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STA LEGAL LOG – MARCH 2019

DIVERSION OF CONSTUCTION TRUST FUNDS – GC FEELS COURT’S WRATH

By Henry L. Goldberg, Legal Counsel, Subcontractors Trade Association
Partner, Moritt Hock & Hamroff LLP
&
Robert Fryman
Partner, Moritt Hock & Hamroff LLP

Pursuant to Article 3-A of New York’s Lien Law, all monies received by a general contractor or subcontractor on a project are construction project trust funds. Each level that receives funds is a trustee to the next level “down.” A trustee must segregate the funds from the funds of other project’s, and ensure the funds are not used to pay non-project-specific expenses prior to paying all debts and obligations for the specific project.  As we often say, money on construction projects must flow “vertically,” not “horizontally.”

In a rare action, a New York Court recently granted “summary judgment” against a general contractor, finding that the contractor’s books and records demonstrated, without need for a trial, that the contractor had paid over $8 million to parties which were not beneficiaries for the specific project’s trust fund.

If trust funds are paid or used for any other purpose outside of the specific project, it is  considered a “diversion” of trust assets. This could leave the contractor/trustee who controlled the funds with significant, personal liability. The purpose of the trust is to ensure that all contractors working on any given project are paid for their work before the trustee (party holding the trust funds) pays themselves, or any other, non-project creditors.

Upon review of the general contractor’s records and bank account information, the court readily found that approximately $11,500,000 of the $17,500,000 of trust funds held for the project was paid for expenses totally unrelated to the project. Of the money spent, approximately $8,500,000 was paid to contractors which did not perform any work on the “project,” and another $1,500,000 was paid to a labor union on another unrelated project.

Significantly, although the general contractor argued that some of those payments were to subcontractors who worked on the subject project, the general contractor was unable to prove it. Thus, in an unusual move, the court granted summary judgment in favor of the subcontractor as compensation for the diversion of trust funds.

Perhaps most telling was that the contractor’s banks records showed that approximately $1,200,000 was paid to the general contractor’s wife and another $300,000 to his brother, ultimately leaving only $187.00 in the contractor’s operating account to pay subs and suppliers.

Fortunately for the contractor, the court determined that there was not enough evidence (at this stage of the case) to prove that the principal of the corporation general contractor knowingly diverted trust funds from the project, thus avoiding (at least temporarily, personal, and even criminal, liability). Corporate officers may be personally liable for diversion of trust funds, provided that the officer knowingly participated in or permitted the diversion of funds by the corporation.  However, the court made clear in its decision that should later evidence in the litigation demonstrate that the principal of the general contractor knowingly diverted trust funds, he could still be held personally liable.

MHH Commentary:

This case serves as a stark reminder of the fiduciary responsibilities imposed by the Lien Law. Had the general contractor/trustee kept appropriate (and statutorily required) records of all receipts and payments on the project, the court might have been able to find the payments to be valid applications of trust funds.

The recordkeeping requirements of trust fund accounting cannot be complied with after the fact.  Only with a disciplined program of tracking job-specific revenue, costs and payments, can a contractor avoid liability for trust fund diversions, whether inadvertent or not.  Consultation with experienced construction accountants and/or attorneys, familiar with the record keeping requirements of the Lien Law, and the obligations of a contractor as a trustee, is essential.

 

The granting of summary judgment by the court at the outset of the case, which deprived the defendant its day in court, was a severe reaction by a court. The court in this instance was clearly unsympathetic to the GC’s claims of innocence and had no patience for the inadequacy of the GC’s record keeping.

It also ordered the general contractor to produce its entire trust fund records to a forensic accountant, at contractor’s expense, to investigate the extent of trust fund diversions.  In addition, the court went so far as to take over control of all payments by the GC, requiring its prior approval, thereby imposing a virtual receivership of the GC on this project!

Final Thoughts: Trust fund diversion is not uncommon in construction. Too many contractors are tempted to use “good” job funds to get over a cash flow crunch on a “bad” job thinking, “what’s the harm if I use a good job for temporary funding? I will reconcile all receipts and disbursements later, when cash flow catches up on the bad job.” This case is a clear reminder of the folly of not resisting the temptation of this reasoning. As with IRS audits, you don’t want to be the one scrutinized and examined.

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Henry L. Goldberg, is a partner at Moritt Hock & Hamroff LLP, and the Chair of its Construction Practice Group.  Please feel free to contact Mr. Goldberg at (516) 873-2000 or via email at hgoldberg@moritthock.com.

Robert J. Fryman, is a partner at Moritt Hock & Hamroff LLP, and a member of its Construction Practice Group. Please feel free to contact Mr. Fryman at (516) 873-2000 or via email at rfryman@moritthock.com.