Appellate Court Rules General Contractor May Assert A Trust Fund Diversion Claim as Subrogee

In addition to mechanic’s lien foreclosure proceedings, the Lien Law affords contractors another safeguard for payment in connection with the improvement of real property – the trust fund.  Article 3-A of the Lien Law creates rights and obligations for contractors with respect to monies paid in connection with real property improvements.  Any monies received with respect to an improvement shall constitute trust funds to be held on behalf of those who provided labor and materials to the trustee in connection with the improvement.  These trust funds may only be used for trust purposes (which are defined by the Lien Law, but generally relate costs incurred for labor, materials, and general conditions required to complete the project), and if they are not, a beneficiary of the trust may bring an action to enforce the trust.  The Appellate Division, 1st Department issued a recent decision in the case  Flintlock Constr. Servs., LLC v HPH Servs., Inc., ___AD3d___, 2024 NY Slip Op 04282 [2024] to answer the question of whether a general contractor, who made involuntary payments to the vendors of a defaulted subcontractor (to obtain needed supplies being withheld due to nonpayment), may bring an action as subrogee of those vendors and enforce their rights as beneficiaries of the trust fund. 

Flintlock was the general contractor on a 20-story hotel project in midtown Manhattan (the “Project”), and Flintlock hired HPH as its subcontractor.  Flintlock alleged HPH breached the subcontract by abandoning the Project prior to completing its scope, as well as failing to pay certain vendors who performed work or supplied materials to HPH in connection with the Project.   Flintlock alleged it made involuntary payments to those vendors, then asserted a breach of contract action against HPH for failure to perform the work and failure to pay its vendors, as well as a Lien Law 3-A Trust Fund Diversion action against HPH and its principals. Flintlock alleged that it was a subrogee of the vendors, who are beneficiaries under Lien Law Article 3-A.  After a bench trial, the Supreme Court New York County awarded Flintlock a $450,000 judgment against HPH on its trust fund diversion claim, and the decision was appealed to the Appellate Division, 1^st Department.

The Court ruled that Flintlock has standing to assert the trust fund diversion claim based on its status as subrogee of HPH’s vendors, citing several 2^nd Department cases.  In other words, when Flintlock paid the claims made by HPH’s vendors, it acquired the rights of those vendors to seek satisfaction of the debt(s), including the vendor’s rights as beneficiaries of the trust fund created by Article 3-A.  As such, the Court ruled Flintlock had an actionable claim against HPH to recover the monies spent due to HPH’s failure to pay its vendors in violation of the Lien Law trust fund provisions.

The Court also found the principals of HPH personally liable for trust fund diversion based on evidence supporting the conclusion they knowingly participated in the diversion.  The Court found that one of the principals admitted he was the only person with authority to issue checks and wire transfers to suppliers.  There was also evidence of a $350,000 payment being made to a settlement escrow account managed by the principal’s spouse’s law firm, and then released back to one of the principal’s companies.  As such, the Appellate Division afforded deference to the findings of fact made by the trial court, whose determination was there was a knowledgeable diversion of trust funds perpetrated by the defendants.

Contractors must be aware of the rights created by Lien Law Article 3-A, which can be utilized as a powerful tool to recover monies earned performing work on construction projects in New York.  Contractors must also be aware of the obligations created by Lien Law Article 3-A and the possible consequences of the failure to adhere to them, which can include the personal liability of the principals of any companies who are found to have knowingly participated in any trust fund diversion, as well as punitive damages. Counsel from a seasoned construction law attorney is paramount in understanding the rights and obligations created by the Lien Law and the trust fund provisions enumerated therein.

If you would like more information regarding this topic please contact Frank Gramarossa at fgramarossa@wbgllp.com or call (914) 607-6465