Express Trusts and Bankruptcy Discharge: some Quick Hits

Adas v. Rutkowski, 2013 WL 6865417 (N.D.Ill. 2013), illustrates the confluence of Federal bankruptcy law and state law fiduciary duty and express trust principles in a case involving a failed construction partnership.

The plaintiff and bankrupt debtor (defendant) formed a partnership to buy real estate, build a house  on it and split the profits once the house was sold.

The venture failed and the plaintiff got stuck with a sizeable deficiency judgment in a lender’s foreclosure suit.  After the defendant filed for bankruptcy, the plaintiff objected to defendant’s discharge based on defendant’s lengthy pattern of keeping plaintiff in the dark about the failed venture’s finances.  The bankruptcy court agreed and the defendant appealed.

Held: Affirmed.  Defendant’s obligation to plaintiff is nondischargeable.

Rules/Reasoning:

Normally, a bankruptcy filing gives a debtor a reprieve from creditor collection efforts and forgives (or “discharges”) most of his debts. 

An exception is where the bankrupt debtor engages in fraud, defalcation, embezzlement or larceny.  11 U.S.C. §. 523.

The creditor must show (1) an express trust or fiduciary relationship between the debtor and creditor, and (2) that the debt was caused by fraud or defalcation.  Defalcation equals (roughly) intentional conduct that’s more than negligence but less than fraud.  * 4, 8.

Express Trust – State and Federal Law

The court held that the parties’ business relationship constituted an express trust. 

In Illinois, an express trust exists where (1) there is an intent to create a trust, (2) definite subject matter or trust property, (3) trust beneficiaries, (4) a trustee, (5) a specific trust purpose, and (6) delivery of trust property to the trustee. 

While trusts are normally manifested in a writing (such as a will or property deed), it doesn’t have to be and a trust can be shown through circumstantial evidence. 

The Federal courts view the trust hallmarks as (1) segregation of funds (no commingling, e.g.), (2) management of the funds by an intermediary, and (3) the entity that controls the trust funds or property has only bare legal title to the funds.  *6.

The court found the evidence established a trust arrangement between the parties.  There was an intent to create a trust, trust property (loan funds), subject matter (the house), a trustee (defendant), a beneficiary (plaintiff) and delivery of the trust property.  *5.

Fiduciary Duty

The Court also blocked defendant’s discharge because defendant breached his fiduciary duties to the plaintiff.  Federal law defines a fiduciary relationship as one where there is an imbalance of power between parties and a stronger party takes advantage of weaker one.

Here, the defendant occupied a position of power and influence over the plaintiff and abused the position by excluding the plaintiff from all aspects of the parties business. *7.

Defalcation

Finally, the Court refused to discharge defendant’s debt to plaintiff because of the defendant’s “defalcation.”  

Defalcation applies where a debtor’s conduct is intentional or criminally reckless.  The conduct must go beyond negligence, doesn’t rise to the level of fraud, but still requires subjective intent. 

Defendant’s conduct easily met the defalcation standard.  He engaged in a pattern of secretive and ethically challenged business activity by submitting inflated sworn statements and phantom receipts, commingling funds, and hiding project data from the plaintiff.   *8-9.  

Comments:

(1)  An express trust will exist where someone gives money or property to another with explicit directions as to how to apply those funds; and no writing is required;

(3) a creditor can defeat a bankrupt debtor’s discharge if it can show the debtor intentionally or recklessly violates an obligation to the creditor – even if the debtor’s conduct doesn’t rise to the level of fraud.

 

Building Owner’s Lawsuit Against Security Firm Rejected in Chicago Jeweler Building Damage Case

mallers

This post involves a storied building in Chicago’s Diamond District.  St. Paul Mercury Insurance v. Aargus Security Systems, Inc., 2013 IL App (1st) 120784, examines the nature and scope of an independent contractor’s liability in a multi-million dollar property damage case.

Facts:

The Mallers Building (see 1993 article here) is a nearly century-old, 21-story building in downtown Chicago that primarily houses jeweler tenants.  In the early 1990s, the building owner entered into a written security services contract with the defendant to monitor tenant and visitor access to and from the building.

The building’s insurer sued when a propane tank being delivered to a tenant exploded, causing some $14M in property damage.  The plaintiff claimed the security firm breached the security contract and was negligent in allowing the tank into the building.

The trial court granted summary judgment for the security firm and the insurer appealed.

Result: Affirmed.

Rules/Reasoning:

Plaintiff’s breach of contract claim failed since the contract didn’t require the defendant to check, inspect or prevent the delivery of propane tanks to the building or to know and enforce City building code rules governing dangerous materials.   The court also pointed out that the owner knew about prior propane deliveries to the site for years since Jewelers routinely use the tanks in their day-to-day business. ¶¶ 62-64.

The Court also disagreed with plaintiff’s argument that the security agreement was ambiguous and that extrinsic evidence was necessary to explain the full scope of defendant’s security duties at the building.  The Court found the security contract plainly stated the parties’ respective rights and obligations and nothing in either the security contract or a separate security manual (an internal handbook that didn’t involve the owner) could be construed to impose a duty on the defendant to stop propane tanks from entering the building. ¶¶ 62-64.

Plaintiff’s negligence claim also failed.  An Illinois negligence plaintiff must plead and prove that (1) a defendant owed a duty of care, (2) that he breached that duty of care, and (3) the breach proximately caused (4) injury to the plaintiff.  ¶ 58.

