’s subcontractors performed on these properties. However, Samuels and other subcontractors were never paid. As the Bankruptcy Court noted, under Article 3-A of New York’s Lien Law (“Article 3-A”), when a general contractor is hired to improve real property, it is obligated to hold funds paid by the real property owners in trust for the benefit of the subcontractors that worked to improve the real property (e.g. Samuels and other subcontractors). In this case, historically Lehr generally deposited the payments from customers into commingled bank accounts and paid subcontractors from such accounts. Leading up to the bankruptcy filing, subcontractors were not being paid from these commingled accounts.

In February of 2011, Lehr filed for bankruptcy protection under Chapter 11 and a trustee (the “Chapter 11 Trustee”) was appointed to wind down Lehr. Several months later, in June 2011, Samuels filed a state court complaint pursuant to Article 3-A against non-debtor principals alleging that Lehr knowingly and wrongfully diverted Article 3-A trust assets and that the non-debtor principals were personally liable under the statute. Samuels’ state court action was enjoined by agreement of the parties and approved by Court order so that the Chapter 11 Trustee could administer the bankruptcy estate which might have an impact on the state court litigation. The Chapter 11 Trustee was concerned that if the Samuels suit and another similar action brought in state court went forward, such actions could deplete assets otherwise available to the bankruptcy estate.

The matter came before the Court again based on Samuel’s request for relief from the injunction against continuing its state court action. One issue that remained open was whether claims brought under Article 3-A are considered generalized claims or are rather individual/particular (i.e. subcontractor only) claims. This is an important distinction as it determines who may pursue a claim. As the Court explained, general claims are claims with no particularized injury arising from them and if the claim could be brought by any creditor of the debtor, a trustee is the proper person to assert them, and all creditors are bound by the outcome of the trustee’s action. On the other hand, particular or personal claims are claims where there is injury to one specific creditor or a select group of specific creditors and other creditors have no interest in such action.

In 2013 and 2014, the Chapter 11 trustee reached settlement agreements with various principals of Lehr. The Chapter 11 Trustee’s first proposed settlement agreement contained a permanent injunction which would enjoin claims against the principal for violation Article 3-A. The Chapter 11 Trustee took the position that Article 3-A claims were “general” claims and belonged to the Chapter 11 Trustee. Samuels objected and the Court agreed with Samuels to leave the issue open to a ruling at a later date. The settlement agreements that were eventually approved by the Court contained language that enjoined any claim that was duplicative or derivative of claims that could have been brought by the Chapter 11 Trustee  – but did not bar any claim against a principal that was held solely by an individual creditor. This open issue – whether Article 3-A claims are general or particular – was finally addressed by the Lehr Court’s September 2, 2015 decision.

Analysis

The Court held that Article 3-A claims are particularized claims for subcontractors and therefore Samuels is not barred from pursuing its rights in state court even if the Chapter 11 Trustee settles and releases its causes of action. As the Court notes, claims based on a breach of fiduciary duty belong to a corporation and thus, after a bankruptcy, such claims belong to the trustee. In general, a claim that a corporation misused trust funds could be construed as a violation of a fiduciary duty.

However, pursuant to Article 3-A and applicable case law, subcontractors have their own unique breach of fiduciary duty cause of action against a company and its principals. The Court further ruled that just because trust funds may be unavailable and untraceable because of the contractor’s commingling and disbursement, a subcontractor’s Article 3-A cause of action remains viable and not otherwise rendered a generalized claim. The Court then allowed Samuels to prosecute in state court its claims against the principals of Lehr for violation of their duties pursuant to Article 3-A.

Key Takeaways

The Lehr decision clarifies that under New York law, Article 3-A claims of subcontractors are not property of the corporation and therefore not general claims that may be pursued or settled by the bankruptcy estate or any subsequent bankruptcy trustee. A subcontractor can seek to enforce its rights against the principals of a bankrupt company in state court (though the subcontractor may be forced to halt such proceedings while a bankruptcy case is pending).

Importantly, the subcontractor’s monitoring of the bankruptcy case and vigilance in objecting to the Chapter 11 Trustee’s settlement proposals made sure that an order of the court did not override the subcontractor’s rights. Because many other states have similar statutes for subcontractors, this decision may provide guidance in those jurisdictions. Finally, this decision may make settlements with principals of general contractors more difficult as the principals will have to negotiate with both the bankruptcy estate and each subcontractor for resolution of all claims.

