Principals of General Contractors Should Be Aware: Trustee’s Release of Claims May Not Release Bankrupt GC’s Principals from Trust Fund Violations under NY Law

by David Primack

A subcontractor still retains its right to sue the principals of a bankrupt general contractor for diversion of trust funds under New York law even when a bankruptcy trustee settles and releases causes of action against these same individuals on behalf of the bankruptcy estate. Such is the recent decision by the Bankruptcy Court for the Southern District of New York in In re Lehr Construction Corp., Case No. 11-10723-shl (September 2, 2015 Bankr. S.D.N.Y.) and it provides clarity (at least with regard to New York law) to certain rights of subcontractors when their general contractor files for bankruptcy.

Background

Lehr Construction Corp. (“Lehr”) served as construction manager and general contractor for customers in the New York metropolitan area. Lehr subcontracted electrical work to Robert B. Samuels (“Samuels”) for certain properties. The customers paid Lehr for the construction work that both Lehr and Lehr’s subcontractors performed on these properties. However, Samuels and other subcontractors were never paid. As the Bankruptcy Court noted, under Article 3-A of New York’s Lien Law (“Article 3-A”), when a general contractor is hired to improve real property, it is obligated to hold funds paid by the real property owners in trust for the benefit of the subcontractors that worked to improve the real property (e.g. Samuels and other subcontractors). In this case, historically Lehr generally deposited the payments from customers into commingled bank accounts and paid subcontractors from such accounts. Leading up to the bankruptcy filing, subcontractors were not being paid from these commingled accounts.

In February of 2011, Lehr filed for bankruptcy protection under Chapter 11 and a trustee (the “Chapter 11 Trustee”) was appointed to wind down Lehr. Several months later, in June 2011, Samuels filed a state court complaint pursuant to Article 3-A against non-debtor principals alleging that Lehr knowingly and wrongfully diverted Article 3-A trust assets and that the non-debtor principals were personally liable under the statute. Samuels’ state court action was enjoined by agreement of the parties and approved by Court order so that the Chapter 11 Trustee could administer the bankruptcy estate which might have an impact on the state court litigation. The Chapter 11 Trustee was concerned that if the Samuels suit and another similar action brought in state court went forward, such actions could deplete assets otherwise available to the bankruptcy estate.

The matter came before the Court again based on Samuel’s request for relief from the injunction against continuing its state court action. One issue that remained open was whether claims brought under Article 3-A are considered generalized claims or are rather individual/particular (i.e. subcontractor only) claims. This is an important distinction as it determines who may pursue a claim. As the Court explained, general claims are claims with no particularized injury arising from them and if the claim could be brought by any creditor of the debtor, a trustee is the proper person to assert them, and all creditors are bound by the outcome of the trustee’s action. On the other hand, particular or personal claims are claims where there is injury to one specific creditor or a select group of specific creditors and other creditors have no interest in such action.

In 2013 and 2014, the Chapter 11 trustee reached settlement agreements with various principals of Lehr. The Chapter 11 Trustee’s first proposed settlement agreement contained a permanent injunction which would enjoin claims against the principal for violation Article 3-A. The Chapter 11 Trustee took the position that Article 3-A claims were “general” claims and belonged to the Chapter 11 Trustee. Samuels objected and the Court agreed with Samuels to leave the issue open to a ruling at a later date. The settlement agreements that were eventually approved by the Court contained language that enjoined any claim that was duplicative or derivative of claims that could have been brought by the Chapter 11 Trustee  – but did not bar any claim against a principal that was held solely by an individual creditor. This open issue – whether Article 3-A claims are general or particular – was finally addressed by the Lehr Court’s September 2, 2015 decision.

Analysis

The Court held that Article 3-A claims are particularized claims for subcontractors and therefore Samuels is not barred from pursuing its rights in state court even if the Chapter 11 Trustee settles and releases its causes of action. As the Court notes, claims based on a breach of fiduciary duty belong to a corporation and thus, after a bankruptcy, such claims belong to the trustee. In general, a claim that a corporation misused trust funds could be construed as a violation of a fiduciary duty.

However, pursuant to Article 3-A and applicable case law, subcontractors have their own unique breach of fiduciary duty cause of action against a company and its principals. The Court further ruled that just because trust funds may be unavailable and untraceable because of the contractor’s commingling and disbursement, a subcontractor’s Article 3-A cause of action remains viable and not otherwise rendered a generalized claim. The Court then allowed Samuels to prosecute in state court its claims against the principals of Lehr for violation of their duties pursuant to Article 3-A.

Key Takeaways

The Lehr decision clarifies that under New York law, Article 3-A claims of subcontractors are not property of the corporation and therefore not general claims that may be pursued or settled by the bankruptcy estate or any subsequent bankruptcy trustee. A subcontractor can seek to enforce its rights against the principals of a bankrupt company in state court (though the subcontractor may be forced to halt such proceedings while a bankruptcy case is pending).

Importantly, the subcontractor’s monitoring of the bankruptcy case and vigilance in objecting to the Chapter 11 Trustee’s settlement proposals made sure that an order of the court did not override the subcontractor’s rights. Because many other states have similar statutes for subcontractors, this decision may provide guidance in those jurisdictions. Finally, this decision may make settlements with principals of general contractors more difficult as the principals will have to negotiate with both the bankruptcy estate and each subcontractor for resolution of all claims.