Trust No One 1 - A Motto for Builder s Lien Trust Claims in a Bankruptcy Brendan Bissell Goldman Sloan Nash & Haber LLP

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1 Trust No One 1 - A Motto for Builder s Lien Trust Claims in a Bankruptcy Brendan Bissell Goldman Sloan Nash & Haber LLP There have been a number of court decisions over the last year about whether the trust created in many provincial builder s lien statutes will still apply in bankruptcy, with the result that the answer is quite murky. This article will briefly outline what the issues are, the builder s lien remedies that are (and are not) affected, and will close by offering a few practical suggestions for how to cope with the risk that these unsettled issues raise. What is the problem with a bankruptcy for builder s lien trusts? Put simply, the problem is that provincial legislation provides a number of remedies to creditors, but not all of those will still apply after bankruptcy. There is some irony here, because insolvency is probably the exact time when creditor remedies would be the most useful. This disconnect between rights before and after bankruptcy is simply a fact of life, however, because the federal government makes the laws on what happens in bankruptcy, whereas provinces make the laws on what happens up until that time. If a provincial law gives an advantage that is at odds with what the federal government wants to occur in bankruptcy, then what the federal government says in the Bankruptcy and Insolvency Act will win. Not all creditor advantages in provincial legislation will run afoul of this principle, but the builder s lien trust is one where the answer to the question is (at best) unclear. The detail behind the legal debate over whether builder s lien trust provisions still apply after bankruptcy is too much to include here. The point of this article is to highlight that the debate is happening. The following generalization about the court decisions will outline some of the confusion, though: 1 Apologies to X Files fans for using one of its slogans, but it does pretty much fit the bill.

2 - 2 - (a) Some court decisions have said that builder s lien trusts never effectively segregate funds after bankruptcy, (b) Some court decisions have said that these trusts probably do not effectively segregate funds after bankruptcy, (c) Other court decisions have said that these trusts might still apply to segregate funds after bankruptcy, depending on what has happened with the money that was supposed to be subject to the trust, and (d) None of the court decisions conclude that trusts always effectively segregate funds after bankruptcy, because even a trust that would otherwise apply for bankruptcy purposes can still be undermined by what happened with the money that was supposed to be subject to the trust. There is a theme in the court decisions that is worth noting. Namely, how the bankrupt handled the construction trust funds before bankruptcy can be quite important in determining whether funds should be set aside for trust claimants after a bankruptcy. The more that the trust funds are intermixed with other funds and cannot be accounted for separately, the harder it will be to try to argue that funds should be segregated later (whether in bankruptcy or otherwise). This actually applies to any trust claim, but because of how people in the construction industry follow the trust provisions (or, more to the point, do not) this is often a real problem in a construction insolvency. There is also a further complication that can occur due to this type of intermixing by the bankrupt. Namely, if there are project funds that become payable after the date of bankruptcy, some court decisions have found that the intermixing of construction trust funds by the bankrupt before the bankruptcy means that the trustee in bankruptcy does not need to comply with the construction trust after the bankruptcy. That would mean that the trust claims for funds received after a bankruptcy will be effectively wiped out in that sort of case.

3 - 3 - What is, and is not, affected by this bankruptcy issue? Since builder s lien legislation both has other remedies than the trust, and also does other things in the trust provisions, what this issue does - and does not do is worth explaining. Builder s lien legislation typically gives three remedies to try to improve the lot of trades through (i) holdback, (ii) lien and (iii) trust provisions. The first two of those (holdback and lien) are not affected by this bankruptcy issue. Note that bankruptcy can affect holdback and liens, but in a different way that is not the subject of this recent debate in the court decisions. 2 Even when it comes to the trust aspect of builder s lien legislation, only part of what it does is affected. The trust legislation usually imposes a trust over funds received by someone who has to pay others below them in the construction pyramid, 3 which is only satisfied by using the funds for proper construction purposes. Some provinces like Ontario apply this trust to all project funds, while others like Alberta only apply this to some of the funds. This trust leads to the following remedies: (1) Any construction trust funds on hand are (as noted above) segregated for project claimants, (2) The statute will impose liability on anyone who breaches the trust obligations, and (3) In the case of corporations, the statute will also impose liability on the directors, officers or other people sufficiently in charge of a corporation that breaches the trust obligations. The recent court decisions question whether the first element described above, the segregation of funds, is effective after bankruptcy. This is quite important in economic terms, 2 For example, court permission can be required to register a lien or start a lawsuit in support of a lien after a bankruptcy. 3 Such as an owner, general contractor, etc. on a project. This can also apply to subcontractors and subsubcontractors if they also have to pay someone else who supplies services or materials to the project.

