At times, a bankruptcy case will bring you outside of the United States Bankruptcy Code and Rules and into the realm of state law, which provides special protections for construction contractors and subcontractors. Pavarini McGovern, LLC v. Waterscape Resort LLC (In re Waterscape Resort LLC), No. 11-02248 (SMB) (Bankr. S.D.N.Y. Dec. 10, 2012), a recent decision by Judge Bernstein of the United States Bankruptcy Court for the Southern District of New York, explores the issues of “diversion” and “restoration” under New York’s Lien Law.
The court in Waterscape held that the debtor, the owner of a hotel and condominium project, had only bare legal title, as opposed to equitable title, in certain trust funds. Thus, the use of such funds to pay off the principal and interest of a bank’s secured loan on the construction project, as opposed to unpaid contractors, was a diversion of funds prohibited under state law. Notwithstanding the court’s finding of a diversion, the owner established a successful defense of restoration by making a sufficient portion of the diverted funds available to pay unpaid contractors.
Financing for the Waterscape project was provided by two bank loans: (1) a secured “Project Loan” to fund “a portion of the actual hard costs” of the construction project; and (2) a secured “Construction Loan” to fund “certain indirect construction costs . . . that [did] not qualify as cost of improvements” under New York Lien Law. Pursuant to these loan agreements, Waterscape would submit monthly draw requests to the bank and the bank would make monthly advances to Waterscape so that Waterscape could pay its construction manager and subcontractors.
Pavarini, the construction manager, entered into subcontracts with trade contractors and vendors to perform work on the project. Because Waterscape and the subcontractors were not in privity, Pavarini agreed to provide Waterscape with the necessary paperwork to submit draw requests to the bank under the Constructional Loan in order to pay the subcontractors. Thereafter, Waterscape sold some of the condominium units and paid the proceeds of the sale to the bank to reduce the principal and interest due on its Project Loan, with little or no repayment of the Construction Loan. Pavarini further alleged that Waterscape did not turn over funds paid on account of certain Construction Loan draw requests submitted on behalf of Pavarini and its subcontractors.
Four years later, Waterscape filed for chapter 11. Pavarini filed a secured claim, commenced an adversary proceeding, and moved for partial summary judgment on two of several counts in its complaint, arguing, among other things, that under New York Lien Law (1) the unpaid requisitions and the sales proceeds of the condominium units were trust funds that the estate had only “bare legal title” of, with zero equitable interest until Pavarini and its subcontractors’ claims were fully satisfied; and (2) Waterscape diverted those trust funds when it did not remit them to Pavarini and its subcontractors. Pavarini asserted that Waterscape was required to turn over all diverted funds to Pavarini for the benefit of it and its subcontractors.
After substantial negotiations, Waterscape confirmed its Second Amended Plan of Reorganization. The Plan provided that the hotel would be sold free and clear of all liens, claims, and interests. All but $14 million from the hotel sales proceeds would be paid to the bank in partial satisfaction of its claim. Of that $14 million, the bank agreed to carve out $11 million—rounding up Pavarini’s $10.8 million claim—to allow Waterscape to create a trust fund account for the benefit of the unpaid contractors. The hotel sale closed on the effective date of the Plan and the proceeds were apportioned.
The court held that Pavarini’s complaint only raised questions of lien law. In relevant part, Article 3-A of New York Lien Law provides that:
[F]unds . . . received by an owner for or in connection with an improvement of real property in this state . . . and any right of action for any such funds due or earned or to become due or earned, shall constitute assets of a trust . . . . (5) The assets of the trust of which the owner is trustee are the funds received by him and his rights of action for payment thereof (a) under a building loan contract . . . [and] (d) as consideration for a conveyance recorded subsequent to the commencement of the improvement and before the expiration of four months after the completion thereof. N.Y. Lien Law § 70.
A trust comes into “existence from the time of the making of the contract . . . out of which the claim arises,” and continues until “every trust claim . . . has been paid or discharged, or until such assets have been applied for the purposes of the trust.” N.Y. Lien Law § 71, 75. If the trustee is the owner, trust claims include “claims of contractors, subcontractors, architects, engineers, surveyors, laborers and materialmen arising out of the improvement, for which the owner is obligated, and also means any obligation of the owner incurred in connection with the improvement for a payment or expenditure defined as cost of improvement” in section 2(5). N.Y. Lien Law § 71. Under section 2(5), a cost of improvement includes “sums paid to take by assignment prior existing mortgages” and “sums paid to discharge or reduce the indebtedness under mortgages . . . and other encumbrances upon real estate existing prior to the time when the lien” may attach. N.Y. Lien Law § 2(5).
The court held that a trustee only holds bare legal title to trust funds and an equitable interest in the balance of the funds after all trust claims have been satisfied. Accordingly, Waterscape had bare legal title to both the Construction Loan draws and the condominium sales proceeds—both of which it conceded were “trust funds.”
As to Pavarini’s diversion argument, the court held that Pavarini failed to demonstrate as a matter of law that Waterscape diverted the Construction Loan draws because a trustee has the discretion “to determine the order and manner of payment of any trust claims and to apply any trust asset to any purpose of the trust.” Waterscape provided undisputed evidence that an amount greater than all of the Construction Loan draws were used to pay trust expenses. Thus, any presumption of diversion raised by Pavarini was rebutted by Waterscape, and the court found that a material factual dispute existed as to whether Waterscape diverted the missing draws.
With regard to the diverted condominium sales proceeds, Waterscape could not shield itself from a diversion claim simply because it never had possession of the proceeds and paid them directly to the bank. “A trustee cannot avoid a diversion claim by pledging trust funds to a transferee who is not a beneficiary of the trust under the Lien Law.” Indeed, Waterscape’s use of trust funds to pay the Project Loan was a diversion for two reasons:
Pavarini argued that payment of the Project Loan was not a “cost of improvement” under section 2(5) because it was not a sum paid to “take by assignment” a prior existing mortgage or “discharge or reduce the indebtedness” of mortgages or other encumbrances upon the real estate that existed prior to when Pavarini’s rights attached. Although the court did not necessarily agree with Pavarini’s reasoning, Waterscape did not contest it, and the court deemed Waterscape’s failure to dispute Pavarini’s argument as a “tacit admission” that payment of the Project Loan was permissible as a “cost of improvement.”
Even if the repayment of the Project Loan was a “cost of improvement,” the court concluded it was a diversion because the bank never filed a “Notice of Lending” required by section 73 of New York Lien Law. The purpose of this notice is to inform trust fund beneficiaries that trust funds may be used to repay a lender and therefore will not be available to pay other trust beneficiaries. Waterscape did not dispute that it had not filed a Notice of Lending.
Nonetheless, Waterscape successfully established a restoration defense for the diverted condominium sales with the $11 million settlement with the bank. As the court explained, to establish the defense of restoration a trustee must show that the diverted funds are available to pay trust claims. Finding that voluntary restoration of funds serves the “same purpose as an order directing one liable for diversion to post security to assure the proper distribution of trust assets, or furnish assurance in any other manner that trust funds will be available to pay trust claims,” the court held that the $11 million carve-out from the sale proceeds did just that. The bankruptcy process thus resulted in an outcome that preserved trust fund rights under state lien law.