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Construction trust fund payments as a defense to preference claims: a matter of tracing.

Suppliers of goods and services on construction projects may be the beneficiaries of construction trust fund rights. The trust, which can arise by contract, statute or common law, is imposed on sums payable by either the project owner or a general contractor for the benefit of their creditors that provide goods and/or services. The trust is designed to protect creditors providing goods and/or services on a construction project from the risk of nonpayment of their claims against a financially distressed general contractor or subcontractor. The trust frequently arises without the need for any notice and/or filing that would otherwise be required to create and/or perfect a mechanic's lien.

Trust fund status is also a defense to a preference claim. A trust beneficiary can argue that a debtor's trust payments are not property of the debtor and, therefore, do not satisfy one of the elements of a preference claim, the transfer of an interest of the debtor in property.

But what happens if the debtor commingles trust fund payments made for the benefit of their goods and labor suppliers with other funds not subject to trust fund protection? A creditor asserting trust fund status as a defense to a preference claim must follow certain state law tracing rules to trace an alleged preference payment to the trust funds paid to the debtor on a specific construction project for which the creditor had supplied goods and/or services. That is not necessarily so easy, and absent tracing the trust funds to an alleged preference payment, the supplier cannot assert trust beneficiary status as a defense to preference liability.

Tracing became an issue in Lain v. Universal Drywall LLC (In re Erickson Retirement Communities, LLC), pending in the United States Bankruptcy Court for the Northern District of Texas. The liquidating trustee appointed under a confirmed Chapter 11 plan of liquidation had sought to recover a payment, made by a general contractor debtor to a subcontractor defendant, as an avoidable preference. The debtor was a general contractor on several construction projects and the debtor was required by its contract with one of the project owners to hold the owner's payments in trust for the benefit of the subcontractors that had provided goods and/or services on the project.

The wrinkle was that the debtor had commingled the owner's payments subject to the trust with non-trust payments from other projects and sources. Since the debtor had commingled trust and non-trust payments, the defendant had to employ state law tracing rules to trace the trust funds to the alleged preference payments in order to obtain the benefit of trust status to thereby avoid preference liability.

This article discusses the manner in which the parties employed state law tracing rules and the court's application of these rules that significantly reduced the subcontractor defendant's preference liability.

The Elements of a Preference Claim

Section 547 of the Bankruptcy Code governs preferences. A bankruptcy trustee can avoid and recover a preference by proving all of the following: (1) the debtor made a payment or other transfer of an interest of the debtor in property; (2) the payment or other transfer was to or for the benefit of a creditor; (3) the transfer was made on account of antecedent or existing indebtedness owing by the debtor to that creditor; (4) the debtor was insolvent when the payment or other transfer was made, based on a balance sheet definition of insolvency (liabilities exceeded assets), which is presumed during the 90-day preference period; (5) the transfer was made within 90 days of the bankruptcy filing for non-insider trade creditors; and (6) the creditor obtained a greater recovery from the transfer than it would have received in a Chapter 7 liquidation of the debtor in the absence of the transfer.

A trustee must satisfy all of these requirements to prevail on a preference claim. The trustees ability to satisfy Section 547(b)'s "payment from the debtor's property" requirement was at issue in Erickson. The Erickson court applied state law tracing rules to trace the trust funds to the alleged preference payment and significantly reduce (but not eliminate) the defendant subcontractor's preference liability.

The Facts of Erickson

The defendant, Universal Drywall LLC, a drywall construction company, was a subcontractor on a construction project, the Linden Ponds project, on which the debtor, Erickson Construction LLC (the debtor) was a general contractor. The project was owned by Hingham Campus LLC. The debtor and project owner had entered into a Prime Contract that governed their relationship. Under the Prime Contract, "payments received by the Contractor [the debtor] for Work properly performed by Subcontractors [such as the defendant] and suppliers shall be held by the Contractor for those Subcontractors or suppliers, who performed work, or furnished materials, or both, under contract with the Contractor for which payment was made by the Owner". (1) Bottom line, the project owner had paid funds to the debtor for work performed by the debtor's subcontractors (like the defendant) and other suppliers on the Linden Ponds project which the debtor had agreed to hold in trust for their benefit.

The debtor maintained an operating account and a corresponding investment sweep account as its only bank accounts. The debtor's operating account included funds received from different landowners, including the project owner, on various construction projects, other debtors and affiliates, and sometimes other sources, all of which were commingled in the debtor's operating account. The operating account was swept into the investment sweep account on a regular basis and was usually left with a zero balance.

The defendant performed work on the Linden Ponds project. The debtor had paid defendant sums totaling $2,348,134 prior to the preference period. On February 16, 2009, the defendant submitted a final requisition for payment of $215,312 to the debtor.

From January through September 2009, the project owner had paid sums totaling $2,058,660.03 to the debtor for the debtor's work on the Linden Ponds project. The debtor deposited these sums in its operating account. On March 20, 2009, the project owner made its largest payment, of $1,022,503.15 to the debtor. Almost six months later, the debtor paid the sum of $215,312 (the alleged preference) to the defendant by check dated September 23, 2009 that cleared on September 28, 2009.

Shortly thereafter, on October 19, 2009, the debtor filed its Chapter 11 petition. The debtor obtained court approval of a liquidating plan under which a creditor trust was created and the liquidating trustee was appointed. On October 14, 2011, the liquidating trustee commenced a lawsuit against the defendant seeking recovery of the alleged preference.

