Kevin Schlosser Authors, "High Court Bolster Lien Law Trust Protections" for NYLJ

Publication Source: New York Law Journal

One of the most powerful protective devices in a construction contractor’s (and more importantly a subcontractor’s) arsenal is Article 3-A of the New York Lien Law, commonly known as the Lien Law trust fund provisions.(1)

These statutory provisions generally create trust funds out of certain construction financing received by an owner and certain other payments received by contractors to assure that all contractors, subcontractors, suppliers, architects, engineers and others are paid for the material and labor they contribute to the improvement of real property.

In a decision that will have critical impact upon every segment of the construction industry, the New York Court of Appeals has continued its tradition of liberally enforcing the trust law’s provisions by significantly bolstering its protective net.(2)

The trust funds created under Article 3-A of the Lien Law derive from three basic sources: (i) certain funds obtained by the owner of real property related in specified ways to the improvements made to such real property; (ii) payments received by contractors involved in the improvement; and (iii) payments received by subcontractors involved in the improvement.(3)

The basic premise of the trust fund provisions is that before any funds specifically designated to pay for costs of an improvement are used for any other purpose, those who have contributed to the improvement must be paid in full from those funds. Thus, the provisions “were intended to insure that funds obtained for financing of an improvement of real property and moneys earned in the performance of a contract for either a privately owned improvement or a public improvement will in fact be used to pay the costs of that improvement.”(4)

Generally, an owner is treated as a trustee over funds it receives through certain enumerated sources such as building loans or mortgages, insurance proceeds payable for damage to improvements, assignment of rents in connection with the improvement and the like.(5)

The owner must use these funds to pay for “costs of the improvement” — defined broadly under the Lien Law to include a range of items associated with the improvement, including “claims of a contractor, an architect, engineer or surveyor, a subcontractor, laborer and materialman,” certain taxes, benefits and wage supplements as well as certain expenses and interest from the building loan financing.(6)

The contractor and subcontractor are generally treated as trustees over funds they receive or are entitled to receive under their respective contracts for the improvement and from certain insurance proceeds payable because of damage to the improvement.(7) Essentially, both the contractor and subcontractor must hold these funds for the benefit of those whom they engage to work on the improvement.

Specifically, the trust assets held by a contractor or subcontractor must be applied for the following expenditures arising from the improvement:

In various contexts, courts have interpreted the trust fund provisions to afford rights to beneficiaries of the trust funds that are superior to claims of virtually all others making claim to the funds. Thus, for example, courts have held that the trust assets are generally not subject to judgment execution by the trustee’s creditors,(9) are not included in a trustee/debtor’s bankruptcy estate,(10) cannot be recovered by the trustee in bankruptcy as a preference,(11) and cannot be used in a factor/financing arrangement under certain circumstance(12) — indeed, even the federal government’s tax liens take second seat to the trust beneficiaries.(13)

‘Canron’ Decision

On Nov. 19, 1996, the New York Court of Appeals in Canron Corp. v. The City of New York(14) rendered a decision in a dispute between an owner and subcontractor. The trust funds at issue were the ones defined by the statute as “funds ... received by a contractor under or in connection with ... a contract for a public improvement in this state ... and any right of action for any such funds.(15)

In Canron, the City (through the Department of Ports and Terminals) and Northeast Marine Terminal Co. (Northeast) entered into a long-term lease under which Northeast occupied a city-owned marine terminal for its stevedoring business.

Under the lease, Northeast agreed to obtain insurance for the 'buildings, structures and improvements' at the terminal and 'the equipment thereon.' Two cranes at the terminal were thereafter damaged in a violent windstorm. The City elected to apply the insurance proceeds to repair the cranes without any abatement of rent — as the lease provided.

The relationships the parties then created in the course of repairing the cranes formed the basis of the subsequent dispute that led to the Court’s decision. After the insurer agreed to pay all reasonable costs for material and labor to repair the cranes, the City and Northeast made a separate agreement pursuant to which:

Canron was then retained by Northeast to repair the cranes. In the course of the repairs, Canron submitted a series of invoices totaling $797,549.05 to Northeast, who then remitted them to the insurer for payment along with Northeast’s own invoices for its performance under the repair agreement with the City.

The insurer issued six checks representing the total amount of the charges by Northeast and Canron under the repair contract and delivered them to Northeast. The checks were made payable to both Northeast and the City and after endorsing them. Northeast turned them over to the City along with its own vouchers demanding payment from the City in the amount paid by the insurer.

After independently approving the invoices for payment as it had a right to do under the agreement, the City drew and delivered its own checks to Northeast, who then paid Canron the amount due for its approved repair work. This arrangement proceeded for the first five insurance checks, but was not followed for the sixth and final insurance check in the amount of $290,579.03, which became the subject of the dispute.

Unfortunately, Northeast had fallen behind in paying the City rent for the marine facility to the tune of $1.8 million. While the repair of the cranes was going on, the City and Northeast had entered certain agreements for the payment of rent. Critical to this case, Northeast delivered the final insurance check to the City and assigned 'all [of its] right, title and interest' in the check to the City.

