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Fraudulent Earmarking & Duty to Inquire in Construction Lien “Fund” Context

February 6, 2013 | Posted In Business Litigation - Fraudulent Earmarking |

Lumber Yard sells drywall on credit to Carpentry subcontractor for job at Maple Street. Lumber Yard does the same for CS for a job at Walnut Avenue. The General Contractor of the Maple Street property makes a payment to CS from funds from the Maple Avenue owner. Lumber Yard is within time to file a Construction Lien Law (CLL) lien for the Maple St. project, but not for the Walnut Ave. job.

LY generally applies payments to a customer’s oldest account. The Walnut Ave. account is older than the Maple St. account. Walnut Ave and Maple St are owned by different parties.

GC has been in bankruptcy for 3 years.

The parties are not colluding with each other to pyramid payments. They are all just looking out for # 1.

Alternative 1 (Not Earmarked):
CS does not provide any instruction as to the application of the payments.

Alternative 2 (Funds Earmarked):
CS provides written “earmarking” instructions, providing that payment is to be applied against the Walnut Ave. job.

Inquiry Notice:
Despite the written payment application instruction from CS, the LY has reason to believe, or inquiry notice, that the funds paid were actually sourced from the Walnut Ave. Owner, which is in fact the case.

The Issue for Counsel:
Your client, LY, wants to know if it may apply the payment against the Walnut Ave. job under either scenario? This maximizes the balance remaining on Maple Ave., which is still in time for a CLL lien from supplier LY. On the other hand, this fails to apply the owner’s payments at Walnut St. against the lien balance.

Background:
Construction runs on credit. Subcontractors and Suppliers provide labor and materials, incorporated into the Owner’s land. Subs and suppliers expect payment from the GC, who in turn expects payment from the Owner. The food chain reasonably expects that these payments will be applied to the proper job, and that a GC, for example, won’t renege on sending payments down the line and instead “pyramid” an Owner’s payments into financing obligations
on an entirely separate site.

At common law, contractors and suppliers did not have a right to a pre-judgment lien against the owner or the land. If they were subcontractors or material suppliers not in contractual privity against the owner, they had no right at all to a lien against the land.

Due to perceived impairment, various forms of mechanics’ lien statutes were enacted. As rights in derogation of the common law, these are to be construed strictly. New Jersey’s current Construction Lien Law was enacted in 1993, amended in 2010, and may be found at N.J.S.A. 2A:44-1 et seq.

The purposes of the CLL are first and primarily, to provide a mechanism by which contractors and suppliers can protect their right to payment by assertion of a statutory lien against the property itself. The secondary purpose is to protect honest owners from imposition of double payment, payment to the general contractor and then payment on the same balance to a subcontractor in order to discharge a lien.

In order to protect innocent owners, the CLL codifies rules for the concept of the “lien fund.” the maximum amount unpaid and lienable. The CLL provides two formulas for calculation of the “lien fund;” under either formula a deduction must be made for payments previously made against the obligation owing the contractor which is the basis of the lien. This makes sense because if Owner pays General $100,000 earmarked for payment to subcontractor, then fairness dictates that the subcontractor should receive this amount, and that it not be lienable despite payment.

The CLL does not, however, provide substantial guidance in determining how payments from a GC to a sub are to be applied: Which owner is to receive the benefit of the credit against the lien fund? We know it should be the owner that actually paid, but in the absence of joint checks or sufficient documentation and notice to the subs, how is the law to ensure this outcome? What works?

Craft v Stevenson Lumber Yard, Inc. (N.J. 1984)1 : Within a year of the CLL’s effective date, our Supreme Court squared up to the question presented in Alternative 1 above. The check is received by Supplier with no instructions earmarking payment, or designating its intended application. At common law the ‘Application of Payments’ rule would generally have permitted, absent an indication of fraud or collusion, payees to apply such payments as they saw fit. Craft held, however, that if there were some reasonable basis to believe that the monies originated with the Maple St. owner (paid through the same GC as handled the Walnut Ave. property), that the funds must be applied to the Maple Ave. project, even if this is a less-aged debt, and even if this application is contrary to the interests of the supplier. See, Rest. (2d) of Contracts, §§258, 259, 260 (1981).

Craft does not, however, indicate what evidence, other than a frank admission by the GC, would create this inquiry notice. How is the disputed factual issue to be resolved? Must the supplier interplead the funds in court? Must the payee lien both properties and find out later which of the owners is entitled to a credit? Is he to demand production of records by the owners and GC in order to resolve the problem? As a practical matter, what is the subcontractor to do (other than to run and deposit the funds in its bank account before the check bounces)?

L&W Supply Corp. v. Joe Desilva (App. Div., 12/4/12)2: L&W Supply takes the question to the next step (Alternative 2): Must earmarked funds be credited against the designated account even in the presence of inquiry notice that the application of funds may be false, may in fact be pyramiding of accounts? American jurisdictions are split on the issue. L&W held that “if something is amiss in the material purchaser’s allocation of payments to different accounts, then Craft requires that the supplier inquire further and verify the source of the payment funds.” L&W therefore imposes an affirmative duty on the payee to try to find out where the money came from. The opinion suffers from the same deficiencies as Craft, but more so. If the GC earmarks the payments, what evidence should put the payee on inquiry notice that the GC is a liar? The GC has already stated in writing that the funds came from the Maple Ave. owner. When is this not “reliable” evidence? What more evidence does the payee need? To go back to the GC and ask if they were telling the truth? And if the owner says no, the money came from Walnut Ave., which version of the truth is the payee required to believe?

Does the payee then contact the owner, possibly defaming the GC as a fraud? The owners may take weeks or months to come up with ledgers? Does the payee file “precautionary” liens, sworn to under oath, while the 90 day clock is ticking? L&W is correct in its interpretation of the aspirations of Craft. However, does this process play out in the real world? That is the unanswered question.

1 179 N.J. 56.
2 A-2960-10T2, 2012 N.J. Super. LEXIS 189 (approved for publication 12/04/2012).

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