Business Law

Business Lawyers, Be Wary of the Michigan Builders Trust Fund Act


by Ronald A. Deneweth

These are busy times for the construction industry in Michigan. Most competent contractors are at capacity or very close to it. In the highway, commercial, and residential sectors, new construction companies are formed with expectations of huge profits. Additionally, existing out-of-state companies are entering the Michigan markets looking for a piece of the action. As a result, more general practice/business lawyers are gaining general contractors and subcontractors as their new clients.

Representing a construction contractor seems straightforward and not too demanding. One would think that simple applications of the laws of contracts should more than allow a skilled practitioner to adequately represent and protect the new contractor clients. Assuming that the client earns more money than it spends and that you as the attorney and counselor diligently review its contracts to keep the contractor out of onerous deals, there should be no problems.

However, never forget that contractors are the true "eternal optimists." The typical contractor believes that even if it does not earn the anticipated profits or suffers losses on one project, as long as the contractor can continue to generate revenue from new projects, it can always use this new cash to pay its old debts from past projects. In short, the typical contractor’s unwritten business model is to survive the bad projects, forestall the creditors for a while, and sooner or later a "fat" project will come along that will enable the contractor to settle up with its outstanding creditors. After all, paying off old debts with new revenues is one of the unwritten laws of commerce. BIG MISTAKE.

The problem is that the Michigan Builders Contract Fund Act, MCL 570.151, et seq.; MSA 26.332, et seq., is counter intuitive to this unwritten rule of commerce. Especially on private projects (not owned by federal, state, or local governments), the practice of applying funds from one project to pay general business expenses or expenses incurred from an unrelated project may expose the contractor not only to criminal and civil liability, but also the officers of the company may face personal criminal liability and non-dischargeable civil liability for the actions of their company.

HISTORY AND APPLICATION

During the Great Depression, land values dropped dramatically and the real estate interest afforded to the successful lien claimant fell far short of protecting the unpaid contractor from the owners or general contractors who chose to spend funds received for payment of the particular project’s debts on non-project related expenses. To help protect the project’s labor and material suppliers and to supplement the existing lien rights, in 1931, the Michigan legislature enacted the Michigan Contracts Fund Act, MCL 570.151, et seq.; MSA 26.331, et seq. The statute states in part:

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 materialmen, and the contractor or subcontractor shall be considered the trustee of all funds so paid to him for building construction purposes. MCL 570.151, MSA 26.331.

The Michigan Contracts Fund Act, also known as the Michigan Builders Trust Fund Act (MBTFA), supplements the existing lien laws by creating additional relief to subcontractors and material suppliers within the construction industry. The MBTFA is designed to prevent contractors from juggling funds between unrelated projects or other uses. To this end, the MBTFA imposes a trust on the monies earned on a project for the benefit of the subcontractors, laborers, and material suppliers on that project. People v Miller, 78 Mich App 336; 259 NW2d 877 (1977). Furthermore, the MBTFA is a remedial statute intended to prevent fraud in the construction industry and therefore is liberally construed for the advancement of the remedy. Miller, supra.

The MBTFA holds the contractor in receipt of the money to a higher standard than the ordinary business debtor. The contractor in receipt of the money becomes trustee of the funds and owes a fiduciary duty to the beneficiaries (i.e. project labor and material suppliers) to exercise proper and honest judgment. Miller, supra.

The Michigan Supreme Court held in In re Certified Question, 411 Mich 727; 311 NW2d 731 (1981) that the MBTFA applies only on private construction projects and has no applicability to public construction projects. The Court reasoned that the MBTFA was enacted to supplement mechanics lien remedies, which were found to be inadequate—particularly during the Great Depression years. Mechanics or construction liens attach only to private projects in Michigan. Regarding labor and material suppliers on public construction projects, they are protected by the statutorily required payment bonds, which ensure that a proper claimant receives reimbursement for its labor and/or material supplied. [Reference MCL 570.101, et seq.; MSA 26.321(1) et seq. (state highway department projects); and MCL 129.201, et seq.; MSA 5.2321(1), et seq. (all other state projects). The Miller Act, 40 USC 270(a), et seq., controls bonds on federal projects.

