One of the most broadly accepted concepts in the construction business is that when a contractor receives payment on a project that contractor should use the money received to pay that contractor’s subcontractors and suppliers for that same project. Certain states—including Maryland—have recognized this duty with a trust fund statute that requires that contractors hold payments received in trust for the payments of subcontractors and suppliers. Virginia does not have a trust fund statute but the Virginia Supreme Court has stated “[t]here is a moral obligation closely akin to a legal trust relation extending to both the owner and to those whose material or labor has entered into a structure, that the compensation paid therefor by the owner should not be misapplied.” Overstreet v. Commonwealth, 67 S.E. 2d 875, 879, 193 Va. 104, 111 (1951). A trust fund statute can create a number of benefits. The first is the potential to modify the behavior of contractors and subcontractors in a favorable way. For example, an owner who pays a general contractor generally wants those funds to be used to pay subcontractors and suppliers. Trust duties— and the potential heightened consequences of violating those duties when compared to just breaching a contract—create a greater incentive for a contractor to use the funds for that purpose. Of course, this does not always work, but theoretically it should help.
The second benefit from a trust relationship arises after trust duties have been violated. Certain trusts may result in officers or managers of a contractor being personally liable if funds are misused. This can be a meaningful collection tool if a contracting business goes under after misusing funds. Benefits from a trust also arise in a variety of ways when a subcontractor or contractor files for bankruptcy. The easiest example is a situation where a payment is made to a subcontractor who then files bankruptcy while still in possession of the funds. If that payment is not subject to a trust, those funds are now property of the bankruptcy estate. This means that the funds are very unlikely to find their way to that subcontractor’s suppliers on that project. If the contractor who made that payment supplied a payment bond on the relevant project, the contractor might be looking at double liability. However, if the funds are subject to a trust either the contractor or the suppliers on that project may be able to claim those funds and thereby prevent a potential double liability situation. Even when the problem is just that the costs to complete the subcontractor’s work will exceed the remaining balance, a trust may provide an avenue to claw back certain funds which can be used to pay the completion costs. Despite the lack of a trust fund statute, all is not lost in Virginia. In the absence of a trust fund statute, it is generally possible to create trust obligations by contract. A recent decision from the United States Bankruptcy Court for the Eastern District of Virginia provides some guidance about a potential contract drafting pitfall that could mean that even the clear intent to create a trust via contract may not be legally enforceable.
In the case of Gold v. Paige International, Inc. (In re The Truland Group, Inc.), Adv. Proc. No. 16-01015-BFK, a sub-subcontractor (“Sub-Sub”) argued that payments it received were subject to two different trusts created by contract. The first arose from the contract between the relevant subcontractor (“Sub”) and the relevant general contractor (“GC”). This contract stated:
The Subcontractor agrees and covenants that money received for the performance of this Subcontract shall be used solely for the benefit of persons and firms supplying design services, labor, materials, supplies, tools, machines, equipment, plant or services exclusively for this Project in connection with this Subcontract and having the right to assert liens or other claims against the land, improvements or funds involved in this Project or against any bond or other security posted by Contractor or Owner; that any money paid to the Subcontractor pursuant to this Subcontract shall immediately become and constitute a trust fund for the benefit of said persons and firms, and shall not in any instance be diverted by Subcontractor to any other purpose until all obligations arising hereunder have been fully discharged and all claims arising herefrom have been fully paid.
The court determined that this clause did create a trust pursuant to Virginia law. Specifically, the court stated that the phrase “shall immediately become and constitute a trust fund” showed that the “[t]he parties clearly intended the creation of a trust.” The court also determined that the Sub was “clearly restricted in the use of the property” by the clause stating that the funds “shall not in any instance be diverted.” Finally, although the court noted there was no requirement that the funds be kept in a segregated bank account, the language stating that those funds “be used solely for the benefit of any subcontractors or suppliers” was sufficient to create a trust because it mandated a separate accounting for those funds.
The second trust clause at issue in that case was from an indemnity agreement between the Sub and its surety (“Surety”) who had provided payment and performance bonds on the relevant project. The relevant clause in that agreement stated:
IX. TRUST FUND (A) PRINCIPAL and UNDERSIGNED agree that with respect to each specific contract secured by BOND(S) executed, provided or procured by SURETY on PRINCIPAL’S behalf, all money and property representing the consideration for the performance of the contract, (including, without limitation, the proceeds of claims for adjustments, additional compensation, compensation for delay, extra work, change orders, insurance claims and all damage claims) whether in the possession of the PRINCIPAL, UNDERSIGNED or other and whether earned, unearned, paid, retained or to be paid shall be held in trust as trust funds for and shall be used solely for; (1) performance of the contract; (2) the payment of obligation(s) to subcontractor(s), laborer(s), and supplier(s) of material(s) and service(s) incurred or to be incurred in the performance of the contract for which SURETY is or may be liable under BOND(S) and; (3) the satisfaction of UNDERSIGNED’S obligations to SURETY under this AGREEMENT and all other indebtednesses and liabilities of UNDERSIGNED to SURETY. (B) PRINCIPAL shall, upon demand of Surety, deliver the consideration for the contract to a bank designated by SURETY for deposit in an account in the name of PRINCIPAL designated as a “Special Account” or “Trust Account” and withdrawals from said “Special Account” or “Trust Account” shall be by check(s) payable to the beneficiaries and for the stated purpose of this trust, signed by a representative of PRINCIPAL and by a representative of SURETY.
