Wednesday, July 28, 2010

Maintaining Proper Lien Law Trust Records to Avoid Liability

The Lien Law trust laws, contained within Article 3A of the Lien Law, are something that most contractors have heard of, but very few understand.  This is unfortunate since the Lien Law trust laws are one of the few areas of the law that are, arguably, intended to protect contractors, or more particularly, subcontractors, suppliers and vendors (as opposed to owners).  In a nutshell, Article 3A of the Lien Law requires every "trustee" to keep all funds that he receives on a construction project in a "trust account" for the benefit of the trust beneficiaries. Just who is a trustee is not always clear but the following general guidelines may be helpful:  1) if an owner receives a construction loan the owner is a trustee; 2) a general contractor is always a trustee of funds received from the owner; 3) a subcontractor can be a trustee if he, she or it owes money to a sub-subcontractor, materialman, vendor or supplier; or 4) a sub-subcontractor and beyond can be a trustee under the same circumstances as a subcontractor.  A simple rule of thumb is that if you are receiving money on a construction project in the State of New York and you owe money to someone else for labor or materials that they supplied to you on that same project then you most likely are a Lien Law trustee and all monies that you receive are "trust funds."

Lien Law trustees must pay all beneficiaries of the trust before they can use the funds for non-trust purposes.  Most importantly, you cannot use the funds for another project and you cannot use the funds to take your profit until you have satisfied all trust claims.  While the Lien Law does require you to maintain these funds in a trust account, it is generally accepted that you do not need a separate account for each project.  Rather, you must keep separate books and records for each project.  But keeping the funds in one account is not, in and of itself, a trust violation.  Your books and records for the project should show the name of the project, the date and amount of payments received and the date, amount and payee of each payment made from the trust funds.  For example, if the general contractor (GC) receives a $100,000 payment from Owner (O) on Project X and then pays $25,000 to Subcontractor A, $25,000 to subcontractor B and $25,000 to supplier C, each of those transactions must show up on GC's books and records.  Each would be a proper use of the Lien Law trust funds.  The remaining $25,000 from O on Project X, assuming no other beneficiaries have trust claims, can be used by the GC as it sees fit whether that be to take profit, use on another project or something else.

In the above example, GC gets into trouble when Subcontractor D is still owed money but rather than pay Subcontractor D, GC takes $25,000 to order materials for Project Z.  This scenario results in a Lien Law trust violation.  The consequences can be disastrous for the trustee.  First, the court has the ability to order the trust funds repaid if possible.  Second, diversion of trust funds is a crime that you can be prosecuted for.  Third, diversion of trust funds exposes corporate principals to personal liability.  Fourth, diversion of trust funds exposes the trustee to potential punitive damages and attorneys' fees awards.  In summary, diverting trust funds can put you in a whole heap of trouble.  While troublesome for the trustee, everyone below him that was owed money and was not paid is offered the additional leverage of the trust claim in their pursuit of the money they are due on the project.

Lien Law Section 75 requires all trustees to maintain careful and accurate books and records of all of these trust transactions.  Failure to maintain proper books and records creates a legal presumption that the trust laws have been violated.  While not a final determination, overcoming this presumption in litigation can be very difficult and, in many cases, impossible.  As a beneficiary of the trust, you are allowed, under Lien Law Section 76, to demand that the trustee provide you with a verified statement, in writing, showing each of the entries on the books and records of the trust account.  In other words, if a general contractor tells you he hasn't paid you because the owner hasn't paid him you can demand to see his books and records for the project and the general contractor is legally required to disclose them to you.

Another significant reason to be concerned about the Lien Law trust laws is that a contractor, or contractor's principal, that is found to have diverted trust funds, and is found liable for that diversion, cannot discharge the claim in bankruptcy.  That means the debt will follow the contractor for at least 10 years, and more likely 20 years, and there will be no way for the contractor to get away from it.  While that is a long time to wait, it is an added security for the subcontractors that are not paid as they will be able to pursue their claim notwithstanding a bankruptcy.  Especially in the current economy where many general contractors are declaring bankruptcy, being able to pursue a claim despite the bankruptcy is a strong deterrent against general contractors diverting trust funds instead of paying their subcontractors. 

One very important caveat:  a Lien Law trust fund claim has a very short statute of limitations.  It must be brought within 1 year from the time that either the project was completed (if you are a general contractor) or 1 year  from the time that the payment was due from the general contractor or the project was completed, whichever is later (if you are a subcontractor).   Therefore, you must stay on top of anyone that owes you money and keep careful track of the money.  Don't be afraid to exercise your rights under Lien Law Section 76 if you have not been paid and you think someone may have diverted money on the project.  When in doubt, contact your attorney to find out what rights you have and to make sure you preserve any potential claims you may have.  A good construction attorney will be able to use tools such as the demand pursuant to Lien Law Section 8 or the demand for a verified statement pursuant to Lien Law Section 76 to help establish and set up a trust diversion claim for you. 