CONDOMINIUM ASSOCIATION CLAIMS NOT DISCHARGED BY CONFIRMED PLAN -DELAWARE DISTRICT COURT APPLIES FRENVILLE TEST

by Jason Angelo

In re WCI Communities, Inc., 2015 WL 4477696 (D. Del. July 22, 2015)
In the Third Circuit, the answer to when a claim “arises” for purposes of the discharge depends upon what law applied at the time of the discharge.
The Court in the WCI case looked at three Third Circuit Court of Appeals decisions that addressed when a claim “arises”: In re M. Frenville Co., Inc., 744 F.2d 332 (3d Cir. 1984), which used the widely criticized accrual test based on whether an entity has a right to payment and when such right arose under state law; In re Grossman’s Inc., 607 F.3d 114 (3d Cir. 2010), which overruled the accrual test and used a test based on when the claimant was exposed to the product or conduct that led to the injury and formed the basis for the claim to payment; and Wright v. Owens Corning, 679 F.3d 101 (3d Cir. 2012), which addressed the due process issues raised when a person who did not have a “claim” under the Frenville test applicable at the time of plan confirmation would have had a claim under the subsequent Grossman’s test, thereby retroactively denying due process. The result as set forth in WCI following the opinion in Wright is an approach that permits Frenville to apply in narrow circumstances when to do otherwise would deny due process.

Background
In WCI, following the entry of the confirmation order and the discharge, a condominium association sought inter alia to pursue claims in state court against the reorganized debtor/builder for construction defects and past due amounts owed to the condominium association. As discussed below, the District Court for the District of Delaware, following the Third Circuit Court of Appeals decision in Wright, affirmed the Bankruptcy Court decision that the claims in question did not “arise” until after the discharge and therefore were not barred by it.

WCI Communities, Inc., along with its 126 subsidiaries (the “Debtor”), filed a voluntary Chapter 11 petition on August 4, 2008. Prior to filing its petition, the Debtor constructed homes and operated residential communities throughout the country, including the Lesina at Hammock Bay Condominium in Florida. Debtor filed a Condominium Declaration in 2007, which included Articles of Incorporation and the By-Laws for the community’s Condominium Association (the “Association”), which administers and manages the property. The Articles of Incorporation provided that the Association would be managed by a three-person board of directors appointed by the Debtor until an event known as “Turnover” under Florida law, at which point the control of the Association would be ceded to a five-member board elected by the Condominium owners.

The Bankruptcy Court set the bar date for filing claims against the estate as February 2, 2009, and thereafter approved the restructuring plan in August 2009. The Bankruptcy Court’s confirmation order contained a general discharge of all claims against the Debtor and permanently enjoined any holders of claims from asserting their claims against the Debtor. Following entry of the confirmation order, “Turnover” occurred on December 4, 2009. After the “Turnover,” an independent audit revealed that Debtor owed the Association over $80,000 in payments pursuant to the Condominium Declaration. An inspection by an engineering firm also revealed construction defects at the property with a repair cost of approximately $500,000.

The Association, when it was still under Debtor control prior to the “Turnover,” had timely filed a broad proof of claim that included any claims for “any defect in workmanship” and “assessment funding of association dues for unsold units.” However, post-Turnover, the Association contended that the confirmation order did not discharge its claims and filed a motion for declaratory relief pursuant to 11 U.S.C. §105(a) seeking a determination that the Debtor’s obligations to it were not discharged through the Plan and that Debtor was unjustified in threatening sanctions if the Association commenced a state court action.

Before the Bankruptcy Court ruled on the motion, the Third Circuit issued its opinion in Wright and utilized the standard for determining when a claim arises that was set forth in Frenville rather than the standard articulated in the en banc decision in Grossman’s. Thus, in WCI Judge Kevin Carey of the Bankruptcy Court for the District of Delaware held that Wright compelled the determination that the Third Circuit’s Frenville test applied to the Association’s claims and, under that test, the claims did not “arise” until after the “Turnover” date. Since the “Turnover” date was after the confirmation of the Plan, the Association’s claims were not subject to discharge under the Bankruptcy Code. Judge Gregory Sleet of the District Court upheld the Bankruptcy Court decision.

