Kushnick | Pallaci PLLC Attorney At Law

Maintaining Proper Trust Records to Avoid Trust Diversion Liability in New York

Maintaining Proper Trust Records to Avoid Trust Diversion Liability in New York

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Contained within Article 3A of the New York Lien Law are some of the most dangerous legal requirements a general contractor will ever see.  Many general contractors have heard of the Lien Law “trust fund” obligations, but only a few actually understand what these obligations mean.  This lack of knowledge and understanding can expose an unwitting general contractor to extensive liability if the proper precautions are not taken.  In a nutshell, Article 3A of the Lien Law requires every “trustee” to keep all funds that he or she receives on a construction project in a “trust account” for the benefit of the trust beneficiaries (subcontractors, suppliers, materialmen, etc.).  Just who qualifies as a trustee is not always clear but, in general, a general contractor is always a Lien Law trustee.  A simple rule of thumb is that if you are receiving money on a construction project within the State of New York and you owe money to someone else for labor or materials that they supplied to you on that same project then you, most likely, are a Lien Law trustee and all of the monies that you receive on the project are “trust funds” subject to the rules and regulations set forth in Article 3A of the Lien Law.

Lien Law trustees must pay all beneficiaries of the trust before they can use the funds for any non-trust purpose.  Most importantly, the trustee cannot use the funds for another project and cannot use the funds to take its own profit until all trust claims have been satisfied.  While the Lien Law does require that the general contractor maintain these funds in a trust account, it is generally accepted that a separate account is not needed for each project.  Rather, the general contractor must keep separate books and records for each project.  But, despite a popular misconception, keeping the funds in one account is not, in and of itself, a trust violation.  The general contractor, as a trustee, must maintain books and records that show: i) the name of the project; ii) the date and amount of payments received; iii) the date, amount and payee of each payment made from the trust funds; iv) a description of the reason for payment (labor, materials, insurance, etc.); v) all trust accounts payable; and vi) all trust accounts receivable.  The bookkeeping obligations are the same for the trustee, whether it is a $10,000 project or a $10,000,000 project.

While Lien Law §74 permits the trustee to determine the order in which it pays trust claims, it must make sure that all trust claims are paid before using the funds for any other purpose.  For example, if trustee (GC) receives a $100,000 payment from Owner (O) on Project X and then pays $25,000 to Subcontractor A, $25,000 to Subcontractor B and $25,000 to Supplier C, each of those transactions must show up in the trust books and records.  Each would be a proper use of the Lien Law trust funds for Project X.  The remaining $25,000 from O on Project X, assuming no other beneficiaries have trust claims, can be used by the GC as it sees fit; whether that be to take profit, use on another project or something else.

In the above example, GC gets into trouble when Subcontractor D on Project X is still owed money but rather than pay Subcontractor D, GC takes $25,000 from Project X to order materials for Project Z.  This scenario results in a Lien Law trust violation.  The consequences can be disastrous for the trustee.  First, the Court has the ability to order the trust funds repaid (by the GC), if possible.  Second, diversion of trust funds is a crime for which the GC can be prosecuted, fined and sent to jail.  Third, diversion of trust funds exposes the GC’s corporate principals to personal liability.  Fourth, diversion of trust funds exposes the trustee to potential punitive damages and attorneys’ fees awards.  The bottom line for a GC working in New York is that diverting trust funds can put it in a whole heap of trouble.

Lien Law §75 requires the trustee (the GC) to maintain careful and accurate books and records of all trust transactions.  A trustee’s failure to maintain proper books and records creates a legal presumption that the trust laws have been violated and that a diversion has occurred.  While the presumption is not a final determination, overcoming it in litigation can be very difficult and, in many cases, impossible.  As a beneficiary of the trust, subcontractors and suppliers are permitted, under Lien Law §76, to demand that the GC provide them with a verified statement, in writing, showing each of the entries on the books and records of the trust account.  Alternatively, the beneficiary has the option to require the GC to open up its books and records for the project to the beneficiary and allow him or her to inspect the books and records on ten days notice.  Few general contractors would be comfortable with allowing a subcontractor or supplier to come into their office and inspect their financial books and records, but it is an unavoidable obligation of the trustee, and a right of the beneficiary.

Another significant reason to be concerned about the Lien Law trust laws is that a general contractor’s corporate principals that are found to have participated in, or acquiesced to, the diversion are exposed to personal liability.  A judgment against the GC and its principals under Article 3A is not dischargeable in bankruptcy and can follow both the GC and its principals around for the next twenty years.

Because of the significant liability to the GC, it is critical to maintain proper books and records for every job.  This is one area where cutting corners simply is not an option.  The personal liability, potential criminal charges, and inability to discharge the debt in bankruptcy should be enough to force every GC in New York to review its accounting practices and make sure that its financial officers, controllers, accountants and bookkeepers are aware of the obligations of a trustee under Lien Law Article 3A.

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Kushnick | Pallaci PLLC Attorney At Law​

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