Appellate Court Reminds Contractors of the Proper Uses of Statutory Trust Funds

New York is among a handful of states where funds paid to a contractor are trust funds, and must be first used to satisfy the claims of unpaid laborers, suppliers, and subcontractors. This is to prevent the practice of “pyramiding”, where a contractor uses the funds received on Project-B to pay a subcontractor for work on Project-A. The obvious problem with pyramiding is that eventually, like all Ponzi-type arrangements, it collapses under its own weight, leaving laborers, suppliers, and lower-tier subcontractors holding the proverbial bag. In the recent case of L.C. Whitford Co., Inc. v Babcock & Wilcox Solar Energy, Inc., an appellate court reminds us that trust funds received by a general contractor must first be used to satisfy downstream claims before it can reimburse itself for what are also legitimate construction costs.

Background

In February of 2021, Babcock & Wilcox entered into contracts to construct several solar energy projects. Under these contracts, B&W was to have been paid over $12 million. B&W retained L.C. Whitford and others as subcontractors. Disputes arose on the project, and the owner ceased paying B&W. At that time, B&W had been paid only $9.5 million, but had paid out over $20 million to its subcontractors. Notwithstanding these payments, there were still nearly $7 million in subcontractor mechanic’s liens outstanding.

Ultimately, B&W settled its dispute with the owner for just over $1.2 million. Once the subcontractors learned of the settlement, they notified B&W that these funds constituted statutory trust funds under Article 3-A of New York’s Lien Law, and then demand payment accordingly. B&W responded that as the amounts B&W previously paid out exceed the amount of trust funds received, the trust had been exhausted, and thus it was free to reimburse itself for those subcontractor payments out of the settlement funds. The subcontractors immediately moved for a preliminary injunction prohibiting B&W from reimbursing itself, arguing that the settlement monies constituted statutory trust funds, and thus should be segregated. B&W pressed its position that even when adding the settlement funds to the trust funds already received, the math was clear that B&W expended over $10 million more than it received. In light of that math, B&W argued, the trust was extinguished, and the settlement funds were no longer trust funds.

Decision

The motion court issued an injunction prohibiting B&W from reimbursing itself, and requiring B&W to segregate the settlement funds. In doing so, the motion court noted the broad purpose of the trust fund statutes to protect laborers, suppliers and subcontractors who provided work and materials to the project, and that the trust also extended to unmatured rights to future payment. Further, the motion court cited well settled case law that the trust continued until all trust claims are satisfied, or until all such trust assets have been applied.

B&W appealed, and a divided appellate court affirmed with a 3-2 majority. The majority of the appellate court also cited the broad purposes of the trust fund statutes, and noted that the contractor’s trust needed to be used to pay claims of subcontractors, laborers, and suppliers, amongst other specific beneficiaries, whereas an owner’s trust permits the owner to pay for the “costs of improvement”, which is a broader category. The dissent argued that B&W’s payment of subcontractor claims with non-trust assets was for a trust purpose, and the reimbursement of those monies was proper as the monies were not going towards paying B&W’s personal debts. The dissent also noted that the practical effect of requiring a contractor in B&W’s position to pay later acquired funds to subcontractors would be that such contractors would simply withhold payment, potentially indefinitely, until such funds were received from the owner, and would refrain from making advance payments of such claims.  In order to avoid what would be viewed as penalizing a contractor from advancing its own funds to keep a project moving, the dissenters would have denied the injunction.

Comment

Both the motion court and the appellate court (both the majority and the dissent) reiterated the broad, laudable purposes of the trust fund statutes, which is to protect those who most directly provided the labor and materials for a construction project. Any time a contractor sees a payment by an upstream entity not flowing down to a trust fund beneficiary, it should be on guard for a potential diversion of trust funds. Also note that an owner who receives proceeds from a construction loan is similarly the Trustee of a separate statutory trust relating to those funds, to which the contractors are the beneficiaries. Additionally, an individual who diverts or misapplies trust funds takes on personal liability for the diversion.  These trust issues are often helpful in collecting contract funds downstream.

The fact that the Appellate Division’s decision was 3-2 gives B&W the right to a direct appeal to the Court of Appeals without having to make the usual motion requesting permission to do so. In the event that B&W does undertake such an appeal and we get an answer to the question of whether the reimbursement for non-trust funds advanced for trust fund purposes is permissible, we will follow up on this article. In the meantime, if you have any questions as to what funds can be expended, and for what purpose, do not hesitate to reach out to experienced construction counsel.

About the authors: Thomas H. Welby, an attorney and licensed professional engineer, is General Counsel to the CIC and the BCA, and is the Founder of, and Senior Counsel to the law firm of Welby, Brady & Greenblatt, LLP, with offices located throughout the Tri-State Region. Gregory J. Spaun, General Counsel to the Queens and Bronx Building Association, and an attorney and a partner with the firm, co-authors this series.

If you would like more information regarding this topic please contact Thomas H. Welby at twelby@wbgllp.com or call (914) 428-2100