LIABILITIES

Civil Liability of the Entity

The MBTFA clearly provides criminal penalties for an entity that fails in its fiduciary responsibilities to the trust beneficiaries and that uses the funds paid by the owner or general contractor to pay off debts not related to the specific project. MCL 570.152; MSA 26.332. However, regarding civil liability, the initial intent of the statute was not so clear and the courts have had to construe the MBTFA in order to provide civil remedies.

The path to civil liability began with B F Farnell v Monahan, 377 Mich 522; 141 NW2d 58 (1966). In Farnell, the defendant-contractor received payment for work it had performed on a private project. The payment was intended to cover the contractor’s labor and material cost. Contemporaneously the defendant-contractor filed a voluntary petition in bankruptcy court. The defendant turned over the funds it had received to the trustee in bankruptcy pursuant to the Bankruptcy Act. 11 USC 110, et seq. This forced the plaintiff-material supplier to stand in line for its money as an unsecured creditor.

Ultimately, the Michigan Supreme Court held that regardless of the remedies afforded the plaintiff-material supplier under the Bankruptcy Act, the money was part of a trust fund and never the "property" of the defendant-contractor. As such, the defendant-contractor violated the MBTFA when it turned over the funds to the bankruptcy trustee. The Farnell court granted the plaintiff-material supplier other remedies, such as civil action against the defendant-contractor resulting from its voluntary action of turning over to the bankruptcy trustee money that did not belong to it.

Furthermore, in quoting Ferguson v Gies, 82 Mich 358; 46 NW 718 at 365 (1890), the Court held that the common law could be used to provide a remedy when the statute is silent regarding civil remedies:

[I]t is claimed by the defendant’s counsel that this statute gives no right of action for civil damages; that it is a penal statute; and that the right of the plaintiff under it is confined to a criminal prosecution. The general rule, however, is that where a statute imposes upon any person a specific duty for the protection or benefit of others, if he neglects or refuses to perform such duty, he is liable for any injury or detriment caused by such neglect or refusal, if such injury or hurt is of the kind which the statute was intended to prevent; nor is it necessary in such a case as this to declare upon or refer to the statute.

Criminal and civil liability of the business entity are just the beginning. If a claimant commences an action under the MBTFA, it is likely that the claimant won’t stop at the business entity. Usually a credible argument can be made to enable the claimant to pursue a separate action against the officers of the entity responsible for the decision to spend the received money to pay debts not related to the project that generated the money.

Personal Liability

The provisions of the MBTFA have been used to impose personal liability upon those individuals who participated in the decision making of how the project funds were to be distributed. In Au Bon Pain Corp v Artec Inc, 653 F2d 61 (CA 2, 1981), the plaintiff hired a general contractor to construct three bakery shops, two located in Michigan. To receive progress payments from the owner, the general contractor’s president signed certifications that stated that all amounts paid pursuant to previous certificates had been distributed to subcontractors, laborers, and material suppliers.

The plaintiff-owner soon discovered that, contrary to the certifications, many of the subcontractors, laborers, and material suppliers were not paid. The plaintiff filed suit and joined the president of the general contractor as a codefendant on a breach of fiduciary duty claim under the MBTFA, as well as for common law fraud. On appeal, the Second Circuit Court of Appeals, applying Michigan law, held that the president could be held personally liable under the provisions of the MBTFA for failing to use advances to reimburse subcontractors, laborers, and material suppliers for the efforts they performed on behalf of the general contractor. Au Bon, supra at 65.

Additionally, in People v Deborah Susan Brown, 239 Mich App 735; 610 NW2d 234 (2000), the Michigan Court of Appeals demonstrated its willingness to apply Au Bon Pain Corp. In Brown, the defendant was the corporate officer of a general contracting company. The owner of the project paid the general contractor for work performed by its subcontractors and material suppliers. The general contractor then used the trust fund money to pay nonproject debts.

As corporate officer, Brown was charged with criminal fraud under the MBTFA. She defended herself by asserting that she was not the "contractor" within the meaning of the statute and that only the corporation could be guilty of the crime. The court rejected her argument and found her personally guilty of criminal fraud. The court stated that it is well established that corporate employees and officials are personally liable for all tortious and criminal acts in which they participate, regardless of whether they are acting on their own behalf or on behalf of a corporation. Accordingly, the court held that the individual defendant could be held criminally responsible under the MBTFA as long as she personally caused the corporation to violate the statute, whether or not she actively participated in the day-to-day operations.

