Emerging Risk - Misappropriation of Pay Application Proceeds Under A Factoring Agreement

Jan 30, 2019
Construction News

The explosion of factors in the construction industry has exposed a legislative gap in the Texas Construction Trust Fund Act (the “Act”). The Texas Legislature created the Act as a remedial measure to ensure that contractors, subcontractors, and materialman are paid for their work to improve real property. The Act imposes a fiduciary duty on contractors and subcontractors who are paid directly under a construction contract. These contractors and subcontractors are trustees who must hold payments in trust for the beneficiary—the artisan, laborer, mechanic, contractor, subcontractor, or materialman who labors or furnishes material for the construction or repair of real property.

What happens when the trustee misappropriates trust funds by assigning pay application proceeds to a factoring company?  What is the legal recourse for the beneficiaries? The Act provides civil and criminal penalties for trustees who misappropriate funds under the Act.  However from a practical standpoint, it may be very difficult for the beneficiary to recover the funds it’s owed. Factors are often lenders of last resort for contractors who are in immediate need of capital.  By the time the beneficiary files suit for the breach of fiduciary duty, the contractor/trustee will likely already be defunct. 

The beneficiary will be tempted to recover the funds from the factor.  Thus far, such attempts have been unsuccessful.  Texas courts have been reluctant to allow the beneficiary to recover from the factor under the Act.  Consistently courts have reasoned that factors do not step into the shoes of a contractor/trustee by virtue of the assignment.  The Act limits the fiduciary duty to a contractor, subcontractor, or to an officer, director, or agent of a contractor or subcontractor.  The fiduciary duty does not extend to factors.  Nonetheless, the courts understand that this limitation frustrates the purpose of the Act.

Until the Texas Legislature amends the Act to fill in the statutory gap, unpaid beneficiaries under the Act remain at risk of nonpayment when the trustee misappropriates trust fund proceeds by assigning them to factors.  An amendment to the Act imposing a fiduciary duty on factors will likely have unintended consequences such as drying up funding sources for contractors who are unable to access funds from traditional sources.  However, a contractors’ ability to secure funding from a factor should not come at the increased risk to those who should be protected under the Act.  At a minimum, the Texas Legislature should consider imposing a notice requirement whereby factors are mandated to disclose pay application assignments to beneficiaries of the Act.  Disclosures detailing the assignment’s impact to the beneficiaries’ ability to recover funds under the Act will allow the beneficiaries to take the necessary steps to mitigate their risk.

Consult with your lawyer prior to signing a construction contract if you are beneficiary under the Act and you suspect that the contractor may not be adequately capitalized. This will allow you to be proactive in protecting the proceeds from your pay applications.  Although incorporating anti-assignment clauses for pay application proceeds may be void under Article 9 of the Uniform Commercial Code, there are other contractual mechanisms to help protect your interest. Consider incorporating a contractual provision requiring disclosure for pay application proceeds assignments.  It would also be good practice for a beneficiary to require a third-party guarantor if the pay application proceeds are assigned and the contractor defaults on its financial obligations.

In summary, the Texas Legislature has not kept up with the realities of the current construction industry where contractors have increased their reliance on factors to supplement capitalization. The Act’s current statutory gaps leave beneficiaries at risk without recourse when a contractor/trustee assigns pay applications proceeds to a factor.  Until the gap is closed, beneficiaries will have to be proactive by implementing contractual safeguards to help mitigate their financial risk and improve chances of recovery in case of default.

Gregory Franklin is an attorney in the Dallas office of Munsch Hardt. His practice focuses on construction litigation and his primary focus is to help his clients solve problems that threaten their business in a practical and efficient manner.

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