Vincent T. Pallaci is a partner in the New York law firm of Kushnick Pallaci, PLLC.  His practice focuses primarily on the area of construction law including prosecuting and defending claims for diversions of New York Lien Law trust laws.  KP has offices in the NYC metro area and in Buffalo, New York allowing it to provides legal services across the State of New York.

10 comments:

  1. Hi ,,,
    This is an interesting article. Question:
    If a contractor was unaware of the Lein Law.. and never set up a trust.. the project was completed,, and then less than a year later, the homeowner decides to sue the contractor for the amount,,, using the Lein Law as their suit...
    IS there any protection for the contractor?
    And what type of ramifications will result in their wording of "larceny",, criminal consequences?"
    Please help!?

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  2. I will respond to your comment with general information - if you are looking for specific legal advice on a specific set of facts you can contact me at vtp@kushnicklaw.com.

    In general terms, a contractor's lack of knowledge of the lien law trust provisions is not a defense to violation of the trust provisions of the Lien Law. Most courts have held that a contractor does not need to set up a separate "trust fund" in order to be in compliance with Lien Law Article 3A. A claim cannot be made against a contractor simply because the contractor failed to set up a separate trust account. The Lien Law trust provisions require the contractor to keep track of certain books and records on a project (See Lien Law Section 75). A beneficiary of the trust that has suffered harm because of a lien law trust violation can bring a claim against the trustee (the contractor) for damages arising out of that violation. Failure to maintain the proper books and records of the trust give rise to an assumption that a violation occurred. The trustee (contractor) can overcome that assumption with evidence but it is very difficult.

    If the proper books and records have been maintained then the party seeking damages for an alleged violation must establish a trust violation rather than the violation being presumed.

    Violations of Lien Law Article 3A can lead to criminal charges.

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  3. Thank you for your reply... I found it very helpful. Your site has been interesting to read.

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  4. For government work once a lien is filed what percentage of that lien amount is the government agency legally allowed to withhold?

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  5. If a homeowner is in arrears to a contractor for 100K, and then that homeowner gives a check to the contractor for 35K as a deposit toward cabinets,(keep in mind the homeowner is still in arrears 100K) but the contractor sent only half of the cabinet deposit to the cabinet company but the contractor used the remaining cabinet funds for labor and material toward the homeowners project other than cabinets...and over time, the homeowner became in arrears an additional 370K...can the contractor be guilty of lien law violation 3a? (and note, the owner used his personal funds on the project, which I believe is not considered a trust fund asset)

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  6. Your question is very specific and you need an attorney to look over your books and records to determine if there is a potential trust violation. However, in general, the scenario you laid out does not absolve the contractor from liability under Article 3A. The trustee (contractor) may not use the trust assets for ANY non-trust purpose until all trust liabilities are satisfied. However, the trustee has the freedom to determine the order of trust payments as long as each is a valid trust expenditure. So it is possible that the $35K could be used towards other items. The problem is the designation as a deposit for cabinets. If that was designated specifically for a cabinet, a potential trust diversion exists.

    As to the source of the funds, while the home owner is not a trustee because he used his own funds, the money once transferred to the contractor became trust funds for which the contractor is liable as trustee.

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    1. I have a complex issue at hand. Because of the complexities, would you be willing to meet with me and consult on the issue?

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  7. E-mail me at vtp@kushnicklaw.com to discuss setting up

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  8. One question before I set an appt with you. In another article you wrote about diversion of funds, you wrote the following;

    "Of course not all uses of the trust asset are improper or illegal. So we look to the next element of the Lien Law trust fund diversion claim. That money that the contractor received on Project X must be "used for any purpose other than a trust purpose. The logical question then becomes what is a trust purpose? Lien Law Section 72 points us towards the answer in Lien Law Section 71.

    There are two parts of Lien Law Section 71. Sub part 1 of Lien Law Section 71 says that the trust funds that contractor is holding on Project X can be used and applied for "payment of the cost of improvement." Quite simply that means contractor can use the trust funds for Project X to pay for costs of construction on Project X (for example he can use the trust funds to pay for supplies). Sub part 2 of Lien Law Section 71 then gives us a nice list of exactly what types of things the contractor, as trustee, can pay with the Project X trust funds. Section 72(2) says the funds can be used to pay:

    (a) payment of claims of subcontractors, architects, engineers, surveyors, laborers and materialmen;"

    In your article about diversion of funds, you state that funds for project x must be used on project x.

    I did use a portion of cabinet trust funds for project x on project x...Meaning... a deposit was given that was originally slated for cabinets. A portion of the cabinet deposit was used to cover costs for other approved improvements on his project. Costs that I paid out of my pocket to the tune of over 350K of improvements to his house for costs of material and labor on the project and have not yet been paid for.
    So I am very confused why you would state using cabinet funds for another approved improvement on his project (especially when he owes me 10 times the amount of the deposit) might be a trust fund violation?

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