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Kevin Schlosser Authors, “Another Bomb Explodes in the Lien Law Minefield” for NYLJ

Publication Source: New York Law Journal

Kevin_SchlosserYou represent a general contractor involved in a construction project. One of your client’s principal subcontractors has fallen behind in paying its subcontractors and suppliers, who threaten to put a lien on the job and stop the work at a critical time. Your client asks you if it can and should pay the subcontractors and suppliers of the principal subcontractor directly to ensure that the project is completed on time. You figure Article 3-A of the Lien Law requires the principal subcontractor to pay the claims of its subcontractors and suppliers before using the money it receives from your client for any other purpose. So you advise your client to avoid the liens and keep the work moving by paying the subcontractors and suppliers of the principal subcontractor directly and assert such payments as an offset against any claims made by your client’s subcontractor. You have provided timely and effective legal advice, right? Wrong. Your client could be in for double trouble if it followed your advice.

This scenario is quite similar to the facts of a new decision handed down by the Appellate Division, First Department, which must be closely read and understood by anyone intending to give advice in the construction field. This article will review the statutory provisions analyzed by this new case law and discuss the important implications of the First Department’s decision.

Article 3-A

As summarized in a recent article in this column, Article 3-A of the Lien Law creates a “trust” over certain funds used in connection with any construction project.(1) Among the different types of funds that are encompassed within this trust are payments received by contractors involved in a construction project as well as payment received by subcontractors.(2) The trust fund provisions ”were intended to insure that funds obtained for financing of an improvement of real property and monies earned in the performance of a contract for either a privately owned improvement or a publice improvement will in fact be used to pay the cost of that improvement.’ ‘(3)

As applied to contractors and subcontractors, the trust fund provisions require that both the contractor and subcontractor hold any payments they receive or are entitled to receive under their respective contracts for the improvement of real property for the benefit of those they engage to work on that improvement. Specifically, the trust assets held by a contractor or subcontractor must be applied, among other things, to pay ‘claims of subcontractors, architects, engineers, surveyors, laborers and materialmen…’(4)

As it relates here, the Lien Law provides that a lender of the contractor or subcontractor can validly receive the payments due to that contractor or subcontractor under its construction contract so long as(1) the lender has complied with Lien Law §73 by filing a ‘Notice of Lending’;(2) the payment received from the contractor or subcontractor ‘was made as security for or in consideration of or repayment of advances made to or on behalf of the (contractor or subcontractor)’; and(3) the lender ‘procured from the (contractor or subcontractor its) written agreement that (it) will receive the advances and will hold the right to receive such advances as trust funds to be applied to the payment of trust claims’ under Article 3-A of the Lien Law before using them for any other purpose.(5)

‘Quantum’ Decision

In the recent decision of Quantum Corporate Funding Ltd. v. L.P. G. Associates, Inc.,(6) the First Department analyzed the effect of Article 3-A of the Lien Law on a factoring arrangement with a subcontractor on a public housing project.

The general contractor’s subcontractor was DDV Construction, Inc. DDV made a series of assignments of its accounts receivable under the contract with the general contractor to the plaintiff-factor. Before the general contractor paid DDV any funds under the construction contract, the plaintiff-factor notified the general contractor of each assignment and obtained the general contractor’s “written guarantee that the work had been performed by DDV, that the amount represented by the underlying invoice was therefore due and payable and that there was no set-off or claim against payment in excess of 20 percent of the invoice amount.” According to the court, the plaintiff-factor also “duly recorded its assignment of interest.”

During the course of the construction project, the plaintiff-factor advanced to DDV $180,900.50 against an invoice in that amount issued from DDV to the general contractor. On that advance, DDV repaid only $20,000 to the factor, leaving a balance due of $160,900.50. After the plaintiff-factor had recorded the assignment given by DDV, the general contractor learned that DDV had not paid its subcontractors and suppliers, which were threatening to file liens against the construction project. Significantly, instead of remitting the amount due DDV to the plaintiff-factor, the general contractor decided to pay the amount of the invoice directly to DDV’s subcontractors and suppliers. The plaintiff-factor then brought an action against the general contractor for the amount outstanding under the invoice from DDV – even though the entire amount due under that invoice was paid by the general contractor to DDV’s subcontractors and suppliers.

In defense, the general contractor argued that it was a trustee under Article 3-A of the Lien Law and was obligated to insure that DDV’s subcontractors and suppliers were paid before the money due to DDV was used for any other purpose, including payment to plaintiff-factor. The Supreme Court accepted the general contractor’s defense and “decided that [the general contractor’s] obligation to make payment to [plaintiff-factor] was satisfied by its payment to DDV’s subcontractors and suppliers.” The First Department reversed and granted summary judgment to the plaintiff-factor.

