Reproduced with permission from Real Estate Law &Industry Report, 4 REAL 494, 07/12/2011. Copyright �2011 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

M E C H A N I C S ’ L I E N S

Trust Fund Statutes Augment Lienor Payment Rights; but U.S. Law May Preempt

BY KEVIN J. CONNOLLY

L awyers who practice construction law and convey-ancing need to be familiar with the lien laws oftheir jurisdictions. The laws of all 50 states and the

District of Columbia have statutes that grant to at leastsome persons who furnish materials and labor for con-struction a lien to enforce their right to be paid for theirwork. There is a remarkable diversity of lien lawschemes that varies along multiple dimensions, includ-ing whether a lien can gain priority over conveyancesthat are recorded before notice of lien is given.

The archetypal lien dispute revolves around the rela-tive priority of liens and mortgages. Many states haveprovisions that subordinate the lien of a mortgage tomechanics’ liens to the extent that money is advanced

under the mortgage after a lien or ‘‘stop’’ notice isfiled.1 Other states provide that if the mortgage is re-corded before notice of the construction project is re-corded, then the priority of lien of the mortgage cannotbe assailed.2 Yet another provides that the mortgagehas priority with respect to the state of the land prior tothe work being performed, and the mechanics’ lienorshave priority with respect to the value of the improve-ments performed.3

All of these statutes express a public policy in favorof protecting a particular class of creditors—those whorender services and furnish materials to construct abuilding. In some states, the protections extended to thefavored class include more than the right to establishand enforce a lien: they include ‘‘trust fund’’ provisionsthat interact with the lien law and other legal schemesto weave a tapestry of complex and sometimes poorly-understood policies. Much of the complexity flows fromthe fact that construction finance operates on multiplelevels. On one level, an owner or developer may borrowmoney, giving a mortgage on the property as security.On a different level—one of which owners, developers,and construction lenders are often blissfully ignorant—the contractors, subcontractors, and material suppliers

1 New York Lien Law§ 13(1); California Civil Code § 3166;Texas Property Code § 53.084; Nevada Revised Statute§ 108.2275

2 See, e.g., National Loan Investors, L.P. v. Burgher, 742So.2d 406, 24 Fla. L. Weekly D2030 (1999)

3 LaSalle Bank NA v. Cypress Creek 1, LP, —N.E.2d. —,2011 WL 681797 (Ill. Sup. Ct.)

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Real Estate Law &Industry Report

have their own financing, including factoring of theiraccounts receivable and floating liens as security for re-volving lines of credit.

Statutory Trust. Construction Trust Funds, like me-chanics’ liens, are, with few exceptions, creatures ofstatute.4 The exceptions refer to those rare cases inwhich a common law fiduciary relationship has beenfound. The trust fund statutes are no less diverse thanthe lien statutes that they supplement, but all of themhave in common that some of the money received bysome of the participants is received in trust. The preciseterms of the trust are, likewise, highly variable, but thegist of the law is that trust funds are supposed to flowdownstream—from lender to owner, owner to generalcontractor (GC), GC to subcontractors and materialsuppliers, and subcontractors to laborers and materialsuppliers. Not every statute provides that all of theseparticipants are beneficiaries of the trust, but some ofthem are obligated to pay their ‘‘downstream’’ counter-parties before using any of the money for any other pur-poses (such as paying salaries to executives and divi-dends to owners).

In part, the impact of the trust fund lies in giving theprotected parties additional remedies that may be avail-able notwithstanding the unavailability of a lien lawremedy.5 To judge from the volume of reported cases,however, the primary effect of the trust fund is felt inthe enforcement of security interests other than real es-tate liens, and in bankruptcy court. As a general rule,assets held in trust are excluded from the estate of thetrustee, and the attachment of security interest to atrustee is dubious.6

One of the recurrent issues in these cases is whetherthe money in the trustee’s general bank account is sub-ject to the trust, particularly since the funds will mostlikely have been commingled. The cases that havereached this issue generally apply the ‘‘lowest interven-ing balance’’ rule for tracing funds.7

The issue most often addressed, and most readily re-solved, is the non-dischargeability of trust fund obliga-tions. When one who received the funds in trust usesthem for a purpose not permitted by the statute, the di-version is generally treated as a defalcation. If there ispersonal liability for the diversion—and there usually isso long as the trustee had notice of the trust—the obli-gation is not dischargeable in bankruptcy.8

One of these diversion cases is especially instructivewith respect to the rights of a factor.9 Many construc-tion contractors borrow money on the security of their

accounts receivable, and these lenders generally securean Article 9 Security Interest in the contractor’s ac-counts. In many cases, the bank account that has beenpledged will include trust funds. Trying to untangle thecompeting interests of the trust fund beneficiaries,mortgagees, and factors can try the patience of even themost patient and enduring judge.

