A typical trust fund statute provides that payments to a construction contractor are treated as funds held in trust until its subcontractors and suppliers have been paid. In the case of a contractor bankruptcy this can be a significant benefit, since the subcontractors and suppliers can argue that the trust funds should be turned over for payment since they are not even part of the bankruptcy estate since. However, sometimes the value of this protection can be illusory, as a material supplier discovered in this case while trying to defend against a preference
In Powers Lake, the prime contractor (C.D. Smith Construction, Inc.) hired the debtor (Powers Lake Construction Company, Inc.), which in turn had a contract with material supplier (Little Limestone, Inc.) to supply limestone, for a wastewater treatment plant project.
Although the supplier submitted four separate invoices over the course of four months, the supplier contended that the parties agreed it would be paid once all the materials had been delivered. On February 25, 2010 (which was after all of the limestone had been delivered), the prime contractor issued a check to the debtor, the debtor issued a check to the supplier for the full amount of the four invoices, and the supplier gave a lien waiver.
When the debtor subsequently filed bankruptcy and its chapter 7 trustee attempted to recover the payment from the supplier as a preference, the supplier’s first argument was that the payment involved a transfer of funds held in trust for the supplier (under the applicable state statute), and thus did not constitute property of the bankruptcy estate. (See Construction Lien Payments: Trust Funds or Not? for discussion of a similar argument.) In response, the trustee noted that the debtor comingled the trust funds so that the supplier was required to trace the funds in order to obtain the benefit of the trust status.
The court agreed with the trustee and held that the rule for determining whether there were any trust funds was the “lowest intermediate balance test.” Under this test, when trust funds are comingled with other funds in an account, if at any time the balance goes below the amount of the trust funds, only the lowest intermediate balance is considered to be trust funds. This is based on the fiction that non-trust funds would be used first, and also means that if all of the money is withdrawn, the trust fund status is lost.
In this case the timeline was as follows:
- The prime contractor’s February 25 check was credited to the debtor’s account on February 26.
- Debits reduced the account balance so that on March 1and 2 it showed a negative balance.
- The debtor made two large deposits on March 3, so that the check to the supplier was able to clear on that date.
The court noted that the date a check clears is the relevant date for determining whether a payment by check is a preference. So, the payment to the supplier was evaluated as of March 3. Since the lowest intermediate balance between that date and the date that the trust funds were deposited was less than zero, there were no trust funds. Consequently, the payment involved a transfer of assets of the bankruptcy estate and was potentially recoverable as a preference (since all of the other elements of a preference were met).
The supplier also argued that it had a defense in that the transfer involved a contemporaneous exchange for new value. However the limestone material was not delivered contemporaneously with the payment, and the lien release benefited the property owner, not the debtor.
The supplier’s final defense was that the payment was in the ordinary course of business. The court concluded that it was not appropriate to grant summary judgment on this issue since it was so fact intensive. So, that final issue was left for a trial.
As illustrated by this case, anyone doing business with a troubled construction contractor should recognize that notwithstanding the potential benefit of trust fund treatment of money received by the contractor, there is still a preference exposure.
Theoretically there are steps that could be taken to reduce this exposure (for example, perhaps requiring that payment received by the contractor be deposited in a designated trust account). However, under normal circumstances a subcontractor or supplier will not have sufficient leverage to negotiate any special protection – although it may be able to get the contractor’s attention by reminding the contractor’s principals that they face potential personal liability for misuse of trust funds (assuming that is the case under applicable state law).
Vicki R. Harding, Esq.