Another option

Editor's note: Although it is Professional Roofing's policy to provide location information for companies mentioned in articles, some locations are missing from this article because information about the companies in question could not be found.

You most likely are well aware of the three most common legal remedies you can employ when payment is not made: instituting a legal claim for breach of contract; filing a mechanic's lien on private projects; and making a claim on a labor and material payment bond for public projects and bonded private projects. However, another—and potentially potent—remedy may be available: trust fund statutes.

Trust fund statutes have been enacted by state legislatures to ensure payments made on construction projects are used to pay the people and firms that provided labor and materials. At the same time, trust fund statutes also are intended to benefit building owners so compensation paid by an owner for a specific job will not be misused.

In states with trust fund statutes, money paid by a building owner to a general contractor is considered a trust fund, which must be held in trust for subcontractors and suppliers. When an owner pays a general contractor, the general contractor is considered the trustee and subcontractors and suppliers are beneficiaries of the trust. As the trustee, the general contractor cannot use a trust fund to reimburse himself or herself or pay for other jobs or any person until beneficiaries have been paid. Failure to abide by a trust fund statute can result in civil and, in some states, personal and criminal liability for the officers and representatives who diverted trust funds.

Just as a general contractor is the trustee for funds received from an owner, in states with trust fund statutes, subcontractors are trustees for downstream sub-subcontractors and suppliers who provided labor and materials to them. Therefore, a subcontractor could be a beneficiary and trustee.

In some states, building owners also are subject to the trust fund statute. In those states, a loan extended to a building owner for property improvement must be used to pay the contractor and others who perform the improvements.

States with trust fund statutes

Arizona, Colorado, Delaware, Illinois, Maryland, Michigan, Minnesota, New Jersey, New York, Oklahoma, Texas and Wisconsin have enacted construction trust fund statutes. Many of these statutes were enacted more than 50 years ago; the Wisconsin statute was enacted nearly 100 years ago. Although trust fund statutes vary by state, all trust fund statutes provide a civil remedy so trust fund beneficiaries can bring civil suits against parties who use trust funds for any purpose other than paying subcontractors and suppliers.

The trust fund statutes in Arizona, Colorado, Maryland, Michigan, Minnesota, New Jersey, Oklahoma, Texas and Wisconsin also entitle trust fund beneficiaries to recover payment personally from corporate officers, directors and agents who had responsibility for diverting trust fund assets.

The parties entitled to the benefit of trust fund statutes vary among states. In some states, such as Colorado, New York and Oklahoma, only parties who are entitled to file a mechanic's lien are covered under the construction trust fund statute. The Arizona statute applies only to owner-occupied residential construction. The Illinois statute applies only to projects where lien waivers are required. New Jersey has separate construction trust fund statutes for public projects and private parties who have paid toward the purchase of a residence.

In addition to states with trust fund statutes, 15 states have criminal statutes applicable to contractors who receive payment but fail to pay those who furnished labor and materials. Criminal construction nonpayment statutes are on the books in Arkansas, California, Florida, Georgia, Indiana, Kentucky, Louisiana, Massachusetts, Nebraska, Nevada, New Mexico, South Carolina, South Dakota, Tennessee and Virginia. However, because these criminal statutes do not provide a civil remedy and require a higher standard of culpability, they are not frequently invoked.

New York

New York has one of the oldest and most comprehensive trust fund statutes. The New York statute applies to all funds, including construction loans and mortgages, paid to an owner, contractor or subcontractor for an improvement to either private or public property. The funds the owner, contractor or subcontractor receives are designated by statute as trust funds that are to be held by the recipient on behalf of the beneficiaries who provided labor and materials to the trustee. Owners, contractors and subcontractors who receive funds are trustees. Suppliers are not trustees.

All parties who are entitled to file a mechanic's lien in New York are covered under the trust fund statute and considered trust beneficiaries. However, even if a subcontractor or supplier has waived his or her lien rights, allowed lien rights to expire or failed to comply with the procedural requirements to perfect a lien, the subcontractor or supplier still can assert a claim under New York's construction trust fund statute.

