A common credit management devise is the joint check agreement (“JCA”). This requires the consent of more than one player on the construction project. The creditor supplier needs the consent of not only of the debtor customer, but also the customer’s buyer (normally the general contractor, but sometimes the owner or a subcontractor). An owner or general contractor needs the consent of the debtor customer but may also want agreements or waivers from the creditor supplier.
The next important thing to understand about joint check agreements is that they vary tremendously in how they are worded. There is no such thing as a “standard” joint check agreement. You do not know what rights it gives you until you see it. Some joint check agreements remove more rights than they give, sometimes including a waiver of mechanic’s lien and bond rights.
A manager must be able to evaluate the joint check agreements offered and suggest changes that will better protect company assets. The most common joint check agreements state only that a general contractor will write any check jointly. This offers no protection if the customer defaults on their contract or is not owed any money. Some agreements provide no recourse against a general contractor if there is a failure to issue a joint check.
What if the debtor customer disappears, goes out of business or refuses to endorse a check? What if there is a disagreement about the amount owed the material supplier? What are the regulations on the use of Joint Checks on government projects for Disadvantaged Business Enterprises? Creditor suppliers need to learn how to provide guaranties, actual security and trust fund provisions in a joint check agreement that will protect company assets in the event of debtor customer bankruptcy. Owners and general contractors need to learn how to limit their exposure.
Joint Check Agreements for Owners and General Contractors
An owner or general contractor may want or be willing to agree to a joint check agreement to attract better suppliers or better pricing. These arrangements may also allow the use of cheaper subcontractors that cannot otherwise get supplier credit. Any time that marginal subcontractors are used, however, the owner or general contractor must take on the greater administrative burden of policing the subcontractors. To protect against mechanic’s liens and payment bond claims, the general contractor must be aware of all suppliers and make sure that they are paid. The subcontract should require a complete list of suppliers on the project and prohibit the use of unauthorized suppliers. This allows an owner or general contractor to make sure they have lien waivers from all suppliers on the project at each progress payment. A general contractor should also require the debtor customer to come to the general contractor’s office to endorse the joint check and then the general contractor should deliver that check to the creditor supplier. This eliminates any risk of forgery on the check and makes sure the check is actually delivered.
A trust fund agreement in subcontracts and joint check agreements, discussed below, is as beneficial to a general contractor as it is to a creditor supplier. This does not add any additional burden or risk on the general contractor and provides important protection to both the general contractor and the supplier if the debtor customer files bankruptcy.
In addition to a trust fund provisions, all parties want the JCA to clearly identify the general contractor, debtor customer, creditor supplier and the project. The general contractor also wants to limit the total dollar amount of the JCA for this project and require lien and bond waivers in exchange for payments. The creditor supplier should be willing to agree to these provisions.
A general contractor does also have an opportunity to get added protection by getting a supplier to waive various rights. Most importantly many general contractors get unwary suppliers to waive mechanic’s lien and bond rights in exchange for the joint check agreement. A supplier can also agree to a “Pay if Paid” provision, eliminating any obligation in the general contractor if payment is never received from the owner. A general contractor may also say that the agreement does not create any contractual rights in the creditor and is made solely as a “convenience” or “accommodation” for the creditor supplier. All these provisions are shown in the third form at the Appendix.
Since the wording of joint check agreements does vary tremendously, each party involved would certainly prefer to draft the joint check agreement if possible. If someone else drafts the agreement, it is important to make sure your manager knows how to read them, evaluate them and revise them.
Enforcement of Joint Check Agreements for Creditor Suppliers
Creditor suppliers can certainly encounter difficulties in enforcing rights under a joint check agreement that states only that a general contractor will write any check jointly. These agreements are often vague about exactly what the agreement is or exactly what obligation the owner or general contractor has. Without a bankruptcy, the creditor supplier will be seeking judgment against the owner or general contractor and probably trying to force them to pay a second time. If the owner or general contractor had not already mistakenly paid the debtor, then there would probably be no need to enforce the joint check agreement.
