Your client, the building subcontractor, calls you frantically with the following tale of woe: "My company had a contract with General Contractor Corp. We provided masonry work on a new construction project. We finished the job and expected to be paid on our final invoice. Rather than receiving a check, we were handed a bankruptcy notice! I was shocked. We never expected General Contractor Corp. to file bankruptcy; that's why my company never perfected its lien rights against the construction project, and now the time has expired to perfect liens. I just found out that General Contractor Corp. never posted a bond—I have nothing to proceed against. The only thing I heard is that the project owner hasn't paid General Contractor Corp. yet—is there anything I can do to get my hands on my money?"

At first blush, most lawyers might conclude that the client is out of luck given its failure to protect itself by timely perfecting a construction lien. Consequently, most lawyers would advise the client to immediately file an unsecured proof of claim in General Contractor Corp.'s bankruptcy case, in the hope that a nominal distribution to the client will eventually be made.

Thanks, however, to a Builders' Trust Fund Act (BTFA), which has been enacted in several states, your client might be protected after all. In order to properly represent any client in the building business, you need to determine whether the applicable state has enacted a Builders' Trust Fund Statute. Michigan has enacted such a statute. This article will review that statute and the case law decided thereunder to show how the BTFA may provide a viable way to collect an unsecured debt. To this writer's knowledge, at least 12 states have enacted a BTFA similar to that enacted in Michigan. Those states are Colorado, Maryland, New York, Texas, California, Tennessee, Oklahoma, Delaware, Ohio, Wisconsin, Washington and Utah. Please refer to your state's BTFA and the case law construing it to determine if your client can benefit from the BTFA.

In Michigan, the BTFA^[1] provides, in pertinent part, as follows:

In the building construction industry, the building contract fund paid by any person to a contractor, or by such person or contractor to a subcontractor, shall be considered by this act to be a trust fund, for the benefit of the person making the payment, contractors, laborers, subcontractors or material men, and the contractor or subcontractor shall be considered the trustee of all funds so paid to him for building construction purposes.

The BTFA, therefore, actually creates a trust fund upon construction proceeds received by a contractor, which runs to the benefit of all of the contractor's unpaid laborers, subcontractors and suppliers.

The application of the BTFA has particular significance in the bankruptcy context. In construing the BTFA, it has been determined that builders' trust funds do not constitute property of the debtor's bankruptcy estate.^[2] In Selby v. Ford Motor Co., the 6th Circuit Court of Appeals expressed the following policy considerations:

The Michigan Builders' Trust Fund Act is designed to remedy problems in the construction industry. Like the law merchant of an earlier day, the building trades have gradually created a set of commercial expectations as the result of the customs and practices of the industry. The nature of the industry is such that the commercial expectations of the parties are defeated when a building contractor or subcontractor does not use accounts paid to him on a job to pay subcontractors or material men. Unless the parties see that construction funds are properly applied down the line, the liabilities of the parties up the line are affected. The unpaid workers must undertake the lengthy and wasteful process of filing, perfecting and foreclosing on their mechanics liens. The owners' property and the construction lender's security are encumbered.

The statutory builders trust is not simply special legislation that the building trades have lobbied through state legislatures. Its justification is that the contractor, subcontractor and material men cannot spread their risks in the same way as the grocer or other merchants with many customers. Large quantities of labor and materials may go into a single construction project over a long period of time. A large part of a tradesman's capital may be tied up in a small number of construction projects. There is a substantial risk that a general contractor who goes bankrupt will pull down with him some of his subcontractors and material men, as well as cause serious economic loss to the owner.

The construction lender, owner, disbursing agent, contractor, subcontractor or surety company which furnishes a payment bond may not have a direct contractual relationship with a material man down the line. The courts and legislatures have increasingly found that the parties have an independent legal duty arising from reasonable commercial expectations to see to the proper application of construction funds. In the absence of statute, courts have declared that construction funds in the hands of a contractor are held subject to a constructive trust or an equitable assignment or an equitable lien. (citations omitted). Even in the absence of a state builders' trust statute, federal bankruptcy courts in a variety of situations have refused to apply the property, preference and statutory liens sections of the bankruptcy act to favor unsecured creditors over the equitable claims of subcontractors and material men to the proceeds of a construction project in the hands of a bankrupt contractor. (citations omitted).

State builders' trust fund statutes simply recognize in statutory form the principles embodied in these court decisions. The remedies provided by mechanics lien laws are unsatisfactory, and state legislatures in a number of states, like Michigan, have adopted builders trust fund statutes. The property rights created by these state statutes should be recognized and enforced in the bankruptcy system. The trustee in bankruptcy should not be permitted to appropriate the trust of another and distribute it to the bankrupt's creditors.

In light of the persuasive reasoning expressed in Selby, the courts have been clear in holding that builders' trust funds are not subject to the claims of secured creditors, lienors or a bankruptcy trustee.^[3] Thus, a BTFA can provide a subcontractor with super-priority status over all claimants, including a bankruptcy trustee or secured creditor.^[4]

Interestingly enough, it should follow that builders' trust funds are not subject to a bankruptcy trustee's surcharge powers asserted under 11 USC §506(c). Section 506(c), which was enacted as part of the extensive 1978 revisions of the bankruptcy laws, governs the definition and treatment of secured claims, as well as a trustee's ability to surcharge for the costs and expenses he or she incurs in preserving or disposing of such property. In analyzing this bankruptcy statute, the Supreme Court, in United States v. Ron Pair Enterprises,^[5] determined that §506(c) applies only to claims by creditors that are secured by a lien on property in which the estate has an interest. Because the courts have held that builders trust funds are not part of a debtor's bankruptcy estate, it would logically follow that a bankruptcy trustee could not obtain a §506(c) surcharge against any of such proceeds he may collect for the debtor, since the proceeds are not part of the bankruptcy estate.

Accordingly, when confronted with a factual situation similar to the one presented in this article, you should determine whether your state law includes a BTFA. If so, you and your client may be pleasantly surprised with the results that you can achieve.

Footnotes

^[2]Selby v. Ford Motor Co., 590 F. 2d 642 (6th Cir. 1979).[RETURN TO TEXT]

^[3]See, e.g., Parker v. Klochko Equipment Rental Co. Inc., 590 F. 2d 649 (6th Cir. 1979); In re Imperial Title and Contracting Co., 940 B.R. 97 (Bankr. W.D. Mich 1988); Blair v. Trafco Product Inc., 142 Mich. App. 349 (1985); and B.F. Farnel Co. v. Monahan, 377 Mich. 552 (1996).[RETURN TO TEXT]

^[4]See Weather Vane Window Inc. v. White Lake Construction Co., 192 Mich. App. 316 (1991), which held that builders' trust funds never become property of the debtor regardless of when received and are, therefore, not subject to intervening or subsequently perfected claims of secured creditors, lienors or a bankruptcy trustee.[RETURN TO TEXT]

^[5]United States v. Ron Pair Enterprises, 49 U.S. 235, 109 S. Ct. 1026, 103 L. Ed. 2d 290, (1989).[RETURN TO TEXT]