New York’s First Department Clarifies Standing Requirements for General Contractor to Assert a Trust Fund Diversion Claim Against a Subcontractor Under the Lien Law

As New York construction lawyers know, New York’s Mechanics’ Lien Law (the Lien Law) at Article 3-A generally provides that monies paid by a general contractor to a subcontractor are trust funds for the benefit of the subcontractor’s sub-subcontractors and suppliers. The reported decision is important as it clarifies the standing requirements for a general contractor to assert a trust fund diversion claim against a subcontractor under the Lien Law.

In August of 2022, the Supreme Court held a bench trial in this case, which arose out of HPH and Haddad’s alleged diversion of funds that Flintlock, as general contractor, paid for equipment in connection with the construction of a hotel (the Project). HPH, as a subcontractor, entered into a subcontract with Flintlock to provide labor, materials and equipment for the Project. The causes of action before the court included diversion of trust assets, fraud and negligent misrepresentation against HPH and Haddad.

The evidence at trial established that HPH submitted seven payment requisitions to Flintlock between January 1, 2012, and July 21, 2012, and Flintlock paid HPH $583,900 on those requisitions. On September 21, 2012, Flintlock paid an additional $480,000 on an eighth requisition which consisted of $451,326 to cover equipment deposits. Upon its receipt of payment for the eighth requisition, HPH abandoned the Project and terminated the subcontract. Subsequently, Flintlock learned that HPH had not paid its suppliers and subcontractors from the money paid to it by Flintlock, which was “trust funds” under Article 3-A. Following the filing of a mechanic’s lien against the property by one of those suppliers, Flintlock contended that it “involuntarily” paid the various suppliers and subcontractors over $600,000 in exchange for assignments of claim. In addition, HPH and Haddad failed to produce the books and records that they were obligated to maintain under Lien Law § 75.          

Flintlock maintained that it was a trust beneficiary pursuant to Lien Law § 77, which permits a trust beneficiary to “recover trust assets from anyone to whom they have been diverted with notice of their trust status,” and that the involuntary payments to HPH’s suppliers imbued Flintlock with standing under the doctrine of equitable subrogation. For context, Flintlock maintained that its payments to HPH’s suppliers were “involuntarily” for a host of reasons, including inter alia to prevent the Project from shutting down, to avoid delays in the completion of trade work, to prevent the imposition of liquidated damages, to avoid claims against Flintlock’s payment bond and to prevent additional mechanics’ lien filings. In affirming the trial court’s findings that the payments were involuntary, the First Department focused upon the trial court’s firsthand evaluation of witness testimony and credibility. Flintlock also obtained written assignment of the suppliers’ trust fund diversion claims against HPH, with the court finding the assignments were valid.

In addition, Flintlock sought to enforce the subcontractor’s record-keeping obligations under Lien Law § 72. Per § 72 of the Lien Law, “[a]ny transaction by which any trust asset is paid, transferred or applied for any purpose other than a purpose of the trust . . . before payment or discharge of all trust claims with respect to the trust, is a diversion of trust assets.” Lien Law § 72. In the absence of a “reasonable excuse,” the “[f]ailure of the trustee to keep the books or records required by this section shall be presumptive evidence that the trustee has applied or consented to the application of trust funds actually received by him as money or an instrument for the payment of money for purposes other than a purpose of the trust.” Lien Law § 75(4). To explain the missing trust records, HPH argued that the records were destroyed during a storm and possibly taken by a former employee. Finding these excuses to be “conclusory and vague,” the Supreme Court concluded that they were insufficient to overcome the presumption of trust diversion. As such, the equipment deposits totaling $451,326.00 paid by Flintlock constituted trust funds—and trust assets—diverted by the defendants for non-trust purposes. Specifically, the defendants diverted the trust assets to their own businesses. Importantly, the trial court found HPH’s principal, Haddad, personally liable for trust diversion based on his knowing participation by requesting the equipment deposit money, objecting to Flintlock’s direct payment to suppliers and subcontractors, acknowledging that no funds were paid to those same suppliers and subcontractors, and affecting the diversion through his spouse’s law firm’s trust account. Again, in affirming the trial court’s award to Flintlock, the First Department credited the Supreme Court’s credibility determinations and admission of documentary evidence.

Notably, Flintlock’s demand for punitive damages was denied. The First Department acknowledged the availability of punitive damages under Lien Law Article 3-A but declined to adopt a rule making punitive damages recoverable in any case involving a diversion of trust assets.

Co-authors Gaetano Piccirilli, partner, and C. Quincy Conrad, associate, are members of the Litigation Department at Klehr Harrison.