Analysis
As the District Court noted, when determining when the claims arose, the “dispute hinges upon whether the Association’s asserted statutory claims ‘arose’ prior to the date of the debtor’s plan confirmation.” In re WCI Communities, Inc., 2015 WL 4477696 at *3. The standard in the Third Circuit has been particularly fluid in recent years following the overruling of the widely-criticized Frenville “accrual” test. Under Frenville, a claim did not ripen until a right to payment arises, which in turn was decided by reference to state law. In re M. Frenville, 744 F.2d at 337. The Third Circuit further expounded on this in In re Remington Rand Corp., 836 F.2d 825, 830 (3d Cir. 1988), holding that “the existence of a valid claim depends on: (1) whether the claimant possessed a right to payment; and (2) when that right arose” as determined by reference to relevant non-bankruptcy law.” The Third Circuit’s 2010 Grossman’s decision abrogated the Frenville test. There, the Court held that a “claim” arises when an individual is exposed pre-petition to a product or other conduct giving rise to an injury, which underlies a “right to payment.” In re Grossman’s, 607 F.3d at 125. According to the Grossman’s Court, Frenville’s emphasis on a “right to payment” failed to give sufficient weight to other words in the statutory definition that modified the term “claim,” such as “contingent,” “unmatured,” and “unliquidated.” Id. at 121.

Wright addressed the retroactive effect of the Grossman’s decision, carving out specific exceptions where a claimant’s due process rights would be affected by its application. Specifically, claimants operating under the Frenville test would not have realized that they held “claims” and would not have taken action to protect their interests prior to the bar date and plan confirmation. To ensure that such claimants were afforded due process, instead of allowing claimants operating under the Frenville test to have their claims discharged in an earlier bankruptcy without notice or an opportunity to be heard, the Third Circuit in Wright held that the Frenville test applies to plans proposed and confirmed prior to the Grossman’s decision on June 2, 2010. So those who all of the sudden had “claims” under Grossman’s were exempt from the new test.

Since the WCI Debtor’s plan was confirmed prior to the Grossman’s decision, the Bankruptcy Court applied the Frenville accrual test and determined that the Association’s right to payment did not accrue under Florida law until the “Turnover,” which occurred after confirmation, and thus that the claims did not fall within the scope of the discharge. In upholding the decision, the District Court recognized that Grossman’s is not retroactively applicable in all situations, but only when a claimant’s due process rights would not be violated as per Wright.

The Debtor in WCI argued that the Association had been permitted due process because the Association (prior to the “Turnover”) had actually filed a proof of claim and thus had the opportunity to participate in the bankruptcy proceedings. In Debtor’s view, the filing of a proof of claim alone, even if a claimant did not yet hold a “claim,” would allow such a claim to be discharged upon confirmation of a plan.

The District Court refused to adopt such a bright line rule and countered that the mere filing of a proof of claim does not, in and of itself, mean that a claimant was afforded full due process. The District Court stated that “[w]hether a party receives proper due process depends on the circumstances of a particular case.” In re WCI Communities, Inc., 2015 WL 4477696 at *6 (citing In re Grossman’s, 607 F.3d at 127). Here, the Association could not have asserted the claims against Debtor until “Turnover,” since its cause of action under Florida law did not accrue until the condo owners acquired control of the Association. Further, since it was controlled by a Board hand-picked by the Debtor itself up to that point, the Association was not independent from the Debtor, and under Florida law, its actions were attributable to the Debtor rather than the condo owners until post-“Turnover.”

Key Takeaways
While Grossman’s and Wright have complicated the ever-evolving issue of when a “claim” arises in the Third Circuit, the District of Delaware recognized that due process concerns override the formalistic approach advocated by the Debtor. Additionally, the court made clear that the mere filing of a proof of claim would not per se meet the standard for due process under Third Circuit precedent.

Jason D. Angelo is an Associate in MCELROY, DEUTSCH, MULVANEY & CARPENTER, LLP.’s Bankruptcy Practice Group and is admitted to practice in Delaware and New Jersey.