The court stated that the Sub-Sub’s arguments based on this clause were abandoned by the Sub-Sub, but in a footnote still determined that this clause did not create a trust. The reason provided by the court was that “Article IX(B) . . . provides that ‘upon demand of the Surety’ all contract proceeds will be segregated and separately accounted for.” While the court acknowledged as to the first trust that trust funds do not need to be segregated, it seems to have determined as to the second trust that whether or not comparable separate accounting requirements exist, the discretionary right to require segregation means that funds are not separately accounted for in the absence of a segregation demand. Therefore, a trust was not created.
The broader meaning of this ruling is somewhat harder to discern. The court states that segregation is not necessary and found that language requiring that the funds “be used solely for the benefit of any subcontractors or suppliers” was sufficient to create a trust. However, the language in the indemnity agreement similarly states that the funds be used “solely for” certain defined purposes yet the court determined the clause does not create a trust because the agreement also includes a discretionary right to also require that the funds be kept in a separate bank account. Ironically, the Surety seemingly retained a greater level of control over the funds in the possession of the Sub and this additional control was determined to mean that a trust did not exist.
In light of this decision, there seem to be a few possible drafting solutions that can increase the likelihood that a trust clause be held to create a trust under Virginia law. The easiest is to avoid including any discretionary right to require that funds be segregated. A trust clause that tracks the language in the contract between the GC and the Sub here and does not include a discretionary right to require segregation should create a trust. Essentially a trust clause should either require segregation from day one or not require it at all while still requiring separate accounting. This solution should work even if this decision means that the inclusion of a discretionary right to require segregation means absolutely that no trust was created.
A second and somewhat riskier drafting solution might be effective if the discretionary right to require segregation is something that cannot be removed from an agreement for some reason. This solution would be to include language that makes clear that separate accounting and the other trust obligations exist are mandatory from day one even if a demand to segregate the funds is never made. It is, however, unclear whether this would resolve the problem as the language of the clause in In re Truland does not seem to imply that duty to separately account for the funds required a demand for segregation to take effect. While an explicit statement that the trust arises prior to such demand is better than silence on the issue, it is unclear whether it would result in a different outcome than the one reached in In re Truland. This ruling might mean that a discretionary right to require segregation means that a trust cannot exist. Doing anything other than removing such a right potentially brings additional risk into play.
A third solution might be to simply use a choice of law clause to specify that the law of state other than Virginia applies to the contract containing the trust clause. At least one court has applied the law of a different state and found a trust to arise from a clause with a similar unexercised discretionary right to require segregation. The Sixth Circuit Court of Appeals decided under Kentucky law that the following clause did not prevent a trust from being formed even though a demand to segregate was never made:
Fourth: Undersigned covenant and agree that all funds received by them, or due or to become due under any contract covered by any Bond are trust funds whether in the possession of the Undersigned or another, for the benefit of all parties to whom the Undersigned incurs obligations in the performance of the contract covered by the Bond(s) and/or the benefit of, payment to or reimbursement of the Surety for any liability, loss or expense the Surety may incur under the Bond(s) or in enforcing this Agreement. If the Surety discharges any such obligation, the Surety shall be entitled to assert the claims of any party to the trust funds. The Undersigned shall, upon demand of the Surety and in implementation of the trust, open an account or separate accounts with a bank designated by Surety, which account(s) shall be designated as a trust account(s) for the deposit of such trust funds and the Undersigned shall deposit therein all monies received pursuant to said contract. Withdrawals from such account(s) shall be by check or other instrument signed by the Undersigned and countersigned by a representative of the Surety. Notwithstanding anything to the contrary herein above this dedication may be implemented in any other manner provided at law or in equity.
Poynter v. Great Am. Ins. Co. (In re Poynter), 535 Fed. Appx. 479 (6th Cir. 2013). Specifying that Kentucky law applies to the relevant contract and copying this clause might help create an enforceable clause. There are many reasons that parties to various construction documents might want to create a trust. Such trusts are largely a manifestation of the principal—described the Virginia Supreme Court as a moral one—that funds received on a construction project should be used to pay the expenses on that project. However, careful drafting with an eye on most current case law can mean the difference between a trust that is enforceable under law or just wasted paragraphs in your contract documents.