The Bankruptcy Code prevents an individual debtor from discharging certain debts, including, upon request of the creditor, debts for “fraud or defalcation while acting in a fiduciary capacity.” 11 U.S.C. § 523(a)(4). The Seventh Circuit recently confirmed in Stoughton Lumber Co., Inc. v. Sveum, No. 14-3339 (June 4, 2015), that a contractor’s debt for misappropriation of funds that are to be held in trust for subcontractors may be non-dischargeable under the Code if the misappropriation is intentional.

The debtor, Peter Sveum, had for over thirty years owned a home-building company in Wisconsin called Kegonsa Builders. Between 2008 and 2011, Kegonsa purchased hundreds of thousands dollars of building materials from Stoughton Lumber Co. for several homes it was building. The materials were purchased on credit, and Stoughton was to be paid out of the construction proceeds. Kegonsa never paid, and Stoughton sued Kegonsa, Sveum, and his brother (who co-owned the business).

Among Stoughton’s claims was one for violation of Wis. Stat. § 779.02(5), Wisconsin’s theft-by-contractor statute. The statute requires contractors to hold all funds received for a project in trust to pay the subcontractors on the project. A contractor’s failure to pay a subcontractor from those trust funds constitutes civil and criminal theft, and individual officers or agents can be held liable along with the corporate entity. The parties initially settled Stoughton’s claims for $650,000, and Stoughton later obtained a default judgment of $589,638.10 against Sveum in an action for breach of the settlement agreement.

Sveum filed a chapter 7 bankruptcy petition just after the default judgment was entered, and Stoughton sought to have the debt declared not dischargeable under 11 U.S.C. § 523(a)(4). Sveum defended the action by claiming, quite unbelievably, that he was ignorant of the requirements under Wisconsin law and that he had made an honest mistake in not paying Stoughton. The Seventh Circuit affirmed the decisions of the bankruptcy court and district court declaring the debt not dischargeable.

The court first confirmed that Sveum had held the proceeds at issue in trust and as a fiduciary pending payment to his subcontractors, satisfying the threshold requirement of §523(a)(4). The only real question was whether Stoughton had proved defalcation—i.e., that Sveum acted intentionally, or at least recklessly, in diverting the trust funds, a finding required under Bullock v. BankChampaign, N.A., 133 S. Ct. 1754, 1760 (2013). The court had little trouble agreeing with the lower courts that Sveum, even if he had not acted intentionally, had played “ostrich” by consciously disregarding the risks of his conduct, which was enough to constitute defalcation.

The result isn’t really surprising, especially since, absent clear error, the appellate court was bound to uphold the bankruptcy court’s factual findings regarding Sveum’s intent. E.g., In re Smith, 582 F.3d 767, 777 (7th Cir. 2009). One lesson here is, as we’ve discussed before, that plaintiffs should always be thinking about a defendant’s inevitable bankruptcy when litigating claims that might be excepted from discharge. Stoughton may not have been able to save itself from a third trip to court in this case, but it often will be worth the effort to establish the elements of a non-dischargeability action in the first instance.