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The most important financial regulation affecting those who lend to the construction industry is not Dodd-Frank, but the Michigan Builders Trust Fund Act. For lenders, it is critically important to understand this Act and the rules that have grown up around it.
The Trust Fund Act is only three sentences long. But in this short space the Legislature imposed a trust on construction contract funds paid to a contractor, turned the contractor into a trustee, elevated the contractor’s vendors and the project owner into trust fund beneficiaries, and imposed criminal penalties on those who violate the trust.
While the express language of the Trust Fund Act does not differentiate between public and private projects, in 1935, the Michigan Supreme Court limited the Trust Fund Act to private sector jobs only, on the theory that subcontractors and suppliers could recover from the payment bonds required for public works projects. Michigan case law contains many situations where this logic has failed, and lower tier subcontractors and suppliers were not protected by the bond. Creative attorneys are waiting for the right case to challenge the limitation to private projects.
Although the express language of the Trust Fund Act mentions only criminal penalties for its violation, in 1966, the Michigan Supreme Court discerned a private, common law remedy. Afterward, Michigan courts saw a steady increase in civil claims under the Trust Fund Act.
The Act does not mandate any special form of accounting for trust funds. It only prohibits the use of construction project funds for something other than that particular project. Courts have rightfully interpreted this as giving contractors discretion in handling trust funds. As long as everyone providing labor and materials gets paid, commingling funds from multiple projects into one bank account is acceptable. However, if a lower tier entity is not paid it opens up a contractor – and sometimes the lender if it swept the account – to potential litigation over the exercise of such discretion. Because there is no legislated standard of accounting for trust funds, the contractor and lender may have difficulty defending the claim, even if payment was withheld for a valid reason.
Most importantly, Michigan courts grafted rules associated with ordinary trusts onto the trusts created by the Act. Two such rules particularly impact financial transactions. First, trust funds are not property of contractors receiving payment; rather, the funds belong to the beneficiaries (project owner, subcontractors, and various suppliers). In the event of contractor insolvency, trust funds never become part of the bankruptcy estate because the funds never belonged to the contractor to begin with. Thus, your borrower can defeat the trustee’s preference claim if it is a lower tier supplier.
But this rule also means trust funds cannot be pledged by the contractor as collateral because the contractor lacks power to transfer any rights to them. Further, a borrower’s construction funds held in deposit accounts are not subject to set-off by the lender. In a nod to modern banking practices, the Michigan Supreme Court created an exception for lenders whose credit facilities enable contractors to pay their laborers, subcontractors, and suppliers.
The second common law rule affecting financial institutions concerns the legal fiction that the trust fund is itself an identifiable piece of property. Whereas money is normally regarded as fungible – one dollar is just as good as another – property held in trust is unique. Trust funds maintain their character as property of the beneficiary so long as they can be identified, whether in the original account or in an account they have been transferred into. But once trust funds are untraceably dissipated, they are gone forever.
These rules present lenders with the proverbial two-edged sword. On one hand, the rules help borrowers on the lower tiers of a construction project recover receivables. But the Trust Fund Act also forces lenders to handle a contractor’s receivables carefully because the receivables may not belong to the contractor at all. Regardless, it is of critical importance for lenders to understand the opportunities and obligations imposed by the Michigan Builders Trust Fund Act if they are to lend to those in the Michigan construction industry.