A trust comes into existence when payment is first made and continues until all claimants have been paid or the trust is exhausted. The trustee can use trust funds only for trust purposes, meaning trust funds must be used to pay parties who supplied labor or materials to the trustee before any trust funds can be used for any other purpose.

For instance, trust funds cannot be used to pay the trustee's office rent or salaries until beneficiaries have been paid. Once all claims have been paid, the trustee is entitled to the balance of the trust's assets, which then become the trustee's property. Only then can the trustee pay overhead or other debts unrelated to construction of the project for which trust funds were received.

The New York trust fund statute expressly creates a fiduciary relationship between a trustee and beneficiary. As a result of having a fiduciary relationship, the trustee owes duties and loyalties to its beneficiaries, including a duty to keep and render accounts for the beneficiaries, a duty to keep trust funds separate from the trustee's funds, and a duty to furnish beneficiaries' information and permit beneficiaries to examine the trust's accounts.

A trustee is not required to maintain a separate bank account for each project's trust funds, but the trustee's books must clearly show what funds were received and paid on each trust.

Separate books must be maintained for each construction project, and the books must be kept separate from the trustee's office overhead and expense accounts. Failure to keep the required records is considered presumptive evidence that the trustee diverted or consented to the diversion of trust funds for nontrust purposes.

New York law prohibits using trust funds for any purpose other than those directly related to the particular improvement for which the funds were received. If trust funds are used for some other purpose, the trustee and recipient of the funds have liability if the recipient knowingly received trust funds. The requirements of the New York trust fund statute arise automatically and cannot be waived by contract.

Michigan

Similar to the New York trust fund statute, the Michigan Builder's Trust Fund Act provides that any funds paid to a contractor or subcontractor are to be considered trust funds and that contractors and subcontractors are to be considered trustees of all funds paid to them for building construction purposes. But unlike New York's statute, Michigan's act does not apply to building owners. However, it goes further than the New York statute by establishing civil and criminal personal liability on individuals within contracting and subcontracting firms who violate the statute.

The Michigan Builder's Trust Fund Act states any contractor or subcontractor who, with intent to defraud, retains or uses any of the payment made to him or her for any purpose other than to pay laborers, subcontractors and materialmen will be guilty of a felony if any funds are appropriated to his or her use and terms of his or her contract remain unpaid.

A criminal proceeding may be brought against the contractor, and upon conviction, the individuals who were responsible for the diversion of funds can be fined and imprisoned up to three years at the court's discretion. By the terms of the Michigan law, the use by a contractor or subcontractor of any money paid to him or her before paying laborers, subcontractors, materialmen or others entitled to payment is deemed to be evidence of intent to defraud.

In the 2007 case Livonia Building Materials Co. v. Harrison Construction Co., the Michigan Court of Appeals demonstrated the potential effect of the presumption that nonpayment is evidence of intent to defraud.

In the case, Harrison Construction went out of business because of financial problems in 2003 without paying debts owed to Livonia Building Materials Co., Livonia, Mich., one of its material suppliers. Livonia Building Materials filed suit against Harrison Construction; Henry Bell, Harrison Construction's president and chief operating officer; and Keith Penner, Harrison Construction's treasurer and chief financial officer, asserting claims under the Michigan Builders' Trust Fund Act.

Because of Harrison Construction's lack of assets to pay a judgment, Livonia Building Materials sought to establish that Bell and Penner had personal liability under the Michigan Builders' Trust Fund Act. During the trial, evidence was presented that Harrison Construction had received payment for jobs for which Livonia Building Materials had supplied materials but had not been paid.

Harrison Construction's lawyers argued there was no specific evidence Harrison Construction or its officers had used money received from jobs where Livonia Building Materials had supplied materials to pay debts owed on other jobs. They also said Harrison Construction was a victim of a bad economy and simply did not have enough money to pay everyone to whom money was owed.