Thereafter, instead of using the insurance proceeds to pay Northeast as it had previously done, the City applied this final insurance payment against the balance then due from Northeast for rent. “The City thus accounted for the sixth [insurance] check both as a payment on Northeast’s debt to it under the lease and rent arrears stipulation, and as payment of its debt to Northeast under the crane repair agreement.”(17)

As these things usually go, Northeast filed for bankruptcy after the last insurance check was turned over to the City, leaving a balance of $265,271.90 to Canron for its repair work. Canron promptly sought payment from the City, which rejected its demand for payment.

Thereafter, Canron instituted an action seeking to impose a statutory trust under Article 3-A of the Lien Law upon the funds that the insurer had paid for the repairs to the damaged cranes and which remained in the City’s control.

Based upon stipulated facts and evidence, the Supreme Court in New York County ruled in favor of Canron, finding that Northeast had waived its right of action against the City for the balance due under the crane repair agreement and that this waiver constituted a diversion of trust assets under Lien Law §72. The Appellate Division, First Department, affirmed in a 4-1 decision.(18) The Court of Appeals subsequently affirmed the Appellate Division in a unanimous decision.

Two Rationales

The Court of Appeals based its decision on two independent rationales. First, it held that Northeast obtained the benefit of the proceeds of the last insurance check because they were applied to an unrelated debt and to the crane repair agreement, “since the City also accounted for the insurance proceeds as payment on its debt to Northeast under that agreement. Thus, functionally, the proceeds were funds ... received by a contractor ... in connection with ... [this] contract for a public improvement (Lien Law §70[l]). and in that way a trust asset was created.”(19)

After noting that the “primary purpose of the Lien Law is to insure that ‘those who have directly expended labor and materials to improve real property [or a public improvement] at the direction of the owner or a general contractor’ receive payment for the work actually performed,”(20) the Court found: no reason not to apply the doctrine, primarily utilized to prevent tax avoidance, whereby a party who has the right to receive compensation is held to have constructively received or come into possession of it upon directing application of the funds to satisfy a personal debt or to achieve some other personally desired result.(21)

Such “constructive possession,” the Court continued, “was always understood to be sufficient to confer trust status on contract funds so held.”(22)

As its second rationale, the Court held that Northeast, at the time the final check was disposed of, possessed a trust asset in the form of a right of action for such funds under Lien Law §70(1). The Court further found that this trust asset was illegally diverted for a non-trust purpose when Northeast agreed to apply the proceeds to its rent arrears in full satisfaction of the balance legally due to it under the public improvement (repair) contract.

Given the rather salutary purposes of the Lien Law trust provisions and the traditionally broad interpretation of the statute by the courts, the Court of Appeals' decision seems quite straightforward. The City, however, vehemently (and understandably) argued that it was being forced to pay Northeast's subcontractor when Northeast had no right to any money from the City in the first place.

The City argued that the subcontractor, Canron, was not entitled to anything from it because the City did not owe any money to Northeast. Specifically, the City asserted that if Northeast had sued it for payment arising from the crane repairs, the City could have avoided payment to Northeast altogether by way of a counterclaim, recoupment claim or offset arising from the outstanding rent due from Northeast to the City.(23)

The City did, in fact, have a point. Long-established case law also indicates that claims asserted by subcontractors against owners are generally derivative of the rights of general contractors against the owners.(24)

In further support of its argument, the City noted that the Lien Law itself provides that where the trust asset is a right of action, the “right as a trust asset does not enlarge the right or excuse any performance or condition upon which it depends.”(25) Thus, the City argued, the fact that Northeast’s cause of action against the City was a trust asset did not enlarge Northeast’s claim to payment from the City.

The Court of Appeals disagreed that the Legislature, in adding this “non-enlargement” language to the statute, intended to subject the trust asset to any and all offsets or counterclaims that the owner might have against the contractor. On the contrary, the Court held that “to accept the City’s position would largely frustrate the salutary purposes of the Lien Law trust fund article.”

Key to its decision, the Court found that the “non-enlargement” language was added solely “to ensure that the enforcement rights of trust beneficiaries against the owner were not greater than the rights of the contractor under the [improvement] contract and subject to the owner’s defenses to payment, if any, under the [improvement] contract.”(26) The Court of Appeals also rejected the City’s attempt to characterize its offset as arising out of the repair contract, rather than the separate lease and rental obligation thereunder.

The Court of Appeals further held that insofar as a contractor-trustee holds the trust assets in a fiduciary capacity akin to that of a trustee of an express trust, “the contractor is statutorily prohibited from applying trust assets to his personal debts to the detriment of valid trust claims,"(27)

Repercussions

This decision indicates that to the extent an owner may have claims against the contractor that are not related to the improvement contract, those claims cannot be offset against payments due on the improvement contract or diminish payment on the improvement contract so long as there are any unpaid trust fund beneficiaries.

It is unclear whether an owner now has the right to provide in the improvement contract itself that the contractor’s entitlement to payment for the improvement will or could be offset by other unrelated claims by the owner.

It is clear, nevertheless, that the critical mistake made by the City in Canron was failing directly to link Northeast’s entitlement to payment under the repair contract with the outstanding rental obligations. It remains to be seen, therefore, whether such direct linking would ever be sufficient to avoid claims against the owner by trust fund beneficiaries.

The Canron decision certainly provides another significant remedy for subcontractors, suppliers and all others involved in the construction process to obtain payment for contributing to the improvement of real property.

This decision and its bolstering of the power behind the trust fund provisions is a rude awakening for owners and general contractors who must scrupulously analyze and follow these new pronouncements to avoid adverse and unintended financial repercussions.