Construction Claims: Trust Funds Can Go Poof (Round 2)

Lain v. Universal Drywall LLC (In re Erickson Retirement Communities, LLC), 497 B.R. 504 (Bankr. N.D. Tex. 2013) –

A chapter 11 liquidating trustee sought to recover a prepetition payment made by the debtor to a subcontractor on the basis that it was a preference.  The case turned on whether the funds used for payment constituted property of the debtor.

The debtor was a general contractor on a number of construction projects.  Under its contract with one of the project owners, it was required to hold payments received from the owner for work done by its subcontractors on the project for the benefit of those subcontractors.

The debtor had only one bank account (together with a related sweep investment account).  So, any payments received by the debtor were comingled with payments from other projects and sources.

In March the debtor received a payment of ~$1,000,000 from the owner.  Almost six months later the debtor paid ~$215,000 to the subcontractor.  Shortly after that payment, the debtor filed bankruptcy.

The basic elements of a preference claim are that (1) there is a transfer of an interest of the debtor in property, (2)  to or for the benefit of the creditor, (3) on account of an antecedent debt, (4) made while the debtor was insolvent, (5) made within 90 days before the bankruptcy (or one year for insiders), (6) that enabled the creditor to receive more than it would in a chapter 7 liquidation.  The only two elements in dispute in this case were whether there was a transfer of the debtor’s property and whether the debtor was insolvent.

Generally interests in property are determined under state law.  In this case the question was whether the payments were made using funds held in trust for the benefit of subcontractors, and thus were not property of the debtor.  Since the payments from the owner were comingled, the court concluded that it was required to apply the “lowest intermediate balance test” to trace the trust funds.

This approach is based on the legal fiction that when funds are withdrawn from an account, non-trust funds are withdrawn first.  If the amount of funds on hand drops below the amount of the trust fund claims, then the trust fund claims are limited to that lowest intermediate balance.  In this case, the lowest intermediate balance was ~$192,000.

However, there was more than one subcontractor entitled to payment from the trust funds for the project.  In fact, another subcontractor was paid ~$172,000 on the same day as the defendant subcontractor, and the other subcontractor’s check cleared first.  In an interesting twist, the trustee argued that this second payment depleted the trust funds so that the defendant’s claim was limited to only ~$20,000.

In essence, the trustee was using a combination of the lowest intermediate balance test and actual tracing of funds.  However, the court rejected that approach and concluded that every subcontractor was entitled to have the lowest intermediate balance test applied to it in isolation.

With respect to whether the debtor was insolvent, the only evidence provided by the defendant subcontractor was an affidavit by a restructuring expert regarding the debtor’s assets and liabilities on a book value basis.  However, book value is not the same thing as “fair value,” and the court determined that the evidence was legally insufficient to rebut a statutory presumption of insolvency.

Consequently, ~$23,000 of the ~$215,000 payment to the subcontractor was avoided as a preference.

Subcontractors often rely on trust fund theories to protect their ability to get paid.  While the trust fund status of payments can certainly be useful, as this case illustrates, it may not be enough.  For another example, see Trust Funds Can Go Poof.

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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