Overruling a jury verdict that found Bell personally liable for $60,600 and Penner liable for $40,400 under the Michigan Builder's Trust Fund Act, the trial court judge exonerated Bell and Penner on the grounds that Livonia Building Materials had not demonstrated the defendants had intent to defraud. Livonia Building Materials appealed the trial court judge's decision to the Michigan Court of Appeals.

The Michigan Court of Appeals reversed the trial court judge's decision, finding the jury's verdict of personal liability should be reinstated because of the statutory presumption that nonpayment is evidence of intent to defraud. The court pointed out the Michigan Builder's Trust Fund Act states intent to defraud is evidenced simply by appropriation of any money paid to a contractor before payment by the contractor of all money owed.

In this case, it was undisputed that Harrison Construction had received payment for projects for which Livonia Building Materials supplied the materials, yet Harrison Construction did not pay Livonia Building Materials; this, by itself, said the court, gave rise to a reasonable inference of Harrison Construction's misappropriation of trust funds before all payments were made to those entitled to receive payment.

In reversing the trial court judge's decision, the Michigan Court of Appeals said the defendants' general assertion that there was not enough money to go around was not sufficient to rebut the presumption of misappropriation. The court noted all money received by Harrison Construction and two other entities controlled by the defendants was placed in one account and all money owed was paid from this account without regard for the requirements of the Michigan Builders' Trust Fund Act, including payments to parties who were not protected by the trust fund statute.

In its opinion, the Michigan Court of Appeals made it clear that difficulties posed by a downturn in the economy or poor business acumen do not excuse noncompliance with the act's obligations regarding accounting practices and ordering of payment. Although Penner and Bell may not have acted in bad faith and were simply trying to keep their business afloat by paying the most urgent outstanding invoices, the court emphasized the act's requirements must be followed, concluding appropriation of money to others outside the protected class was sufficient evidence of intent to defraud. As a result, Bell and Penner were personally liable to Livonia Building Materials.

Colorado

In addition to establishing personal liability, trust fund statutes have had the effect of barring an individual construction trust fund debtor from being able to obtain a discharge of that debt in a bankruptcy proceeding.

Because some trust fund statutes and court decisions interpreting such statutes state a fiduciary obligation is owed by a construction trustee to beneficiaries, a debt under a construction trust fund statute might not be eligible to be discharged or released even if the debtor files for personal bankruptcy as the owners of a Colorado roofing company learned a few years ago.

Jeffrey and Kerrie Regan were the sole shareholders, officers and directors of Eagle Roofing Inc. Jeffrey served as the company's president, and Kerrie served as secretary and treasurer. Kerrie acted as the bookkeeper from the company's inception in 1997. As the business' sole owners and operators, the Regans controlled the cash flow and made all the necessary financial decisions for the company. Eagle Roofing did not keep separate files for each project but rather maintained a general file for each building owner.

Eagle Roofing opened a credit account with a roofing materials distributor, Fowler & Peth Inc., Denver, to acquire roofing materials and supplies. In 2000, because of cash flow problems, Eagle Roofing decided to pay its suppliers, including Fowler & Peth, based on invoice dates regardless of the project for which money was allocated.

In addition, a portion of project revenues received by Eagle Roofing was used to pay for the Regans' personal living expenses and other general business expenses. As a result, though Eagle Roofing had received full payment for materials supplied by Fowler & Peth for some jobs, Fowler & Peth had not received full payment for all the materials it supplied.

In April 2003, the Regans filed for personal bankruptcy under Chapter 7 of the U.S. bankruptcy code. At the time, Eagle Roofing owed $48,185.03 to Fowler & Peth. During the bankruptcy proceeding, Fowler & Peth asserted the Regans should be held personally liable for the outstanding debt owed to Fowler & Peth and that the Regans should not be entitled to have the debt discharged based on the Colorado mechanic's lien trust fund statute.

Similar to trust fund statutes in several other states, Colorado's trust fund statute applies to parties who are entitled to file a mechanic's lien. Fowler & Peth was within the class of parties eligible to file a mechanic's lien but had not done so, and the time to file a lien had expired. One issue facing the court was whether, under the Colorado trust fund statute, Fowler & Peth was required or able to file a lien to invoke the statute.

