The Texas Construction Trust Fund Act -- What You Don't Know Can Hurt You

It is pretty universally accepted that construction payments and construction loan receipts should be prudently held and distributed. However, this is more than just a sound business practice–a failure to appropriately hold and distribute construction funds could actually land you in jail and bogged down in litigation.

The Texas Construction Trust Fund Act (the "Statute"), found in Chapter 162 of the Texas Property Code, regulates construction payments and loan receipts. The Statute expressly states that construction payments are trust funds if (1) the payments are made to a contractor or subcontractor, (2) under a construction contract, and (3) for the improvement of specific real property in this state. This also applies to loan receipts. The party who receives these funds is a trustee.

A trustee who, intentionally or knowingly or with intent to defraud, retains, uses, disburses, or otherwise diverts trust funds without first fully paying all current or past due obligations incurred by the trustee to the beneficiaries of the funds, has misapplied the trust funds.

Sounds like common sense, right? It might be, but the penalties for failing to adhere to these requirements can be quite stiff. A trustee who misapplies trust funds over $500 in violation of the Statute commits a Class A misdemenor. If the trustee misapplies those trust funds with intent to defraud, they may be guilty of a third-degree felony.

Since potential felony liability for failing to pay subcontractors sounds pretty harsh, it’s important to know exactly what "intent to defraud" means. A trustee acts with "intent to defraud" when he retains, uses, disburses, or diverts trust funds with the intent to deprive the beneficiaries of the funds.

In addition to potential criminal prosecution, misapplication of trust funds can also create civil liability–and hence, litigation. Because the holder of the construction payment or loan receipts is a trustee, there may be a fiduciary relationship with the beneficiary–at least with respect to the trust funds. Fiduciary relationships bring with them heightened duties, including loyalty and the utmost good faith, candor, integrity of the highest kind, and fair and honest dealing.

By failing to pay, the intended beneficiary could bring a lawsuit asserting, among other claims, breach of fiduciary duties. This is notable because an intentional breach of fiduciary duty opens up the possibility for punitive damages.

The Statute does establish affirmative defenses to claims of misapplication of trust funds. It is a defense that the trust funds not paid to the beneficiaries were used by the trustee to pay its actual expenses directly related to the construction or repair of the improvement or have been retained by the trustee, after notice to the beneficiary, as a result of the trustee’s reasonable belief that the beneficiary is not entitled to the funds.

It is also a defense that the trustee paid the beneficiaries all trust funds they were entitled to receive no later than 30 days following written notice to the trustee of the filing of a criminal complaint or other notice of a pending criminal investigation.

The Texas Construction Trust Fund Act underscores the need for good business practices with respect to construction payments. This Statute increases the potential penalties that may arise for failing to appropriately manage these funds. The key is to handle construction payments and loan receipts with great care.

The Wizard Behind the Curtain

One of the most memorable scenes in the Wizard of Oz was when we finally got to meet the notorious Wizard himself. When Toto pulled the curtain back, we saw that he wasn’t the brooding, intimidating figure that his image and reputation led us to believe he was. Instead, we saw a small, mild mannered gentleman who looked incapable of harming a fly. With a simple tug of a curtain, the grand image was blown.

Now, what does the Wizard of Oz have to do with construction and, for that matter, any business? A lot. As paperwork has evolved into computer-work, there has been a shift from focusing solely on paper documents to investigating electronically stored information ("ESI"). In litigation and arbitration, attorneys are not limiting discovery to paper documents. They are investigating electronic versions of e-mails, Word documents, spreadsheets, voicemails, and other forms of ESI.

Why? Because just like Toto pulled back the curtain on the Wizard, ESI allows the curtain to be pulled back on your paper file. There’s a lot more to every document, spreadsheet, and e-mail than just the words on the page. Buried in every file is data about who created it, who modified or accessed it, when it was created, who was bcc’d, etc. ESI reveals spreadsheets formulas that would otherwise generate raw numbers on paper. And those redline changes and comments on your Word document? Well, just read this business plan to find out how not to get a project funded. Then imagine reading a contractor’s bid that unknowingly included all the comments about the corners they can cut.

This isn’t meant to scare you back to a stone tablet and chisel, but it is a cautionary tale. Before you send that contract to the other side, be sure you’re not including your own personal commentary. That e-mail you thought you deleted–it’s still resting comfortably on the company’s server. You make efforts (and probably spend good money) to keep your confidential information confidential. Don’t accidentally hand over the keys to your file room. When it comes to ESI, what you see isn’t always what you get.

Pay When Paid Clauses

"Pay When Paid" contract clauses have become a fairly common tool used by general contractors to limit financial liability to subcontractors in the event of an owner’s insolvency. In a nutshell, they provide that a GC’s obligation to pay the sub is contingent on the GC being paid by the owner. If the GC isn’t paid by the owner, the GC has no obligation to pay its sub. Though the wording will vary from contract to contract, Pay When Paid clauses generally look something like this:

Notwithstanding anything to the contrary herein, payment by the Owner to the General Contractor is a condition precedent to the ubcontractor’s right to payment from the General Contractor.

Partial payments for or on account of Work performed will be made by Contractor to Subcontractor as the Work progresses, provided however, that as a condition precedent to any such payment, like payment has been made by Owner to Contractor.

These clauses are pretty heavy handed since they are an attempt to shift the risk for nonpayment from the general (who contracted directly with the owner) to a sub (who might have little or no relationship with the owner). As such, the question is this: Are Pay When Paid clauses actually enforceable?

In Texas, Pay When Paid clauses are typically enforceable IF they create a condition precedent and not simply a covenant to pay. A condition precedent is an act or event, which occurs after the making of the contract, that must occur before there is a right to immediate performance and before there is a breach of contract. They basically create a contingency, where a party has no obligation to perform X until condition Y occurs first.

While there are no magic words that are necessary to create a condition precedent, terms such as "if," "provided that," "on the condition that," or some other phrase that conditions performance usually indicate an intent to create a condition precedent. Gulf Const. Co. v. Self, 676 S.W.2d 624, 627 (Tex.App.–Corpus Christi 1984).

It is important that the contract language is very clear on this. Because conditions precedent tend to be fairly harsh, courts do not favor finding them in contracts. For example, in a hospital construction project, a contract between between the GC and a sub included the following provision:

When the owner or his representative advances or pays the general contractor, the general contractor shall be liable for and obligated to pay the sub-contractor up to the amount or percentage recognized and approved for payment by the owner’s representative less the retainage required under the terms of the prime contract. Under no circumstances shall the general contractor be obligated or required to advance or make payments to the sub-contractor until the funds have been advanced or paid by the owner or his representative to the general contractor.

The court of appeals ruled that this clause only created a covenant regarding the terms and manner of payment, not a condition precedent to payment. Id. As such, the general contractor did not limit its financial liability. It was required to pay its subcontractors even though the owner failed to pay the GC.

Pay When Paid clauses are an effective way for general contractors to manage risk and limit financial liability when there is a question about an owner’s solvency. Like so many other terms, they are deal points to be negotiated. You don’t want to lose the protection you worked hard to acquire because of a poorly worded contract. The key to having an effective, enforceable Pay When Paid clause is to make sure it actually creates a condition precedent. Without that, the GC has probably done nothing but re-enforce its own obligation to pay.