January 2019 Edition
by Jordan R. Pavlus, Esq., Byrne, Costello & Pickard, P.C.
Many states have a statutory scheme whereby a general contractor is required to hold construction monies it receives in “trust” for trust fund beneficiaries. In this respect, the general contractor serves as the trustee and the subcontractor serves as the trust fund beneficiary. This is a critical component of subcontractor payment rights because it requires that the general contractor pay those construction trust funds to trust fund beneficiaries first, before they are used for any other purpose.
Article 3A of the New York Lien Law requires that general contractors keep construction trust funds for payment to trust fund beneficiaries first, and provides that a diversion of construction trust funds for any other purpose constitutes a larceny under the New York Penal Law. Depending on the amount diverted, this could result in a felony criminal charge. Furthermore, case law has held that individual officers and owners are personally liable for the diversion of trust funds, and that punitive damages may be imposed as well.
But one case went even further to advance subcontractor payment rights based upon principles of trusteeship. In the matter of American Architectural, Inc., et al v. Marino, et al, 109 A.D.3d 773 (3rd Dept. 2013), the Third Department Appellate Division (there are four Appellate Divisions in New York State) had occasion to determine whether a detailed dispute resolution procedure was enforceable based upon the general contractor’s fiduciary duties as a trustee of construction trust funds.
The subject dispute resolution clause set forth various conditions precedent to the making of any “claim, dispute or question arising out of or in relation to [the] subcontract.” Id at 774. Those conditions included a seven-day time period within which a claim must be made. The subcontractor’s failure to follow any of the conditions precedent resulted in a complete waiver of any claims for payment the subcontractor may have had against the general contractor.
The subcontract further provided that the general contractor was the “sole arbiter of all claims, disputes, and questions of any nature whatsoever arising out of …the [subcontract].” Id.
The subcontractor filed a mechanic’s lien on the property and sought to recover approximately $1 million in claims against the general contractor and its surety. The general contractor and the surety sought to have several causes of action dismissed based upon the dispute resolution procedure and conditions precedent in the subcontract.
In response to the motion to dismiss its mechanic’s lien causes of action, the subcontractor argued that the “sole arbiter” provision was void as against public policy because it violated the principles of trusteeship that the general contractor owed to the subcontractor. The court agreed, holding that “the provision in the subcontract which granted the contractor the right to act as sole arbiter violates the principles of trusteeship as reflected in the Lien Law by creating an inherent conflict of interest between [general contractor’s] duty to the trust beneficiaries and its own self interest, and is unenforceable as an impediment to plaintiff’s right to bring an action under article 3-A of the Lien Law.” Id at 775. The court further cited section 34 of the New York Lien Law which prohibits prospective waiver of lien rights.
In making the foregoing conclusion, the court upheld the denial of those branches of the motion to dismiss filed by the general contractor and surety based upon the conditions precedent in the subcontract.
The American Architectural case has potentially far reaching implications on the world of subcontractor payment rights. Not only was it based on express statutory duties imposed on general contractors as trustees of construction funds, but it went even further and relied on common law principles of trusteeship to invalidate a dispute resolution mechanism which created an inherent conflict of interest for the general contractor. To wit: when the general contractor is both the trustee of construction funds and the sole arbiter of claims, it violates its fiduciary duty to the trust fund beneficiaries (subcontractors) because it is in its own self interest to deny those claims.
Inasmuch as many states have a statutory system which provides that general contractors are trustees of construction funds for the benefit of subcontractors, American Architectural may be used as persuasive authority to argue that dispute resolution provisions which violate the duties of trusteeship are void and unenforceable. This may allow a subcontractor to keep its claims alive when they would otherwise be subject to dismissal for failure to meet contractual conditions precedent.
Jordan R. Pavlus, Esq., leads the construction practice at Byrne, Costello & Pickard, P.C., Syracuse, N.Y. He focuses his practice on all facets of construction law, including subcontract drafting and negotiation, performance and payment bonds, mediation, arbitration and litigation. Pavlus regularly advises clients on the nuances associated with construction law, including bond claims, lien law, prompt payment law, and a broad variety of issues faced in the commercial construction field. He has served as lead counsel in numerous multi-million-dollar actions and multi-week arbitrations. Pavlus is a frequent lecturer on construction related issues. He can be reached at (315) 474-6448 or firstname.lastname@example.org.