By: Thomas S. Tripodianos Published: March 2013

Restoration Defense to Trust Funds Diversion Claim

Question. General Contractor was hired by Owner to construct a building (the "Project") in Manhattan. Allegedly owed approximately $11 million, General Contractor contends that Owner has diverted certain New York's Lien Law trust fund monies owed to General Contractor and, ultimately, the subcontractors that worked on the Project. Owner restored the funds and has made them available in the form of present cash to meet future trust claims as they matured. Does the restoration of the funds establish a defense to General Contractor's trust fund diversion claim?

Answer. YES. The Developer established a restoration defense to the trust funds diversion claim asserted by the general contractor.

Owner borrowed monies to fund the construction of the Project. The Construction and Project Loans were advanced as construction progressed. Owner requested advances by submitting monthly Draw Requests to the Bank. The Draw Requests had to be accompanied by a Draw Request Certification that contained affirmative representations by Owner to The Bank that, among other things, the funds being drawn would be applied to fund the Project.

On June 28, 2007, Owner entered into a contract with General Contractor that designated General Contractor as the Construction Manager for the Project. General Contractor entered into subcontracts with various trade contractors and vendors to perform the necessary work. Owner was not in privity with the subcontractors; it paid General Contractor and General Contractor was responsible for paying the subcontractors.

The Bank funded certain requisitions but Owner failed to remit all of the funded proceeds to General Contractor. In addition, Owner sold condominium units and paid the proceeds to The Bank rather than General Contractor in satisfaction of its loan obligations. In a nutshell, General Contractor alleges that the funded requisitions and sales proceeds were trust funds under New York's Lien Law that Owner illegally diverted and all such trust funds should be recovered and returned to the benefit of General Contractor and the Trade Contractors, as the trust beneficiaries.

An agreement was eventually reached that contemplated the sale of the hotel portion of the Project free and clear of all liens, claims and interests. Some of the sale proceeds would be paid to The Bank in partial satisfaction of its claim. Some monies would fund an $11 million Trust Fund Account for the benefit of the Lien Law/trust fund claimants. The $11 million contribution to the Trust Fund Account was not an arbitrary amount, and reflected a settlement.

Owner concedes that the money it requisitioned from The Bank and the net proceeds from the sale of the condominium units constituted trust funds. It argues, however, that it did not divert these funds because it used them to pay other trust fund obligations. Furthermore, even if it diverted trust funds, it restored the diverted funds through the establishment of the $11 million Trust Fund Account under the Plan.

Under Article 3-A of the New York Lien Law, an owner holds in trust the funds received in connection with a contract for the improvement of real property, as well as any rights of action with respect to those funds. N.Y. Lien Law § 70. The trust comes into "existence from the time of the making of the contract ... out of which the claim arises." N.Y. Lien Law § 71(5). It continues "with respect to every asset of the trust until every trust claim ... has been paid or discharged, or until such assets have been applied for the purposes of the trust." N.Y. Lien Law § 70(3).

Trust funds must be "held and applied for the payment of the cost of improvement." N.Y. Lien Law § 71(1). If the trustee is the owner, trust claims include "claims of contractors, subcontractors, architects, engineers, surveyors, laborers and materialmen arising out of the improvement, for which the owner is obligated, and also means any obligation of the owner incurred in connection with the improvement for a payment or expenditure defined as cost of improvement." N.Y. Lien Law § 71(3)(a); accord N.Y. Lien Law § 2(5) (defining "cost of improvement"). The trustee holds bare legal title to the trust funds, and an equitable interest vests in the balance of the trust funds only after all trust claims have been satisfied.

The use of trust funds for non-trust purposes constitutes a diversion, and if done voluntarily by the trustee, is also a breach of trust. N.Y. Lien Law § 72(1). The failure to maintain the books and records required by the Lien Law regarding the trust creates a presumption that trust funds have been diverted, see N.Y. Lien Law § 75(4), but the presumption is only a "permissible inference" and does not shift the burden of proof. Furthermore, the trustee is not required to segregate the trust assets, and may treat the trust funds as running bookkeeping balances rather than as segregated accounts.

The use of trust funds to pay the Project Loan was improper, and constituted a diversion for two reasons. First, the payment of the Project Loan was not a "cost of improvement." A "cost of improvement" as defined by N.Y. Lien Law § 2(5). Second, even if the repayment of the Project Loan was a "cost of improvement," the use of trust funds was still a diversion because The Bank never filed a Notice of Lending. See Section 73(2) of the Lien Law.

While General Contractor has demonstrated that Owner diverted trust funds, Owner has established a defense of partial restoration. A trustee or its assignee may defend against a diversion claim by showing that the diverted funds have been restored, and that the funds are available to pay trust claims. The restoration defense is based on the principle that the law is not designed to impose a penalty upon a violator so as to create a windfall of double repayment for creditors. Moreover, voluntary restoration serves the same purpose as an order directing one liable for diversion to post security to assure the proper distribution of trust assets, or furnish assurance in any other manner that trust funds will be available to pay trust claims. In either case, the spirit of the Lien Law is fulfilled and trust beneficiaries can rely on the restored fund for the payment of their claims.

The settlement that led to the funding of the $11 million Trust Fund Account was intended to restore the trust up to that amount. The amount of the Trust Fund Account was based on the amount of General Contractor's claim, and reestablished the trust in a segregated account.

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