Furthermore, if the individual is found to have committed a violation under the MBTFA, the debts owed to the MBTFA beneficiaries may not be dischargeable in bankruptcy. See In re Mark James Hickey, Case No. 98-CV-75590-DT U.S. Dist. LEXIS 15930. In this case, the defendant, Hickey, was the incorporator and only officer of a construction company that had contracted to build several Office Max stores in Michigan and Ohio. An electrical subcontractor was owed money for work performed at one of the Office Max locations. The general contractor used the funds received from this particular location to pay its debts from a different Office Max project and consequently had no funds to pay the electrical subcontractor. Both the general contractor and Hickey filed for bankruptcy under Chapter 7.

The electrical subcontractor filed an adversary proceeding in the bankruptcy court contesting the dischargeability and seeking the money owed for the electrical work it had performed. The plaintiff-electrical subcontractor claimed that Hickey diverted funds received by his construction company and used them to pay other beneficiaries in violation of the MBTFA. As a result, the plaintiff-electrical subcontractor claimed that Hickey remained responsible for the debt and that this debt could not be discharged in bankruptcy because it was a defalcation under 11 USC 523(a)(4).

The bankruptcy court found that there was evidence that money was diverted from the Office Max project to pay older debts on other Office Max projects and that Hickey had approved such actions. The bankruptcy court nonetheless found in favor of Hickey. The court’s rationale was that the various Office Max projects were to be considered as a "single unit" project and that funds from one can be diverted to pay the creditors on another.

In reversing the bankruptcy court, the Honorable Denise Page Hood of the U.S. District Court found that the different Office Max projects were not a "single unit" because the stores were built at different times, in different states, under separate contracts, with separate funding, and with different laborers. The district court further determined that the burden of proving that a defalcation did not occur should be placed on the debtor (in contrast to James Lumber Co, Inc v J&S Construction Inc, 107 Mich App 793; 309 NW2d 925 (1981)—burden of proof on plaintiff/beneficiary) and that since the debtor had not met his burden of proof, the case must be remanded to the bankruptcy court for a determination of whether the entire debt owed to the plaintiff-electrical subcontractor was a defalcation and was not dischargeable in bankruptcy.

Selby v Ford Motor Co, 590 F2d 642 (CA 6, 1979), contains a good discussion on the bankruptcy trustee’s limitations in the MBTFA. In Selby, the bankruptcy trustee sought to recover payments made by Ford Motor Company, the owner of a project, to subcontractors of the debtor-general contractor within four months of filing bankruptcy. In ruling against the applicability of the trustee’s strong-arm powers the court held:

The beneficial interests of subcontractors and materialmen in a building fund should not be regarded as the property of the bankrupt debtor, at least so long as the beneficial interest are traceable. Selby at page 649.

Trust Fund Liability Resulting from Bonds on Public and Private Projects

As mentioned above, the MBTFA has been held to apply exclusively to private projects; however, on public projects, the applicable statutes require the general contractor to provide payment and performance bonds. [MCL 570.101, et seq., and MSA 26.321, et seq., govern state highway projects; MCL 129.201, et seq., and MSA 5.2321(1), et seq., govern all other state projects, while federal projects are controlled by the Miller Act, 40 USC 270(a), et seq.]

In the instances where bonds are required, before furnishing the bonds, the surety will require that an indemnity agreement be executed. The indemnity agreement is a contract between the surety company and the indemnitors (usually including the officers/owners of the company) who promise to keep the surety safe from any loss, liability, and expense to which the surety company may become legally exposed in providing the surety bonds.

Indemnity agreements frequently contain a trust fund provision requiring the indemnitors to agree that all payments received for or on account of the project relating to the bond shall be held as a trust fund in which the surety has an interest for payment of any obligation incurred in connection with the project.

A typical trust provision may provide as follows:

It is expressly understood and declared that all monies due and to become due under any contract or contracts covered by the Bonds are trust funds, whether in the possession of the indemnitors or otherwise, for the benefit of and for payment of all such obligations in connection with any such contract or contracts for which the Surety would be liable under any of said Bonds, and this Agreement and declaration shall also constitute notice of such trust.

Given the above, the indemnitor owes the surety a fiduciary duty to hold the contract funds in accordance with the terms of the trust fund provision in the indemnity agreement.