Although debts typically are discharged in a bankruptcy proceeding, Section 523(a)(4) of the U.S. bankruptcy code provides that a debtor is not discharged from a debt arising out of misuse of funds when acting in a fiduciary capacity. Breach of a fiduciary duty or relationship exists when there is a specific trust obligation imposed by law, separate from a breach of contract.

Colorado courts have ruled Colorado's mechanic's lien trust fund statute, which states all funds disbursed to any contractor or subcontractor under any construction contract are to be held in trust for the payment of subcontractors, material suppliers or laborers who may have a lien against the property, creates a fiduciary relationship.

Kerrie testified payments received by Eagle Roofing from building owners and general contractors were deposited into a general Eagle Roofing corporate account and that funds from this account were used to pay all corporate obligations, as well as certain personal expenses. She testified that at the end of the year, Eagle Roofing's accountant would reconcile all personal expenses for tax purposes.

Based on this testimony, the bankruptcy court found Eagle Roofing used money, which it was to hold in trust as required by Colorado's mechanic's lien trust fund statute, for purposes other than payment of suppliers and laborers and, therefore, breached a fiduciary obligation. The bankruptcy court ruled Colorado's trust fund statute "appears to provide wronged laborers and materialmen with a second source of protection and relief, separate and apart from the traditional mechanic's lien practice."

The Colorado statute does not expressly state officers, directors or agents will be personally liable for a corporation's failure to hold money in trust. Nevertheless, the bankruptcy court found the Regans were personally liable to Fowler & Peth because as corporate officers and directors of Eagle Roofing they had knowingly misappropriated trust fund property.

Furthermore, the bankruptcy court ruled, the Regans' personal liability to Fowler & Peth would not be discharged in the Regans' personal bankruptcy proceeding. The bankruptcy court concluded that because the Regans were the controlling officers and directors who made a conscious decision to use funds that were to be held in trust for other corporate and personal purposes, "they must suffer the consequences of those actions even if they seek the protection of the bankruptcy laws."

The Regans appealed to the U.S. District Court for the District of Colorado arguing Fowler & Peth was not entitled to protection under the Colorado Mechanic's Lien Trust Fund Statute because Fowler & Peth had not filed a mechanic's lien and the time to file a lien had expired. Interpreting the Colorado trust fund statute, the U.S. District Court agreed with the Regans' argument that Fowler & Peth could not invoke the Colorado trust fund statute because Fowler & Peth had not perfected a mechanic's lien and the time to file a lien had expired.

The U.S. District Court decision prompted Fowler & Peth to appeal to the 10th U.S. Court of Appeals, which, in turn, requested the Colorado Supreme Court to rule on the question of whether a claimant under the Colorado trust fund statute must have perfected a lien or be within the time allowed to file a lien to invoke Colorado's mechanic's lien trust fund statute.

The Colorado Supreme Court ruled in a February 2007 decision that the procedural requirements for filing a lien did not apply to a claim to invoke the trust fund statute. As a result of the Colorado Supreme Court's ruling, the 10th Circuit reversed the U.S. District Court, in effect reinstating the decision of the bankruptcy court finding the debt nondischargeable because of the fiduciary duty resulting from application of the Colorado trust fund statute.

Courts in Arizona, Delaware, Michigan and Oklahoma also have concluded a debt arising from a breach of a state construction trust fund statute is not dischargeable in bankruptcy because of the fiduciary relationship created by the trust fund statute. Courts in Maryland, New Jersey and Texas have reached a contrary conclusion and will discharge debt in a bankruptcy proceeding in the absence of proof of fraud.

Wrapping up

You should be familiar with trust fund statutes in the states in which you conduct business. Knowledge of and compliance with trust fund statutes is important to obtain the benefit of these statutes as an additional way to compel payment and avoid incurring liability for perhaps unknowingly failing to comply with the statute's requirements.

Steven J. Flynn is an attorney and Stephen M. Phillips is a partner with the Atlanta-based law firm Hendrick, Phillips, Salzman & Flatt.