After a brief and somewhat irrelevant discussion of when an owner could be deemed a trustee under Article 3-A of the Lien Law,(7) the court then proceeded to analyze what it considered to be the critical and dispositive issue. That is, the First Department considered whether the general contractor had an obligation under the trust provisions of the Lien Law to insure payment to DDV’s subcontractors and suppliers which did not have direct contracts with the general contractor. After trying in vain to resolve this issue, however, the court stated that it was not necessary to decide the issue because the “operative question [was] not whether the contractor is authorized to make payment to the subcontractor’s creditors out of trust assets but whether, having made such disbursement, the contractor may set up payment as a defense to an action brought by the subcontractor’s lender, whose claim to the funds is based upon a duly recorded assignment.” The Court rejected the general contractor’s defense, relying exclusively upon the general contractor’s “estoppel certificate” given to the plaintiff-factor wherein it acknowledged that “all payments on the captioned invoices are to be made only to [plaintiff-factor]” and that “there will be no claims against the funds paid under any of the subject invoices.” The Court further held that the general contractor was contractually bound to pay the plaintiff-factor because the assurances made by the general contractor created “an estoppel predicated upon the factor’s reliance on that assurance in purchasing the assignment from DDV.”

The court then held that even though the general contractor was subrogated to the claims of DDV’s subcontractors and suppliers as a result of making payment to them, it could not assert any claim against the plaintiff-factor for the payments due to the subcontractors and suppliers. The Court held that “in the absence of complicity in the diversion of trust assets, a factor is not answerable for the subcontractor’s failure to make payment to trust beneficiaries under Article 3-A of the Lien Law.”(8)

Important Implications

Once again, this decision shows that the Lien Law is a minefield waiting to explode on unsuspecting contractors who may not understand or appreciate all of its intricacies and ramifications. In Quantum, the general contractor triggered a self-destructive bomb in the Lien Law minefield when it proceeded to pay the claims of DDV’s subcontractors and suppliers without considering the contractual assurances it gave to the plaintiff-factor and the corresponding rights of the plaintiff-factor arising from these assurances and the assignment from DDV. This decision illustrates the critical need to assess the accuracy and appropriateness of “estoppel certif icates” or assurances requested by lenders and to monitor carefully the subcontractor’s payment of obligations to all that it hires on the project.

The general contractor here appears to have made a critical mistake in representing to the plaintiff-factor that there “was no set-off or claim against payment in excess of 20 percent of [DDV’s] invoice amount.” If DDV had not paid its subcontractors and suppliers and they put a lien on or otherwise interfered with the progress of the job, the general contractor would have certainly had a claim over against DDV. Unfortunately, according to the facts of the case as reported by the court, the general contractor had learned of DDV’s outstanding financial obligations to its subcontractors and suppliers only after plaintiff-factor’s rights were fully enforceable through the assurances and guarantee given by the general contractor.

The Quantum decision is another painful reminder that those involved in the construction process seek timely and effective legal advice at all stages of a project before legal documents are signed and rights are obliterated.
(1) See K. Schlosser, “High Court Bolsters Lien Law Trust Protections,” New York Law Journal, Jan. 14, 1997, p. 1 col. I; N.Y. Lien Law §§70-79a.
(2) See N.Y. Lien Law §70(6) & (7).
(3) Canron Corp. v. City of New York, 89 NY2d 147, 652 NYS2d 211, 214 (1996), quoting 1959 Report of NY Law Rev Commn, at 209 reprinted in 1959 NY Legis Doc No. 65(F) at 25.
(4) N.Y. Lien Law §71(2)(a).
(5) N.Y. Lien Law 73(1) & (2).
(6) Quantum Corporate Funding Lid. v. L.P. G. Associates, Inc., NYLJ. Jan.12, 1998 at p. 25, col. 4 (1st Dep’t).
(7) In this case, the project was a public improvement to rehabilitate a housing project in the Bronx. Thus, the owner was the city of New York and there is nothing to indicate that the city borrowed the funds to pay for this project. Thus, the “owner” on this project could not have been considered a trustee of any funds. An owner that pays for a construction project with its own funds is not considered to be a trustee under Article 3-A of the Lien Law. Pelic Development Corp. V. Whitestone Equities Farmingdale Corp., 199 AD2d 483, 606 NYS2d 32 (2d Dep’t 1993).
(8) Quantum, citing Caristo Const. Corp. v. Diners Financial Corp.. 27 AD2d 661, 276 NYS2d 831 (2d Dept 1967), aff’d., 21 NY2d 507. 289 NYS2d 175 (1968).