Judges are usually reluctant to force a second payment. Yes, the owner or general contractor failed to comply with and “breached” the agreement. But it is a “Battle between Innocents.” There is no “unjust enrichment.” Neither the owner, nor the creditor supplier comes out ahead financially. The owner just made a mistake. The creditor supplier “should have enforced mechanic’s lien or bond rights.” There is generally no clear case law guiding the court to a particular result. The outcome also depends a great deal on the wording of the joint check agreement.
At a minimum, for all these reasons, the creditor supplier wants the agreement to clearly create a clear contractual obligation in the owner or general contractor that all checks shall be payable to two specific payees and make it clear that the creditor supplier is relying on this agreement in order to agree to supply. This also means that the general contractor or owner must sign the agreement, to make it clear they are agreeing to something.
Even with this clear contractual obligation, the most important thing for a creditor supplier to remember about a standard joint check agreement is that IT ONLY HELPS IF A CHECK IS EVER WRITTEN. The general contractor may assert back charges or claim that the subcontractor never completed its contract. If the general contractor is not obligated to pay the subcontractor, the general contractor is also not obligated to write a check and the joint check agreement will do no good.
A creditor also wants a joint check agreement that requires checks be sent directly to the supplier and provides a power of attorney to endorse checks on behalf of the debtor customer. This solves the problem of the debtor that disappears, refuses to endorse a joint check or refuses to give it to the creditor. The debtor can also agree that the owner or general contractor can rely on the creditor’s statements of the total current indebtedness to the creditor. This may prevent the debtor telling the owner or general contractor to issue a check in a lower amount or instruct the owner of general contractor not to issue any check, if there is a dispute with the creditor supplier. In this provision, the debtor has agreed that the owner or general contractor can rely on the amount due to the seller in statement of account from the creditor supplier. This provision essentially lets the money flow and makes the debtor take up any dispute with the supplier later. The first two forms at the Appendix include all these provisions.
In the event the debtor files bankruptcy, a standard joint check agreement may be little or no help to the creditor supplier. The receivable owed by the owner or general contractor will be part of the bankruptcy estate, subject to the rights of the trustee, secured creditors and general unsecured creditors. Whether the creditor supplier can collect anything will depend on what additional features are in the joint check agreement.
Options on Joint Check Agreements for Creditor Suppliers
A creditor supplier would certainly prefer a guaranty from the owner or general contractor. Here, the general contractor guarantees that the supplier will be paid no matter what problems there are with the subcontractor. A guaranty is typically enforceable by the creditor “outside” the bankruptcy, so no permission of the bankruptcy court is necessary, and the owner or general contractor should be able to get credit for the payment to avoid a double payment. The word “guaranty” usually sends shivers up and down spines, but this is an option.
Another option is to request that materials be sold on the owner’s or general contractor’s account. This avoids the risk of liens or bond claims on this project, and the general contractor may avoid a mark-up on the materials.
A joint check agreement is a terrific opportunity to establish the trust fund provision or escrow arrangement discussed below. Remember that the trust fund provision does not place any additional burden or risk on the general contractor or the debtor customer. It just puts the supplier in a better position vis-à-vis the other creditors of the customer, including the customer’s secured lender. Both the supplier and the general contractor would be in a much stronger position, especially if the subcontractor files bankruptcy. General contractors on bonded projects do not want the risk of liability to a supplier on a payment bond, when the general has already paid the subcontractor in full.
Suppliers may also succeed in slightly rewording the standard joint check agreement to include a security interest in the accounts receivable to be due to the debtor customer. This is security, which would make you a secured creditor in the event of bankruptcy. Without this security, your buyer’s accounts receivable go into the general bankruptcy fund to pay all general unsecured creditors. With the security interest, you may have first claim to this one fund.
You can consider an outright assignment of funds, which has some similarities with a security interest. With an assignment of funds, you are already the owner of the fund, not your customer. These mechanisms are not in the joint check agreements at the Appendix, although an Assignment is shown in the Construction Law Survival Manual. It is probably better for you to use the assignment of funds, the security interest or the trust fund provision, but not more than one of these mechanisms in one document. If the intent is ambiguous or contradictory in the document, there is greater risk you will get no remedy at all. The trust fund agreement is probably preferable.