In re Jenkins, 110 BR 74 (Bankr MD Fla 1990) discusses in detail the relationship created by the trust fund provision in the indemnity agreement. The defendant, Theodore Jenkins, the president and sole shareholder of Sunset Oil, a California asphalt paving company, executed a general indemnity agreement as an individual indemnitor in order to secure surety bonds required by California statute to perform work on California state projects. In relying on the general indemnity agreement, the surety issued payment bonds to various government agencies on behalf of Sunset Oil. Although Sunset received full payment from all the projects, it failed to pay its material suppliers and subcontractors who provided materials or labor to the various jobs.

Had they been properly applied, the project funds would have been sufficient to pay these debts. However, in the three months prior to final payments from the government entities, Jenkins paid himself over $187,000 as repayment of loans and advances to Sunset Oil. Additionally, the debtor/defendant transferred funds out of Sunset Oil Company and into a Florida asphalt company leaving no funds to pay its outstanding debts of $302,051.19 to material suppliers and subcontractors owed on the bonded projects.

The general indemnity agreement used in the Jenkins case was similar to the typical general indemnity agreement described above. The Jenkins court was asked to determine whether the debtor’s failure to comply with the trust fund provision as a result of its diversion of certain contract funds constituted a debt that was nondischargeable under the Bankruptcy Code. [11 USC 523(a)(4) (which makes a debt nondischargeable as a result of fraud or defalcation while acting in a fiduciary capacity)]

Before deciding on this, the court first needed to determine whether the trust fund provision in the indemnity agreement created a fiduciary relationship. The court stated:

In order for the language of the general indemnity agreement to create a fiduciary relationship, i.e. in this case a trust, the language must create a trust, establish a trust corpus, and show an intent by the parties to create a fiduciary relationship. 110 BR at 76.

The court in Jenkins found that the general indemnity agreement executed by debtor-defendant met the criteria stated above and that a fiduciary relationship was created between the debtor-defendant and the surety. In finding that Jenkins violated his fiduciary relationship created by the general indemnity agreement, the court used language that has strikingly similar consequences to the language used by the MBTFA at MCLA 570.153. In Jenkins, the court stated:

It is irrelevant whether the fiduciary engaged in wrongdoing or was negligent or ignorant of the misappropriation. Rather, in this context, defalcation includes any failure by a fiduciary to properly account for entrusted funds. Furthermore, there need not be a personal gain to the fiduciary. 110 BR at 76.

The MBTFA at MCLA 570.153 provides:

The appropriation by a contractor, or any subcontractor, of any moneys paid to him for building operations before the payment by him of all moneys due or so to become due laborers, subcontractors, materialmen or others entitled to payment, shall be evidence of intent to defraud.

On bonded projects, both public and private, the typical indemnity agreement imposes upon the contractor and its individual indemnitors responsibilities similar to those created by the MBTFA. The main distinction between them is the lack of criminal liability for the contractors’ or indemnitors’ failure to fulfill their fiduciary responsibilities on bonded projects, because of the solely contractual nature of the indemnity agreement.

CONCLUSION

The construction industry in Michigan is booming and new enterprises are being created or existing companies are moving into the Michigan market to meet the demands of the industry. With the industry approaching "super nova"-like conditions, many contractors are spread too thin and are unable to furnish their projects with capable and experienced labor as well as the appropriate equipment necessary to perform the work.

The fact that many contractors obtain work as a result of competitive bidding only serves to further frustrate the situation. Competitive bidding requires the contractor to intensely bid against other contractors for the work. This can force contractors to keep their margins low to win the right to perform the work at a price disproportionate to the risks involved.

Most contractors are unable to factor into their bids additional contingency costs to account for reworking items incorrectly built as a result of the inexperienced and overtaxed labor pool. It is also even more rare for a contractor to add such contingencies into its bid and still be awarded the project.

For many attorneys, the contractors that they have as clients most likely will be the type that are surviving from project to project, taking on new projects to generate revenue to pay for the last project. Usually, such a contractor will come to you only after it has dug itself so deep into a hole of debt that it can never get out. When this occurs, do not forget the contractor’s fiduciary responsibility to account to the trust funds.



Ronald A. Deneweth
Ron Deneweth is a cum laude graduate of both John Carroll University and the Detroit College of Law. He is president of the Troy firm of Schier, Deneweth & Parfitt, P.C. He concentrates his practice primarily in advising and representing manufacturers and owners, contractors, subcontractors, suppliers, and sureties in the construction process.


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