Fourth Circuit Holds that False Payment Applications May Constitute Fraud for Purposes of Bankruptcy Nondischargeabilty

This June, the U.S. Court of Appeals for the Fourth Circuit affirmed a bankruptcy court’s ruling that false certifications contained in payment applications constitute fraud for the purposes of making those debts attributable to the certifications non-dischargeable in bankruptcy.

In SG Homes Assocs., LP v. Marinucci, 718 F.3d 327 (4th Cir. 2013), Chesapeake Site Contracting, Inc., a site subcontractor performing work on a project in Montgomery County, Maryland, submitted monthly payment applications to obtain progress payments. In each payment application, Chesapeake certified that it would use the requested funds to pay lower-tier contractors on the project, and it further certified it had paid all previously received funds referenced in the application to its lower-tier contractors. Furthermore, despite knowing that it had no bonding capacity, Chesapeake agreed to provide a payment bond to the general contractor, SG Homes. Chesapeake’s false statements eventually came to SG Homes’ attention after several lower-tier contractors contacted SG Homes complaining of non-payment. Thereafter, SG Homes paid the lower-tier claims and terminated Chesapeake.

After SG Homes obtained a default judgment against Chesapeake in state court for the double payments it was forced to make to lower-tier contractors, Chesapeake’s president and owner, Marinucci, filed an individual bankruptcy petition. SG Homes then filed an adversary action in the bankruptcy court to hold Marinucci personally liable for the judgment and to avoid having the debt discharged. SG Homes alleged that Marinucci personally committed fraud and violated the Maryland Construction Trust Statute by wrongfully certifying that it paid lower-tier contractors and falsely stated that Chesapeake could obtain a payment bond. Although the bankruptcy court dismissed the Maryland Construction Trust Statute claim, as the statute did not apply to dischargability of a debt, the bankruptcy court found that Marinucci had committed fraud both in falsely certifying payment applications and falsely stating Chesapeake had bonding capacity. Therefore, the bankruptcy court determined the debt was non-dischargable.

On appeal, the Fourth Circuit considered the limited question of whether the false payment application certifications satisfied the elements of fraud necessary to hold a debt non-dischargable pursuant to 11 U.S.C. § 523(a)(2)(A). After generally discussing the elements required for a finding of fraud, the court considered specifically the fourth element - whether SG Homes had “justifiably relied” upon the false certifications in making payment. The Fourth Circuit upheld the bankruptcy court’s determination that SG Homes could and did rely on the certified payment applications, and took particular note of the fact that Marinucci understood that the Maryland Construction Trust Statute required him to use funds from that project to pay only claimants on that project. SG Homes would not have continued to pay Chesapeake had it known Chesapeake was making false certifications, but would have paid the subcontractors directly. Therefore, the debt against Marinucci was not dischargable in bankruptcy.

The Fourth Circuit’s holding in SG Homes stands in stark contrast to the result reached by the Virginia Supreme Court under similar facts. In Richmond Metropolitan Auth. v. McDevitt Street Bovis, Inc., 256 Va. 553 (1998), the Virginia Supreme Court rejected a claim that payment applications, falsely certifying that work had been completed correctly, constituted fraud on the grounds that the obligation to certify payment applications arose solely by reason of the contract and could only be considered a breach of a contractual duty. To hold otherwise, the Virginia Supreme Court cautioned, there exists the risk of “turning every breach of contract into an actionable claim for fraud.” The question remains as to whether the Virginia Supreme Court would have reached a different result had the false certifications in Richmond Metropolitan been related to diversion of project funds, as in SG Homes, rather than the quality of the work.The SG Homes decision highlights the importance of truthfully certifying payment applications and, conversely, investigating the veracity of payment applications on construction projects.