By: Michael Irwin Silverstein Published: August 2012

The Diversion of Trust Assets by a Public Owner Does Not Automatically Relieve a Surety from Its Obligations Under Its Performance Bond to the Owner.

Sureties should take note that where a public owner admittedly participates in a diversion of trust funds, by applying a progress payment owed to its Contractor to a debt owed by the Contractor on a different project, the obligations of the surety to the public owner, under the performance bond, are not automatically discharged. So says a divided Court of Appeals in a case decided April 3, 2012.

In this breach of contract action, the construction project was undertaken by a Contractor for a School District. As their agreement required, the Contractor secured a performance bond from a Surety, incorporating the terms of the construction contract. While the project was under way, the School District received a notice from the NYS Labor Department (DOL), requiring the School District to withhold money to cover sums owed by the Contractor on a prior project, unrelated to the present one. DOL later authorized the School District to release those moneys to the Contractor, except for $214,000 that the School District was to forward to DOL to satisfy the Contractor's earlier debt. School District did forward the $214,000 to DOL, with Contractor's consent.

Progress by Contractor on the project was then so slow that School District terminated Contractor and turned to Surety to complete the project. Surety refused, resulting in this breach of contract action. Surety defended the School District's action on the ground that Article 3-A of the Lien Law made all of the moneys payable to Contractor a trust fund to cover claims by others that might arise out of this project and that School District's payment of the money to the DOL on an unrelated project was a breach that canceled the Surety's obligation. By a 5-to-2 majority decision, a divided Court of Appeals says no, the Surety is not discharged from its obligations under the performance bond.

The Court of Appeals reasoned that, "whether the School District's payment of contract funds to DOL as [Contractor]'s assignee violated the Lien Law is irrelevant to [S]urety's obligation, because [Surety] did not perform by funding completion of the work upon [Contractor]'s default as required under the performance bond. As such, and as found by the courts below, [Surety] is not subrogated to the rights of the article 3-A trust beneficiaries as a completing surety and lacks capacity to raise any alleged violation of the Lien Law."

Sureties should now be aware that, as a result of this case, the decision not to complete a project, after its principal has been defaulted and terminated, may result in the surety's liability to the owner for completion costs, despite that owner's diversion of trust funds from the project.

If you would like more information on this issue or any other construction related issue, please contact Welby, Brady & Greenblatt, LLP at (914) 428-2100.

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