The first form at the Appendix includes a guaranty of the account and a trust fund provision. If someone objects to one of these provisions, it can be stricken out of the form and you will still have some of the important protections included in the form.
Trust Fund and Escrow Agreements
Trust Fund Statutes and Trust Fund Agreements are discussed in detail in the Construction Law Survival Manual available for free at www.FullertonLaw.com. However, they are an important and underutilized opportunity for joint check agreements and other contracts.
Suppose a bankrupt debtor is the trustee on his niece’s college tuition trust fund. The bankruptcy debtor’s creditors cannot attach this college trust fund, because it is not the bankruptcy debtor’s money. The money belongs to the niece. The trustee has only “legal” title. The niece is the “beneficiary” of the trust and has “equitable” title to the money.
Some states have trust fund “statutes” or laws to protect subcontractors and suppliers in the construction industry, including Maryland[1], New York and New Jersey. When a general contractor receives payment from the construction project owner, the general contractor holds funds in trust for the benefit of the subcontractors and suppliers. Subcontractors then hold funds in trust for their suppliers.
Even in states without trust fund laws, it is possible to create a trust fund relationship by agreement. This works just like a bank trust fund (or the college tuition trust fund for the niece) and would apply in any non-construction industry. It is possible to add clear trust language to a joint check agreement, credit agreement, proposal, quote or to any contract with just a few sentences.
Customer agrees that all funds owed to Customer from anyone or received by Customer, to the extent those funds result from the labor or materials supplied by Seller, shall be held in trust for the benefit of Seller (“Trust Funds”). Customer agrees it has no interest in Trust Funds held by anyone, to segregate and make no use of, except to promptly account for and transmit to Seller all Trust Funds no later than on demand.
We believe that this language creates a trust fund relationship that should work just like the trust fund laws. Your debtor customer agrees that all funds received are held in trust, to the extent funds result from your labor or materials. If your debtor customer files bankruptcy, these funds will not be property of the bankrupt estate. You will not need to share with the general unsecured creditors and should be able to keep these funds as the trust beneficiary.
This language should also be relatively easy to “sell” to a customer on a credit agreement, quote, or joint check agreement. The customer certainly intends to pay you promptly on receipt of funds. That is all this language says. It does not create any additional burden or cost on the customer or general contractor. The issue is whether you would have to “share” this receivable with your customer’s other creditors in the unlikely event of insolvency. This language allows you to identify your customer’s receivable as produced or created by the labor and materials you supplied and claim ownership of that receivable.
Since your debtor is never the owner of trust funds, it is also impossible for the debtor to grant a security interest in trust funds. The trustee could not give away or sell trust property, since a trustee does not have title. The beneficiary of the trust could claim ownership of the trust property, even in the hands of third parties. By the same token, a trustee cannot grant an effective security interest in trust property. The trustee has no good title to sell, give away or grant a security interest in trust property.[2]
Accordingly, trust fund laws or agreements are one way that a creditor supplier can gain priority over a customer’s bank that has a blanket security interest on receivables. This also makes sense. You are essentially saying to a customer that you will not give them the value of your labor and materials if some other lender will have priority over the receivable that is generated by the value you provide. You can refuse to supply labor or materials unless you will have absolute first priority to the value you provided. This absolute first priority is a trust fund agreement.
In the event of bankruptcy, the trust funds held for the benefit of subcontractors and suppliers do not become a part of the bankruptcy estate. While the creditor may need to get appropriate bankruptcy orders, the creditor may be entitled to payment directly from an owner or general contractor. A trust fund claimant may even be able to obtain payment from the bankruptcy estate, by bankruptcy court order, since trust funds are not property of the bankruptcy estate and always belong to the beneficiary.[3]
Trust fund laws or agreements can also be very helpful in “preference” litigation. If a creditor received payments less than 90 days before a bankruptcy, the creditor may have to give the money back as a “preference.” If a trust fund law or agreement applied, however, the payment cannot be a preference. The debtor was giving you your own money. It was never the debtor’s property and was not a payment from the debtor.