Cutting the Gordian Knot. Thus, at least one court haschosen to resolve the Gordian knot of competing liensand trust funds by slicing it apart with the sharp knifeof Federal Supremacy. In In re Hechinger InvestmentCo., 288 B.R. 398, 401-02 9B. Del. 1998), the Court heldthat the Michigan Builders Trust Fund Act is preemptedby § 147(b) of the Bankruptcy Code because it ‘‘ob-structed the accomplishment and execution of the[Code’s] full purposes and objectives.’’10

Potential lienors and beneficiaries of a constructiontrust funds may breathe a sigh of relief to note thatHechinger has been sharply criticized and has notgained a following. There nonetheless remain a welterof traps and sources of confusion.

Trust Fund Minefield. In a Texas case,11 a lender witha perfected security interest in the subcontractor’s bankaccounts prevailed against the claim of a sub-subcontractor who had not perfected its own mechan-ics’ lien. Thus there is at least some authority that pre-vailing on a trust fund claim requires the establishmentof a mechanics’ lien.12 Some trust fund statutes arebroader than the strict liens granted to protected par-ties, while others require that a lien be established be-fore a trust can be enforced.

Similar attacks have been mounted on the groundthat the contractor’s payment of a subcontractor’s claimwas a preferential transfer.13 However, a substantialbody of authority makes the attack on the preferentialtransfer meaningless, because the Trustee takes posses-sion of the bankrupt’s estate subject to the constructiontrust and the subcontractor would have received thesame amount of money under a Chapter 7 liquidation.14

4 Robert F. Carney and Adam Cizek, ‘‘Payment Provisos inConstruction Contracts and Construction Trust Fund Stat-utes,’’ Construction Lawyer, Fall 2004, 5.

5 For example, the property of the Port Authority of NewYork and New Jersey is completely immune from lien rem-edies. However, the funds received by the general contractorwere subject to New York’s trust fund statute, giving the sub-contractors what proved to be an effective remedy. OTG JFKT5 Venture, LLC v. IBEX Const., LLC, 24 Misc.3d 1244(A), 901N.Y.S.2d 901 (Table), 2009 WL 2855776 (N.Y.Sup.), 2009 N.Y.Slip Op. 51874(U).

6 Trust Funds are not part of the estate of the debtor, In reFrosty Morn Meat, Inc., 7 B.R. 988 (D. Tenn 1980).

7 In re R.W. Leet, 372 B.R.846 (6th Cir. BAP 2007).8 In re Siegfried, 5 Fed. Appx. 856 (CA 10 2001); In re Patel,

565 F.3d 963 (CA 6 2009).9 LeChase Data/Telecom Services, LLC v Burgholzer, 370

B.R. 58 (Bkrtcy Ct., W.D.N.Y 2007).

10 Accord, U.S. v. Pierce, 231 B.R. 890-891-92 (E.D.N.C.1998); but see v. J&D Masonry Inc., 2008 WL 4960157 (W.D.Mich 2008), holding that the Michigan Builders Trust Fund Actis not preempted by the Federal Fair Debt Collection PracticesAct, and noting that ‘‘Hechinger stands against the greatweight of authority.’’ Accord, Selby v Ford Motor Co., 405F. Supp. 164 (D. Mich. 1975).

11 In re Waterpoint International, LLC., 330 F.3d 339 (CA52003).

12 See, however, U.P.S. v. Weben, 794 F.2d 1005 (CA 51986) holding that the rights of a beneficiary of the trust fundarise from the receipt of funds and do not require the filing ofa lien, either under the Lien Law or the Uniform CommercialCode.

