4th Department Provides Clarity On Avoiding Civil Liability Under The Lien Law By Restoring Diverted Funds
May 24, 2021
Codified in 1959, Article 3-a of the Lien Law (Lien Law §§70-79a) provides very stringent trust provisions related to certain funds on construction projects. For those not familiar with its terms, project “owners” are required to hold in trust all proceeds received from building or home improvement loans for the benefit of all contractors, suppliers and laborers performing work or furnishing materials on the project. Likewise, contractors must hold in trust all monies received as payment from owners or higher-tier contractors for the benefit of all those furnishing materials or labor on their behalf.
The statute’s primary purpose is to ensure payment to those who have directly expended labor and materials on a construction project and prevent circumstances where an owner or contractor “robs Peter to pay Paul” by utilizing trust funds to pay off unrelated debts. Accordingly, the statute mandates that a trustee cannot use any of the trust proceeds for their own purposes until all trust claims on a project have been satisfied or settled, and provides potentially serious consequences for those that violate its terms, including personal liability and even criminal sanctions. Despite the serious penalties, it has always been my opinion that the statute is relatively under-utilized in disputes involving non-payment on a construction project, particular since, in my experience, most owners and contractors do not strictly adhere to the statute’s rigid requirements. Accordingly, despite the statute being on the books for more than sixty years, the caselaw interpreting it is rather undeveloped, particularly at the Appellate level.
Recently, however, our firm was involved in a matter before the Fourth Department, which rendered a determination on an issue that had seemingly never been addressed by the Appellate Division: whether a trustee could avoid civil liability for diversion by subsequently restoring the trust with non-trust assets. In the decision rendered in DiMarco Constructors, LLC v. Top Capital of New York Brockport, LLP, 2021 NY Slip. Op. 02680, the court ruled that a diversion cause of action under the Lien Law could not be defeated (or reduced) by claims that the diversion had been subsequently restored or “cured”.
Before addressing the significance of this holding, a summary of the underlying facts is in order. In the case, a class of contractors and subcontractors alleged that the project owner breached its contract with its construction manager by failing to pay a sum in excess of $1,700,000 for labor and materials due on the project. The plaintiffs also accused the owner and its principals of diverting roughly $1,400,000 of the trust proceeds the owner received from a building loan with a regional bank. After limited discovery and prior to depositions, the owner and its principals sought dismissal of the diversion claims by asserting, inter alia, that even if there was a diversion of the building loan proceeds, any diversion was subsequently restored, since the sum ultimately paid to the construction manager was equal to or exceeded the total trust res disbursed by the bank on the building loan.
The lower court agreed with the defendants’ restoration argument and substantially reduced the plaintiff’s damages on the diversion causes of action to a maximum of $104,205.99, despite credible evidence that well over a million dollars had been improperly been diverted from the building loan proceeds during the early stages of the project. The IAS court reasoned that the plaintiffs were only entitled to recover the difference between the trust funds disbursed by the bank to the owner ($13,344,999.99) and the total amount plaintiffs had received in payment on the project ($13,230,794). In doing so, the lower court was not persuaded by evidence that the owner utilized non-trust assets to pay down a portion of the debt owed to plaintiffs on the project after the building loan trust had been depleted. Nor was the IAS court swayed by plaintiffs’ argument that defendants use of these non-trust assets did not constitute a “restoration” of previously diverted funds, because these non-trust assets (from private investors) had always been earmarked to pay for a portion of the construction.
On appeal, the Fourth Department modified the lower court’s decision by striking the portion reducing plaintiff’s damages on the diversion causes of action. In doing so, the court rejected the argument that an improper diversion of trust assets could be “cured” by a subsequent payment from non-trust assets, concluding that such circumstances would blunt the rigorous trust regulations set forth in the Lien Law, and would open the door to “pyramiding”, where an owner or contractor use loans or payments advanced in the course of one project to complete another. The Appellate Court was persuaded by language in the Court of Appeals case of Aquilino v. New York State, 10 NY2d 271 (1962), which stated that funds from an express trust may not be diverted “whether or not the diversion is subsequently remedied”. Moreover, the majority addressed concerns expressed by the lone dissenting justice, noting that the plaintiffs would not recover a windfall or “double recovery” by re-imposing the full measure of potential damages, because the plaintiffs alleged that a sum in excess of $1.7 million was due and owing for labor and materials on the project.
The holding is significant because prior to the Fourth Department’s ruling, the issue of whether a trustee could avoid civil liability by subsequently restoring diverted funds was murky at best. Even one of the leading treatises on New York construction law could only profess that it was “debatable” whether a trustee could escape civil liability by restoring the trust. (New York Construction Law Manual, 2d Ed., §9.8). This case appears to mark the first occasion that an appellate court in New York State has specifically addressed the issue of trust restoration under Article 3-a. Prior to this decision, the most cited authority for the proposition that diverted funds could not be restored was a Supreme Court decision from Rockland County, noting that the Lien Law was devoid of any statutory language giving rise to a restoration defense in a civil action. Schwadron v. Freund, 69 Misc2d 342 (NYSupp. 1972). However, as cited by defendants in its appeal brief, there are also several miscellaneous decisions that implicitly recognized a restoration defense, at least in circumstances where the plaintiff could potentially recoup a double recovery.
Now that the Fourth Department has weighed in, there is finally some clarity on the issue of restoring diverted trust funds. While it remains to be seen how this holding will impact future litigation, it should put all trustees on notice that they will not be relieved of liability (including personal liability) merely by paying out an amount equal to the total trust res, particularly when the trust beneficiaries are still owed money for labor and materials. As the statute requires, the trustee must account for the proper expenditure of trust funds, and if they cannot, they may be liable for any amounts diverted.
Article written by Richard T. Bell, Jr., a founding partner of Adams Leclair.