Construction Lien Payments: Trust Funds or Not?

Lain v. V3 Construction Group Ltd. (In re Erickson Retirement Communities, LLC), 475 B.R. 762 (Bankr. N.D. Tex. 2012)

The trustee of a liquidating trust under a general contractor’s confirmed chapter 11 plan tried to recover pre-petition payments made to a subcontractor as either a preference or a fraudulent conveyance.  The court’s decision turned on whether the payments were trust funds under the Illinois Mechanics Lien Act.

On February 11, 2009, the subcontractor submitted an application to the general contractor which certified that the subcontract work was finished and requested payment of the contract amount less a 10% retainage.  The subcontractor recorded a lien after the general contractor failed to pay.  On June 30 the subcontractor provided an invoice for the remaining 10% balance, and the general contractor paid both invoices on July 17 by check.  The subcontractor released its lien on July 22, which was before the checks cleared on July 23.

In response to the trustee’s claim for recovery of the payments as a preference, the subcontractor conceded all of the elements of a preference (see Construction Lien Catch-22) except one – namely that the transfer involved property of the debtor.

The subcontractor argued that there is a statutory trust on funds owed by a contractor when it requires waiver of a mechanics lien in exchange for payment.  It further argued that if the funds used for payment were held in trust for the subcontractor’s benefit, then they were not part of the debtor’s property.

The Illinois statute provides:

Money held in trust; trustees.  Any owner, contractor, subcontractor or supplier of any tier who requests or requires the execution and delivery of a waiver of mechanics lien by any person who furnishes labor, services … for the improvement of a lot or a tract of land in exchange for payment or the promise of payment, shall hold in trust the sums received by such person as the result of the waiver of mechanics lien, as trustee for the person who furnished the labor, services … in exchange for such waiver.

The statute goes on to provide that there is no requirement that the trust monies be held in a separate account and that comingling of trust funds is not a violation of the statute.

The court noted that the subcontractor’s lien was released before the payments actually cleared, and that the payments were made not only for the subcontractor’s services but also as consideration for the release of the lien – which is precisely the situation the statute was intended to address.

The trustee contended that the subcontractor was required to trace the funds that it received to trust property in order to establish that it received trust funds, as this court had held in other cases.  In response, the court acknowledged that tracing is an issue in states where the funds received from the owner for payment of the project costs are to be held in trust, but concluded that the Illinois statute was different in that the trust is imposed on the funds ultimately used to pay the subcontractor.  So, no tracing was required. Rather, by definition the funds paid to the subcontractor were trust funds.

Consequently, the payments were not a transfer of the debtor’s property, and thus did not constitute either a preference or a fraudulent conveyance (which also requires a transfer of the debtor’s property as an element of the claim).

As noted in prior blog posts, bankruptcy decisions often turn on state law, particularly in determining property rights.  Although there is often a general similarity between the law in different states on matters such as construction trust funds, there are also often state specific nuances that can lead to different results.  It is important to identify and evaluate state specific law in attempting to assess the likely outcome in bankruptcy.

Vicki R. Harding, Esq.

About BankruptcyRealEstateInsights

Vicki R. Harding was a partner in the Detroit office of Pepper Hamilton LLP who moved to Arizona seeking warmer weather. Ms. Harding continues to handle commercial transactions with an emphasis on real estate and bankruptcy issues (but no longer owns a snow shovel).
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