13 In re Globe Manufacturing Corp., 567 F.3d 1291 (CA 112009, applying Massachusetts law). Accord, In re M&T Electri-cal Contractors, 267 B.R. 434; (Bkrptcy D DC 2001); Ripley v.Bailey, 27 F3d 563 (CA4 1994): failure to file a mechanics’ liendefeated the subcontractor’s claim to trust funds. But see In reRegan, 477 F.3d 1209 (10th Cir. 2007) [right to access trustfunds not dependent on possession of mechanics’ lien or evenon the right to file a lien so long as the money is received intrust].

14 In re N.A. Flash Foundation, Inc., 298 Fed. Appx. 355(5th Cir 2008); Wickes Boiler Co. v. Godfrey-Richter Co., 116F.2d 842,(2d Cir 1940), mod. On reh’g 121 F.2d 415, cert. cen314 US 86, 62 S.Ct. 297, 86 L.Ed. 549 (1941); In re HervetGelman Construction Co., 34 F. Supp. 109 (W.D. NY 1940); Al-

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The general rule thus appears to be that once it is es-tablished that funds are subject to the statutory trustfund rules, the rights of the beneficiaries are superior tothe rights of secured parties, including sureties.15 How-ever, if a surety is already obligated to pay the lienors—and such is the mission of the ubiquitous PaymentBond—then the trust fund claims—to which the suretyis generally subrogated both under the terms of thebond as well as the common law—then the trust fundbecomes a shield against the claims of the contractor’screditors. If the money that creditors seek was in factsubject to a construction trust, then the funds are notsubject to the creditors’ liens—or the creditor is held totake the collateral subject to the trust fund obligations.

One area in which pre-emption has sometimes beenfound is the interplay between construction trust fundsand federal labor law—particularly the Employee Re-tirement Income Security Act. Thus in Summit Bank v.Local 98, Int’l Brotherhood of Elec. Workers, 2001 W.L.849527 (E.D.Pa.), the court held that a trust fund claimunder the Pennsylvania Wage Payment and CollectionLaw was precluded by the plaintiff’s contemporaneousassertion of claims under the Labor Management Rela-

tions Act and ERISA. However, most courts that havereached the question have held that neither the LMRAnor ERISA re-empts the state construct trust fund law.16

Conclusion. Practitioners who deal with constructionprojects and the liens that sometimes result need tobear in mind that there may be more at work than therelative priority of the mechanics’ liens and the mort-gages. Many states’ laws contain trust fund provisions,and while a variety of assaults have been mountedagainst them, the trust fund—when it exists—furnishesa contractor or supplier with remedies that are equallyapt in foreclosure, accounting, or bankruptcy. In aproper case, the trust fund enables contractors and ma-terial suppliers to recoup more than they can by fore-closing the lien—especially in today’s market, wheredepressed real estate values often make lien enforce-ment a fool’s errand.

Kevin J. Connolly is a shareholder in the firmof Anderson Kill & Olick, PC. His practice con-centrates on construction law, with particularemphasis on risk management and mechanics’liens.

bert Pick Co. v. Travis, 6 F. Supp. 486 (E.D.N.Y. 1933); B.F.Farrell Co. v. Monahan, 377 Misc 552, 131 NYS2d 58 (1966)[holding further that the trust fund was not part of the estateand therefore debts pertaining to it could not have been dis-charged whether or not a proceeding was brought to deter-mine non-dischargeability]; In re I.T. Group, 332 B.R. 673 (B.Del 2005) [trust fund claimant under New York Lien Law hassuperior claim on rust fund over trustee in bankruptcy].

15 Interwork Systems Inc. v. Merchant Financial Corp., 604F3d 692 (2nd Cir 2010); Titan Indemnity Co. v. TriboroughBridge and Tunnel Authority, 135 F.3d 831, 834 (2nd Cir 1998).

16 Swift Electrical Supply v. Township of Lakewood (168F. Supp.2d 298 9d. N.J. 20010; Regan v. Tri-County Excavat-ing, 62 F.2d 501 (D. Pa. 195); Bellmead Development Corp. v.N.J. Council of Carpenters Benefit Funds, 11 F.Supp2d 500(D.N.J. 1983); Laborers’ Trust Funds v. Marie Prince Hotel, 81Haw. 487, 918 P.2d 1143 (1996); Forsby v. Bovi Lend Lease,184 P.3d 610 (Utah App. 2008).

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