Downstream Trust Fund Claims by Contactors Against Their Subcontractors and Their Principals, by Michael D. Ganz, Esq., featured in “The Light,” Suffolk County Electrical Contractors Association Newsletter, 10-2025
Downstream Trust Fund Claims by Contractors Against Their Subcontractors and Their Principals
The Benefits of a Diversion of Trust Funds Claim to Impose Individual Liability
In New York, there is a robust section of the Lien Law under Article 3-A imposing obligations and liability on owners and contractors who are responsible, as trustees, to make payments to their contractors and subcontractors/suppliers respectively. Article 3-A establishes a trust fund for monies received in connection with improvements to real property and designates the recipient of such funds—whether an owner, contractor, or subcontractor—as the trustee of those funds. The trustee is obligated to hold the funds in trust until the claims of all trust fund beneficiaries are either paid or discharged.
For an owner, if the owner uses its own money to finance the construction project, generally the law is not applicable but if the owner finances the project by such mechanisms as a building mortgage loan (using the property itself for the project collateral to the bank), the law is applicable. All contractors who receive payments from an owner have a legal obligation, as a trustee, to use those funds to only make payments for that actual project. In other words, if a contractor receives funds from the owner, it must use those funds to pay its ‘trust fund beneficiaries” such as subcontractors and suppliers and make ‘other permitted payments’ before it uses those funds for any other purpose. Other permitted payments do not include such items as attorney’s fees, general insurance (such insurance required specifically for the project such as builder’s risk may be permitted), payments to subcontractors/suppliers on other projects. Notably, the contractor can choose to pay one subcontractor on the project over another subcontractor on the project since that payment is related to the project. Another critical requirement of the law is that the owner or contractor, as the case may be, must keep and maintain records of all receipts and payments for each project as such failure to do so constitutes a breach of its trust fund obligations to the trust fund beneficiaries. Finally, the principals of the owner and contractor and those responsible for payments may be held personally civilly (and criminally) liable for improper payments as ‘diverting trust funds’. Individual liability is a critical enforcement mechanism so that a contractor or subcontractor/supplier is not left to pursue monies against an empty shell of an owner or contractor. As you can see, the traditional chain of a trust diversion claim is uphill i.e. contractor against owner or subcontractor/supplier against contractor.
Downhill Trust Diversion Claims
However, caselaw including a recent 2024 New York 1st Department case called Flintlock Construction Services, LLC v. HPH Services, Inc., 230 A.D.3d 446 (1st Dept. 2024) addressed ‘downhill’ trust fund diversion claims. Generally, a contractor could not bring a trust fund diversion claim against its own downhill subcontractor for improper payments to its sub-subcontractors or suppliers since the subcontractor received monies from the contractor. Of course, a sub-subcontractor or supplier could bring an uphill trust fund diversion claim against the subcontractor. A key aspect of this case is the court’s affirmation of the contractor’s standing to assert a claim for the diversion of trust assets under Article 3-A of the New York Lien Law. Section 77 of the Article 3-A Lien Law provides that the “holder of any trust claim, including any person subrogated to the right of a beneficiary of the trust holding a trust claim,” may maintain a cause of action for the enforcement of the trust. Here, the contractor made payments to the subcontractor’s suppliers because the subcontractor did not make those payments – even though the contractor fully paid the subcontractor for the supplier’s invoices.
In Flintlock, the court found that the contractor had standing to enforce a trust claim against its subcontractor. This standing was based on the contractor’s status as a subrogee of the subcontractor’s suppliers, a status formed by the contractor’s involuntary payments to the subcontractor’s unpaid vendors. Under the doctrine of subrogation, one party gains the right to enforce another party’s claim by paying the other party’s debt under compulsion or to protect some interest. By making these “involuntary” payments, the contractor acquired the right to assert claims initially held by the subcontractor’s suppliers. Related caselaw emphasizes the claimant must prove that the action is not just beneficial but essential to safeguard its interests.
For instance, a contractor who makes payments to trust beneficiaries can enforce an Article 3-A trust if they have already paid the subcontractor and are subsequently required to pay the subcontractor’s suppliers or sub-subcontractors due to the subcontractor’s failure to do so. Among other situations, this requirement can arise from either a contractual obligation or a payment bond obligation. It is also noteworthy that the appellate court in Flintlock found the principal of the subcontractor personally liable for the diversion of trust assets. The evidence presented showed that the principal knowingly participated in the diversion, including a substantial payment that was funneled through various accounts before ending up with one of his other companies. Moreover, while punitive damages can be awarded for violations of Lien Law Article 3–A involving the diversion of trust assets, the court in this case declined to adopt a fixed rule that would make such damages recoverable in every instance. Therefore, it is on a case-by- case basis.
The decision in Flintlock highlights the potential personal liability for those who divert trust assets. It also clarifies that while punitive damages can be a remedy for diversion of trust assets, they are not automatically awarded and must be justified by the specific circumstances of each case.
As you can see, trust fund diversion claims, if applicable to your situation, may be an important option in pursuing an entity that has not made payments to you as it also may impose individual liability against the entity’s principals. This is critical since the entity may be judgment proof and you would be unable to collect any monies from the entity itself, even if you are successful in proving your damages to a judge or arbitrator.
Michael D. Ganz is a partner in the Woodbury, New York office of Kaufman Dolowich LLP. He focuses his practice on Construction Law and has more than 25 years of experience in construction transactional matters and litigation. He can be reached at michael.ganz@kaufmandolowich.com or (516) 283-8761.
This article is reprinted with permission and was originally published in the Suffolk County Electrical Contractors Association LIGHT publication.