The greatest legal challenge or problem with trust fund agreements is probably the possible requirements in some states that trust funds be “segregated” from the debtor’s funds and not “commingled.[4]” This law generally arises in court case law and does not seems consistently enforced.[5] It is certainly preferable to require that the funds be put in a segregated account. This would make it easier to police the use of the trust funds and help ensure that a court would recognize the existence of a trust. There is also some case law that no trust is created until the trust is funded. However, the prevailing rule seems to be that a trust can be immediately created with just the promise to pay money to the trustee in the future.[6]
In an escrow and trust arrangement, the funds are segregated. This would be a definite solution to these problems. The general contractor makes payments to an escrow agent, who then holds the funds in trust until both the debtor customer and supplier creditor provide the escrow agent instruction on the amount the escrow agent should disburse to each. The escrow agreement can also state in advance the amount of each payment that will be disbursed to each party.
If the debtor customer and supplier creditor do not provide the escrow agent instruction, then the debtor customer, supplier creditor or escrow agent can request a court order regarding the proper disbursement. Legal action can result in additional costs, but that threat of additional cost normally motivates the parties to make an agreement. There is a defense of payment feature to an escrow and trust agreement. If no payment is due to the debtor customer, then the general contractor is not obligated to make any payment.
An escrow or trust arrangement does reduce the risk of insolvency or misappropriation of funds. As explained in the Construction Law Survival Manual chapter on Trust Funds Laws and Agreements, both general contractors and suppliers benefit from trust fund provisions. They reduce the risk of both general contractors and suppliers, without increasing costs.
Security Interest
Security Agreements are also discussed in detail in the Construction Law Survival Manual and are also an important option for joint check agreements and other contracts. It is logical and only fair that the debtor customer grant a security interest in the account receivable they will receive in part because of the seller creditor’s credit for material.
In the typical secured transaction, the lender has two avenues to obtain payment: (1) a claim against the borrower personally, which will eventually enable the lender to go against all the borrower’s assets, and (2) a claim against the collateral or secured property.
Obviously, the existence of two avenues gives the lender a greater chance of recovery. Secured creditors will usually have the same rights as a general unsecured creditor and will also have the first claim against the security property. Unsecured creditors are in a race to obtain a judgment. The first judgment creditor to attach the debtor’s assets will have priority over later judgment creditors. A secured creditor, however, already has a first priority lien in the security property, even without filing suit.
Bankruptcy ends the race to the courthouse. All creditors are forbidden from racing to get judgment liens or otherwise improving their position once a petition for bankruptcy is filed. Once a petition is filed, general unsecured creditors will never be able to secure the amount owed to them, by judgment or otherwise. However, the secured creditor’s lien on property survives the bankruptcy, if the secured creditor obtained that lien at least ninety days prior to the bankruptcy.
The practical result of most bankruptcies is that all secured creditors get some or all their money while general unsecured creditors get nothing. Security interests become most important, therefore, upon the debtor’s insolvency or bankruptcy.
Debtors will normally agree that the seller creditor will be paid as soon as they collect on the project. It is often easy to suggest that the debtor grant a security interest in that single receivable. You probably don’t even have to file a UCC financing statement to perfect this security interest if it is not a significant part of the outstanding accounts of the debtor.[7] This is obviously a vague standard. It is better to provide the creditor the right to file a UCC financing statement. If you have a choice, it is preferable to record a financing statement to perfect this security interest and provide public notice of the security interest.
The Joint Check Rule
Some state courts have developed what is called “The Joint Check Rule,” also known as “The California Rule,” the state where it probably originated. We understand that several states may have some version of this rule.[8] The rule apparently would not apply on federal Miller Act payment bond projects[9] or in any of the Mid-Atlantic states surrounding Washington D.C. In any event, it seems creditors can avoid the harmful effects of this rule with careful management and using carefully drafted written JCAs.
