This article was originally posted in Michigan Infrastructure and Transportation Assocation (MITA) publication, Cross-Section, Summer 2016 edition.
By Mark Rysberg
Contractors performing work on State and Federal construction projects are likely familiar with prompt payment acts. These laws generally require contractors and subcontractors to pay their downstream subcontractors shortly after receiving payment for such work. As the economy has improved, many contractors are finding opportunities in the private sector. The work may be similar, but the rules that apply are vastly different. These differences present pitfalls for the unwary contractor that may result in criminal and civil penalties. One such hazard exists under the Michigan Builders’ Trust Fund Act, which exposes contracting entities and its officers, directors, and employees to individual liability. The consequences for violating the Michigan Builders’ Trust Fund Act could result in substantial financial penalties and prison.i
The purpose of the Michigan Builders’ Trust Fund Act is to prevent fraud in the construction industry, and to ensure that the subcontractors, suppliers, and materialmen that did the work received the payments their work generated.ii
However, courts have recognized that:
[T]he date of its passage, 1931, identifies the act as one of a genre of Depression-era measures intended to afford relief to subcontractors and materialmen in the construction industry.
During the boom period of the 1920’s, speculative builders often undertook to construct projects too large for their available capital to finance, and they frequently paid suppliers and materialmen on older projects with funds received as payment on more current operations. With the advent of the crash of 1929 and the consequent widespread insolvency of many building contractors, these pyramided empires also collapsed and many subcontractors and suppliers were never paid. Subcontractors and materialmen on private projects were left only with mechanics’ liens as remedies, and these were often ineffective.
[S]tatutes like the Michigan Act of 1931 were enacted to afford a “supplement to the Mechanics’ Lien Law,” providing a more effective remedy for private project suppliers against their principal contractors than they had previously.iii
Despite its shrouded history, the Michigan Builders’ Trust Fund Act is a tool for those engaged in the construction industries to collect funds, protect funds from third-parties, and to prevent projects from becoming entangled with problems arising from misuse of project funds.
The Good—It Is Your Money
The backbone of the Michigan Builders’ Trust Fund Act is the imposition of trust status over payments received on private construction projects.iv In its simplest sense, when money is held in trust it creates a property right in favor of the trust beneficiaries. This means that funds impressed with trust status under the Michigan Builders’ Trust Fund Act do not belong to the contractor or subcontractor that receives them.v Rather, the funds belong to the subcontractors, suppliers, and laborers who were engaged by the upstream contractor or subcontractor. As a result, funds subject to the Michigan Builders’ Trust Fund Act are not subject to liquidation in bankruptcy or setoff by lenders.vi Should bankruptcy or default occur, a beneficiary can follow any diverted funds and recover them from third-parties.vii The property rights created by the Michigan Builders’ Trust Fund Act are both a sword and shield intended to guarantee that the funds reach the intended.
The Bad—Officer and Employee Liability
At its core, the Michigan Builders’ Trust Fund Act is a criminal statute that provides civil remedies.viii Accordingly, the use of funds received on a construction project for any purpose other than to pay those who performed the work exposes the individuals and corporate entities that participated in using those funds to criminal and civil liability. In that sense, it is the people involved in causing a violation of the Michigan Builders’ Trust Fund Act who pay the price.
Importantly, the existence of a corporate or quasi-corporate entity does not provide the defense it might otherwise in a breach of contract situation.ix The individuals involved in the processing and decision making regarding the use of project payments are at high risk of personal liability.
The Ugly – Prison, Punitive Damages, and Attorneys Fees
The Michigan Builders’ Trust Fund Act carries significant exposure to criminal and civil liability. On the criminal side, the statute is a felony punishable by up to 12 months in jail and 60 months of probation—per violation.x
Several violations of the Michigan Builders’ Trust Fund Act were punished with lengthy incarceration relative to the amount of money involved.xi
For example, an individual builder was sentenced to 12 months in jail and 60 months of probation for withdrawing $2,000.00 from her account as profit on the project while the project subcontractors were owed at least $1,000.00 resulting in an overdrawn account.xii Other cases reveal criminal sentences ranging from three months to three years.xiii Importantly, these situations involved small construction projects with the amounts received and amounts owed as compared to larger commercial projects.
On the civil side, liability can arise for a violation of the Michigan Builders’ Trust Fund Act or related remedies for statutory conversion. Statutory conversion provides the possibility to recover three times actual damages plus attorney fees, costs, and interest.xiv It is easy to understand the magnitude of exposure when one considers the monthly payables owed to subcontractors, suppliers, and laborers and then multiplies that figure by a factor of three.
Although the risks created by the Michigan Builders’ Trust Fund Act are significant, they may be avoided by prudent business strategies. The key to managing these risks is to understand that they originate in all aspects of construction process. Contract drafting, contract administration, billing, paying vendors, managing cash-flow, financing, and dispute resolution all present opportunities to mitigate these perils. As a result, sensible contractors will make sure that employees involved in those aspects of the construction process understand the Michigan Builders’ Trust Fund Act so they may identify trouble areas and seek resources to assist in avoiding potential problems. Along those lines, engaging professionals can provide insight when developing best practices. Accountants, insurance agents, and attorneys that are familiar with the Michigan Builders’ Trust Fund Act can help prevent and mitigate problems. In short, the Michigan Builders’ Trust Fund Act is an important consideration for successful management of a construction company when entering or expanding work in the private sector.