The defendant moved for summary judgment to dismiss the lawsuit because, in pertinent part, the trustee could not satisfy his burden of proof that the alleged preference was paid from an interest of the debtor in property. The defendant argued that the debtor had no legal or equitable interest in the funds used to pay the alleged preference because they were impressed with trust fund status. As such, the trustee had the burden of proving that the funds used to pay the alleged preference were from non-trust fund sources.

The bankruptcy court denied summary judgment on whether the debtor had used trust funds to fund the alleged preference. The court agreed with the defendant that the prime contract had created a trust in funds the project owner had paid to the debtor for the defendant's work as a subcontractor on the Linden Ponds project. The court also agreed with the defendant that the commingling of the funds the debtor had received from the project owner with other non-trust funds did not defeat the trust.

However, all this did not negate the need to trace the trust funds to the alleged preference. While the trustee had the burden of proving, through normal state law tracing rules, that no trust funds were used to pay the alleged preference, the trustee was able to raise a question of fact as to whether trust funds were dissipated prior to the debtor's payment of the alleged preference.

The Erickson Court's Tracing Analysis

The Erickson court held a trial on December 18, 2012 over whether the alleged preference was paid from property of the debtor. That required considering whether the alleged preference was paid from funds that were held in trust for the benefit of the defendant. Since the debtor had commingled the project owner's payments subject to trust fund status with non-trust property, the parties had to trace the commingled funds to determine whether any trust funds were included as part of the alleged preference.

The court relied on state law tracing rules and, in particular, a rule known as the "lowest intermediate balance" test. According to the lowest intermediate balance test, if the amount of trust and non-trust commingled funds had at all times equaled or exceeded the amount of the trust claim, the trust beneficiary would be entitled to payment of the full amount of its trust claim from the commingled funds. This test creates a legal fiction that a debtor is deemed to first use non-trust funds when payment is made from a commingled account containing trust and non-trust funds. If the balance of the cash in the account on any given day, after withdrawal of non-trust funds, is less than the amount of the trust claim, the trust claim is limited to that "lowest intermediate balance."

In Erickson, the court conducted a tracing analysis by applying the lowest intermediate balance analysis to the debtor's operating account and investment sweep account on a combined basis. At the trial, the trustees expert testified that on August 26, 2009, just prior to the payment of the alleged preference, the lowest intermediate balance in both accounts, combined, was $191,631.13. The expert then noted that another subcontractor on the Linden Ponds project, asserting the same trust fund rights regarding the project owner's payments to the debtor on the Linden Ponds project, had received payment from the debtor on the same day as the defendant received the alleged preference. The debtor's payment to the other subcontractor was by check that cleared first on September 25, 2009, three days before clearance of the alleged preference on September 28, 2009.

The expert concluded that the debtor's earlier payment of trust funds to the other subcontractor had reduced the amount of trust funds available to pay the defendant on a dollar for dollar basis. The expert treated the other subcontractor as a beneficiary of the same "lowest intermediate balance" of trust funds, totaling $191,631.13, that was available to the defendant. The expert argued that the other subcontractor's earlier receipt of payment reduced the trust fund portion of the alleged preference to only $19,812.18 ($191,631.13 minus the $171,818.95 payment to the other subcontractor). The remainder of the alleged preference, $195,499.82, was property of the debtor and recapturable as a preference.

The court rejected the liquidating trustee's novel application of the tracing rules as an inappropriate hybrid of the lowest intermediate balance rule and literal tracing. The court held that every subcontractor asserting trust status is entitled to do its own "lowest intermediate balance" test separate and apart from other trust fund claimants. That requires: (1) identifying whether there was a trust fund (here, the sum of $2,058,660.03) that the project owner had paid to the debtor from January through September, 2009 for work done on the Linden Ponds project prior to payment of the alleged preference; (2) identifying the lowest intermediate balance in the debtor's accounts prior to the payment of the alleged preference (here $191,631.13); and (3) treating the lowest intermediate balance as the remaining trust funds that belonged to the defendant.

Applying the lowest intermediate balance test in this manner, the court held that $191,631.13 of the alleged preference of $215,312 was paid from trust funds and not subject to preference liability. The defendant was liable for only $23,680.87 of non-trust funds that were considered "an interest of the debtor in property:'

Conclusion

Erickson made clear that where commingled funds are involved, a construction supplier's trust fund status is a defense to preference liability only where the supplier can trace the trust funds to the alleged preference payment. However, proving the existence of a trust is one thing; tracing the trust funds to an alleged preference payment to rebut preference liability is quite another.

The defendant in Erickson successfully applied the tracing rules, and in particular, the "lowest intermediate balance rule," to deflect a significant portion of its preference exposure. It just took a little "tracing" to accomplish that.

(1). The trust fund in Erickson arose by contract. More than a dozen states also have builders' or construction trust fund statutes that impose a trust on the sums payable to suppliers of material and labor on a construction project.

Bruce S. Nathan, Esq. is a partner in the New York office of the law firm of Lowenstein Sandier LLP, practices in the firm's Bankruptcy, Financial Reorganization and Creditors' Rights Group and is a recognized expert on trade creditors' rights and the representation of creditors in bankruptcy and other legal matters. He is a member of NACM and is a former member of the Board of Directors of the American Bankruptcy Institute and is a former co-chair of ABI's Unsecured Trade Creditors Committee. Bruce is also the co-chair of the Avoiding Powers Advisory Committee working with ABI's commission to study the reform of Chapter 11. He can be reached via email at bnathan@lowenstein.com.
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Date:Feb 1, 2014
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