Under the Joint Check Rule, the creditor supplier is deemed to be paid in full and to have received the money if the creditor supplier endorses a joint check. The endorsement discharges the owner, general contractor, their surety and the project property from liability to lower tier contractors or suppliers, any mechanic's lien or bond rights.[10] The endorsement of a joint check presumes that the creditor supplier received all money due, even if not received, unless there was a specific allocation of the payment to specific invoices.
A carefully drafted formal Joint Check Agreement should avoid this rule by including a guaranty from the owner or general contractor, and/or specifically stating that the California Joint Rule would not apply, and/or that checks received will always be deemed partial payment until the creditor supplier has actually signed a final release, and/or that the owner or general contractor can only rely on the creditor’s statement of the total current indebtedness. The creditor supplier can also withhold their endorsement until receiving payment or by restricting any endorsement or insisting on a formal escrow arrangement.
Using JCAs with Disadvantaged Business Enterprises
Using Joint Check Agreements when doing business with Disadvantaged Business Enterprises (“DBE”) on public projects can present special problems. On U.S. Department of Transportation (“DOT”)-assisted contracts and most Maryland state contracts, for example, the regulations state that there are no DBE participation points unless the DBE contractor performs a “commercially useful function” (“CUF”).[11] In essence, the DBE must actually participate and add value to the project. However, there are no restrictions on using JCAs with DBEs on most public projects, which have no CUF regulations.
The CUF regulations do not allow the DBE to be an “extra participant in a transaction, contract or project, through which funds are passed in order to obtain the appearance of DBE participation.”[12] To perform a commercially useful function with respect to materials, the DBE must also be responsible for negotiating price, determining quality and quantity, ordering the material and installing materials (where applicable) and paying for the material. Controversies exist regarding joint check agreements, because joint check agreements make it more difficult to determine whether the DBE is paying for the material and controlling its operations independently of the general contractor.
Joint checks are not prohibited,[13] but are subject to conditions and are a “red flag” calling for further scrutiny. The general contractor must act “solely as a guarantor;” the DBE must release the check to the supplier; the use of joint checks must be a commonly recognized business practice in the industry;[14] the state transportation agency must approve the practice before it is used; and the state agency must monitor the practice to avoid abuse.[15]
These rules do not prohibit the use of joint checks, they only created administrative hurdles. It is necessary to get agency preapproval for the use of a joint check agreement and this is often cumbersome for general contractors and suppliers. The general contractor must release the joint check to the DBE and the DBE must then deliver it to the non-DBE supplier.
A payment guaranty, like a payment bond, from a general contractor has no impact on DBE participation credit. It is a preferred mechanism, at least for federal highway projects. For DBE participation compliance, there may not be any rules restricting the use of joint check agreements with most government agencies.
Using Trust or Escrow with Disadvantaged Business Enterprises.
It is possible to create an escrow or trust payment agreement for the benefit of the general contractor, the DBE and the supplier. This arrangement has been approved or even proposed in the past by some federal government procuring agencies without impacting minority participation points to the general contractor. Any government owner, private owner or general contractor could agree to this arrangement. An advantage is that only the DBE and general contractor need to agree. No agreement from the government is necessary. However, the supplier would want the general contract, or at least the subcontract, to contain an obligation to make payment to the escrow agent pursuant to the escrow agreement.
[1] Maryland Real Property Code §9-201 et seq.
[2] Mid-Atlantic Supply Inc. of Virginia v. Three Rivers Aluminum Co., 790 F.2d 1121 (Va. 1986)[any words “which unequivocally show an intention that the legal estate was vested in one person, to be held in some manner for some purpose on behalf of another” are sufficient to create a trust].
[3] Mid-Atlantic Supply Inc. of Virginia v. Three Rivers Aluminum Co., 790 F.2d 1121 (Va. 1986) [a constructive trust under Virginia law arising out of a joint check agreement. Rights of beneficiary superior to bankruptcy Trustee].