Duty means an obligation to conform a defendant’s standard of conduct for the protection of another against an unreasonable risk of harm.  Whether a defendant owes a legal duty to the plaintiff is a question of law decided by the court.  If the defendant doesn’t owe a duty to the plaintiff, the defendant is entitled to summary judgment.  ¶ 58.

Here, based on the clear language of the security contract and the security firm’s own internal manual, the defendant owed no duty to personally inspect or prevent the delivery of propane tanks to the site. ¶ 62.

The Court also rejected plaintiff’s “voluntary undertaking” negligence argument.  The voluntary undertaking rule posits that when a defendant gratuitously provides services to another (think Good Samaritan), the defendant can be liable to the plaintiff if the defendant causes bodily harm to the plaintiff based on the defendant’s failure to exercise ordinary care. ¶ 61.

The voluntary undertaking rule didn’t apply though because (1) the rule is narrowly construed in Illinois and (2) defendant’s services weren’t gratuitous: it was being paid by the hour for its security services. ¶ 61-62.

The Court also struck two of plaintiff’s security experts’ affidavits under Supreme Court Rule 191.

Rule 191 requires affidavit testimony to be factual, based on personal knowledge and not based on speculation, hearsay, opinion or legal conclusions.  The Rule also requires that any documents referenced be attached and verified.  SCR 191; ¶¶ 68-70.

The court found the security experts’ opinions that the defendant breached its duties to the owner were conclusory and irrelevant since duty is a question of law for the court; not for the experts.  The Court also discounted plaintiff’s experts’ affidavits since neither expert had any involvement in the negotiation of the security contract or had regular involvement in the building’s operations.  ¶ 72.

Take-aways:

– Where a negligence duty is premised on a breach of contract, the terms of the written contract will control;

– a party’s legal duty to another won’t be expanded beyond contract terms where a contract governs the parties’ relationship (note: this rule doesn’t apply if there’s special relationship or inequality between the parties)

– voluntary undertaking rule is construed narrowly and only applies in limited fact settings;

– Rule 191 affidavits (opposing or supporting summary judgment) must be present-tense factual and not speculative or conclusory.

 

 

Illinois Lawyer’s Practice Management Software Qualifies for Trade Secret Protection

Geraci v. Amidon, 2013 IL App (2d) 120023-U, exhaustively analyzes Illinois trade secrets law in the context of a pitched battle between two competing law firms and their respective practice management software programs. 

The plaintiff, a bankruptcy attorney whose ubiquitous television presence is likely familiar to most Chicagoland viewers, sued a former employee and competing bankruptcy firm under the Illinois Trade Secrets Act, 765 ILCS 1065/1 (ITSA) claiming the former employee pilfered the plaintiff’s secret  practice management software and used it while working for the competing firm. 

Defendants argued that the software was an independent creation of the former employee’s and wasn’t a trade secret.  The trial court granted summary judgment for defendants.

Result: Trial court reversed.

Reasoning:

The Second District held that plaintiff raised a genuine issue of fact on his trade secrets claim sufficient to defeat summary judgment.

An Illinois trade secrets plaintiff must show (1) the existence of a trade secret, and (2) use of that secret by the defendant in the defendant’s business. 

To establish that information is a trade secret, a plaintiff must demonstrate that the information is sufficiently secret to provide economic value to the trade secret’s holder, is not within the realm of general knowledge and skills of a given industry, and that the information can’t be readily duplicated without major time, effort and monetary expense.   ¶ 76; 765 ILCS 1065/2(d). 

A claimed trade secret doesn’t have to rise the level of a protected patent and computer software can qualify as a trade secret under Illinois law. ¶ 77.

The Court held that plaintiff produced sufficient evidence that the software was a trade secret and that defendants used that program in their competing business.

On the “sufficiently secret” trade secrets prong, the Court pointed to plaintiff’s evidence that the software was the first of its kind in the industry and there were no comparable programs when plaintiff developed it in the late 1980s. 

The Court also found that plaintiff’s software had economic value based on plaintiff’s affidavit testimony that the program was the “single most important aspect” of running his law firm and that he developed the software over two decades and at an expense of several million dollars.  Geraci ¶¶ 80, 83.

The Second District also found that plaintiff offered enough evidence that he tried to keep the software secret; citing as examples plaintiff requiring employees to sign confidentiality agreements, preventing employees from taking the software code off-site, password-protecting firm computers and sequestering the firm server in a locked room.  ¶¶ 5-51, 79.  Taken together, these efforts adequately demonstrated plaintiff’s efforts to maintain the software’s secrecy to survive defendants’ summary judgment motion. 

Plaintiff also offered enough evidence that defendants misappropriated the software. program under trade secrets law.  

Misappropriation means disclosure or use of another’s trade secret without express or implied consent.  ¶ 85, 765 ILCS 1065/2(b)(2)(B)(ii).  Plaintiff’s expert witness testified that there were too many similarities between the competing software programs to be a mere coincidence.   The defendant also admitted that he regularly took copies of plaintiff’s program home with him while employed by plaintiff.  This was at least circumstantial evidence of misappropriation to raise a contested fact question for a later trial.  ¶ 96.

Take-aways:  Tedious (at times) technical analysis aside, Geraci provides a thorough synopsis of the key elements and factors which govern the prosecution and defense of a trade secrets case.  The case illustrates the quantum of evidence needed to establish the existence of a trade secret and that it was impermissibly used by a defendant. 

The case also shows how expensive it is to state a colorable trade secrets case and that, at least in the context of warring software programs, how crucial it is to have a computer expert’s testimony to support a trade secrets claim.  Without detailed expert testimony on the similarities between the two competing software programs, it’s clear that plaintiff would have lost his trade secrets claim.