|Construction Credit Management
Be aware of your protections
Subcontractors and materialmen are afforded numerous protections when shipping to a questionable contractor, or any contractor for that matter. As a subcontractor or materialman it is important that you are aware of these protections and how they protect your investment of labor and/or product. This article will provide a brief summary of the available protections, including mechanics’ liens, stop notices, statutory trusts, contractual trusts, and joint checks.
The mechanics’ lien is a lien created by statute for the purpose of securing priority of payment for the price of the value of work performed and materials furnished in construction or repair of improvements to land. The lien attaches to the land as well as the improvements. Essentially, the mechanics’ lien is a powerful tool that provides special protection to those who labor to improve the property of others.
Generally, to be eligible for a mechanics’ lien, the claimant must (1) provide labor and/or materials to the project; (2) the labor or materials must be consumed in the project; and (3) the owner or the general contractor must authorize the services or materials. More specifically, the claimant will need to (1) serve a preliminary 20 day notice, (2) record the mechanics’ lien, and (3) file a lawsuit to foreclose on the lien. Generally, the lien may not be recorded until the claimant has finished furnishing labor and/or materials to the project.
Although recording the mechanics’ lien is often the most important element, it is critical that the lien notice requirements are complied with. The preliminary notice notifies owners of potential lien claims against their property. A defective notice may result in the loss of mechanics’ lien or stop notice rights.
A stop notice provides notice to a lender or owner that a subcontractor or materialman has not been paid. Unless a bond is posted to cover the unpaid balance, the lender must withhold moneys due the general contractor. The stop notice gives the claimant a lien against undisbursed construction funds in the possession of the owner or the lender. Generally, the mechanics’ lien and stop notice may be utilized simultaneously along with a lawsuit for breach of contract on the underlying debt.
The same eligibility requirements for the mechanics’ lien apply to the stop notice. In addition, the claimant will need to (1) serve the stop notice, (2) record the stop notice, and (3) file a lawsuit to enforce the stop notice.
Unfortunately, mechanics’ lien and stop notice laws are very technical and require the proper steps to be taken to assure that the remedies will not be lost. In the event that the remedies are lost, the subcontractor or materialman may still commence a lawsuit for breach of contract to recover the underlying debt.
Some state legislatures have established construction trust statutes that provide additional protection to subcontractors and materialmen (e.g., Colorado, Delaware, Illinois, Maryland, Michigan, New Jersey, New York, Oklahoma, Texas and Wisconsin). Generally, under a statutory trust, any money paid under a contract by an owner to a contractor, or by the owner or contractor to a subcontractor for work done or materials furnished, or both, for or about a building by any subcontractor, shall be held in trust by the contractor or subcontractor, as trustee, for those subcontractors who did work or furnished materials, or both, for or about the building, for the purposes of paying those subcontractors. Essentially, when a contractor or subcontractor receives payment for work on a construction project, those funds may be considered “trust funds” which are earmarked for payment of downstream subcontractors or materialmen.
If the trust funds are used for any other purpose, the contractor’s or subcontractor’s “managing agents” may become personally liable to any lower tiered subcontractors or materialmen who remain unpaid as a result. A “managing agent” is usually defined as any employee of a contractor or subcontractor who has direction over or control of money held in trust.
Contractual trusts are similar to stat utory trusts in application, however, unlike a statutory trust which is created by the legislature, a contractual trust is created by agreement. Basically, the subcontractor or materialman can simply refuse to do business unless their contracts to perform include trust fund provisions. In the event that the owner or general contractor defaults on the debt, the trust provision will enable the subcontractor or materialman to preserve priority over the debtor’s secured lenders. Practically speaking, subcontractors and materialmen will find general contractors and owners resisting this arrangement. The most common contractual trust for a subcontractor or materialman will involve three parties, the subcontractor/ materialman, the general contractor, and the owner.
The trust agreement will usually include language which states the contractor agrees that all funds received by the contractor to the extent those funds result from the labor or materials supplied by the subcontractor or materialman shall be held in trust for the benefit of the subcontractor or materialman. The trust agreement will also state that the contractor agrees it has no interest in the trust funds and to promptly account for and pay to the subcontractor or materialman all trust funds.
Trust fund laws or agreements are one way that a subcontractor or materialman can gain priority over a customer’s bank that has a blanket security interest on receivables. The subcontractor or materialman is essentially saying that it will not provide the value of labor and materials if some other lender will have priority over the receivable that is generated by the labor and materials provided. The subcontractor or materialman can refuse to supply labor or materials unless it will have absolute first priority to the value provided. This absolute first priority is a trust fund agreement.
Many construction contracts are written so that the owner will pay for labor and materials by way of joint checks. Typically, a contractor will submit a payment application itemizing work performed by various subcontractors during that month’s pay ment cycle. The owner will then issue checks payable jointly to the general contractor and to the subcontractor whose work was listed on the application. This process can work to the subcontractor's advantage, because it prevents the general contractor from using payments earmarked for the subcontractor to satisfy other obligations.
However, the use of joint checks may present a number of complications. Some courts have held that a signature on a joint check constitutes payment even if the money was actually not received (i.e., the second party on the check kept all of the funds). The “joint check rule” states that when a supplier or subcontractor endorses a check payable jointly to him and the general contractor, he is presumed to have received all sums then owed to him, even though he actually may have received only part or none of the amounts owed to him. This rule presents a quandary for subcontractors and materialmen because they have to endorse the check if they want to be paid at all. However, their endorsement of the joint check creates a legal presumption that they have been paid the full amount of the check, even if the general contractor has withheld the funds or has otherwise reduced the payment.
The presumption that the subcontractor or materialman was paid everything owed up to the date the check was endorsed will be disregarded if an agreement exists between the subcontractor or materialman and the owner or general contractor as to allocation of the proceeds. As such, a subcontractor or materialman should obtain a written agreement from the owner and general contractor that his endorsement of the check is not an acknowledgement of payment of everything owed at the time of the endorsement, but is instead merely an acknowledgment of amounts actually paid. Failure to obtain such an agreement places the subcontractor or materialman at risk of never getting paid for the work not included in the joint check.
As a general rule of caution, if you intend to use any of the above mentioned remedies, you must comply precisely with the conditions for using them. Subcontractors and materialmen, protect your rights.
Reprinted by permission from The Trade Vendor Quarterly Blakeley & Blakeley