[4] M&T Elec. Contrs., Inc. v. Capital Lighting & Supply, Inc. (In re M&T Elec. Contrs., Inc.), 267 B.R. 434, 479 (Bankr. D.D.C. 2001), citing Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp.), 810 F.2d 270, 274 (D.C. Cir. 1987) [for a trust to be present, whether an express trust or a constructive trust, “the courts have uniformly required a contract irrevocably obligating the debtor both to segregate the “trust funds” from the debtor’s own funds and to deliver the “trust funds” to the creditor”].
[5] Federal Insurance Company v. Fifth Third Bank, 867 F.2d. 330, 334 (6th Cir. 1989) [The Bank also argues that there was not a trust formed because there is no evidence in the contract that the State required Becker to hold this money in a separate account. However, this is not a determining factor of whether a trust was formed. The requirement to hold the funds in a separate account is a fiduciary obligation of Becker’s, as trustee, and therefore, when a trust is formed, the trustee has this obligation regardless of the trust agreement wording]. See RESTATEMENT (SECOND) OF TRUSTS § 179 (1959)]; In re Marrs-Winn Co. Inc., 103 F.3d 584, 591 (7th Cir. 1996) [“Missouri law requires four elements for a valid express trust: identified beneficiaries, a trustee, an identifiable trust res, and actual delivery of the trust corpus,” citing Electrical Workers, Local No. 1 Credit Union v. IBEW-NECA Holiday Trust Fund, 583 S.W.2d 154, 161 (Mo. 1979) (en banc)].
[6] Holmes Envtl. v. Suntrust Banks (In re Holmes Envtl., Inc.), 287 B.R. 363, 378 (Bankr. E.D. Va. 2002), citing Restatement (Second) of Trusts, cmt § 17(a)(3) (1959).
[7] UCC Section § 9-309. SECURITY INTEREST PERFECTED UPON ATTACHMENT.
The following security interests are perfected when they attach: (2) an assignment of accounts or payment intangibles which does not by itself or in conjunction with other assignments to the same assignee transfer a significant part of the assignor's outstanding accounts or payment intangibles;
[8] California, Iowa, Louisiana, Missouri, South Carolina, Texas, Washington.
[9] See e.g. Clark--Fontana Paint Co. v. Glassman Constr. Co., 397 F.2d 8 (4th Cir. 1968); Marmet Corp. v. Becon Services Corp., 794 F. Supp. 428 (D.C.D.C. 1992).
[10] See e.g. Post Bros. Constr. Co. v. Yoder, 569 P.2d 133, 135, 20 Cal. 3d 1, 141 Cal. Rptr. 28 (Calif. 1977)[When a subcontractor and his materialman are joint payees, and no agreement exists with the owner or general contractor as to allocation of proceeds, the materialman by endorsing the check will be deemed to have received the money due him. Inclusion of the materialman as payee makes clear that the maker of the check intends to discharge obligations owed the materialman. The materialman was at least under the duty of inquiring as to his intention with respect to the application of the funds represented by the checks].
[11] 49 CFR 26.55 (c)(2).
[12] 49 CFR 26.55 (c)(2).
[13] DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, pp. 46-47 states that the “text of the DBE rule does not mention the use of joint checks. Consequently, the rule does not prohibit prime contractors and subcontractors from using joint checks” and “[h]istorically, what has led to problems is not so much the use of joint checks in itself, but concealment or a lack of honesty concerning their use.”
[14] If joint checks are available to a DBE subcontractor, they should be made available to all subcontractors (DBEs and non-DBEs). DOT Official Questions and Answers 49 CFR Part 26. April 15, 2016, p. 49.
[15] See e.g. Maryland Minority Business Enterprise Program Manual (June 2012, revised March 2015) at page 71 of 97. With respect to the use of joint checks by the prime contractor, MDOT follows USDOT Guidance on Use of Joint Checks Under the DBE Program dated August 30, 2006. Double-payee checks are prohibited except for purchase of supplies and materials. Two-part checks are allowable only in the following situation:
- The other party acts solely as a guarantor,
- The funds do not come from the other party,
- It is a commonly recognized way of doing business, and
- Must be approved in advance by the Administration’s DBE Compliance Officer.