4 - 4 - because if it applies, then any funds on hand are subject to a builder s lien trust and therefore get segregated for the benefit of the project creditors who should have been paid. A trust claim therefore is almost at the top of the pecking order in terms of who gets paid in a bankruptcy or insolvency. Being a trust claimant is therefore one of the best places to try to end up if you are owed money. The other two elements of builder s lien trust legislation, which impose liability for breach of trust, are not affected by a bankruptcy. So even if you cannot claim that there should be segregated trust funds after a bankruptcy because of this issue in bankruptcy law, a lawsuit can still be brought against the person that was supposed to pay. Of course, if the person that was supposed to maintain the trust is bankrupt, then that lawsuit may not be all that worthwhile. More helpfully, however, a similar claim will still apply against directors and officers in the case of a company. So if there is a bankruptcy and the segregated trust claim seems like it will not work (either on the facts of how the funds were dealt with, or because of the legal issues currently being debated) do not forget about the lien and holdback provisions, nor the other trust provisions that apply. The other trust provisions in particular pose risk for the insiders of a bankrupt contractor and corresponding opportunity for project claimants who are out money. So what is to be done about a claim that there are trust funds in the hands of someone who is (or may be going) bankrupt? Here are a few practical suggestions: Try to make sure that project funds are being handled properly. As already discussed above, whether the funds are in fact kept separate by the company that later ends up bankrupt can make a big difference to whether a successful segregated trust claim can be made.

5 - 5 - Trades whose progress payments get held up too much should therefore start asking questions sooner than later about how the person who is supposed to pay has been dealing with trust funds. While trades might normally wait until the time limit for lien rights is coming up, that may be too late for these purposes. In appropriate cases, trades should consider asking people further up the construction pyramid for evidence that subtrades are being paid (such as the statutory declarations or other evidence on progress draws). Non trade creditors of a contractor that may go bankrupt, such as an operating lender (bank), are in the opposite position. They may be best off not inquiring about whether funds are supposed to be held in trust or not. They may not have an obligation to ask those sorts of questions, and if they start going down that road then a court may prevent that person from laying a claim to funds that should to that person s knowledge (having asked the question) have been held in trust. Owners or other players up the construction pyramid may be somewhere in the middle. They may have a practical reason to try to make sure that trust is being maintained by a company about to go bankrupt because this can also avoid problems like materials that have been delivered to site being reclaimed by the trades for non-payment. The trades that end up being unpaid may also be important to complete a job, and the already chaotic problem of completing a job where a player has gone bankrupt can be all the more costly if trades are trying to make up for lost payments. That said, an owner or someone else above the bankrupt company will not have to pay twice for payments to a company that goes bankrupt. Do not assume that a builder s lien trust does, or does not, apply to any funds on hand after bankruptcy just because someone says so, or provides a case that says so. There are new court decisions arriving almost monthly and offering different legal conclusions on this issue and some of the decisions are very fact-dependent, so unless the amount owing is too small to be worthwhile, get advice from someone who is current on this area of law before making any decisions. This whole issue is presently before the Supreme Court of Canada in a case out of Alberta to see whether that court will agree to hear an appeal, so the

6 - 6 - answer you get today may also not be the answer you get next year if the Supreme Court weighs in on the matter. If a court fight about trust issues might be necessary, trades should consider cooperating with other trades (or similarly aligned people, such as bonding companies 4 ) to more efficiently get through the issues. This will cost the trades less if they can agree to split the costs (usually in proportion to what they are owed). It can also make it much less chaotic and costly for the other stakeholders to deal with, such as the bankruptcy trustee and non-trade secured creditors. Be very cautious with how project funds that are payable to the bankrupt after the date of bankruptcy are handled. Project funds that do end up being payable to the bankrupt (usually net of set-off claims, which are another fact of life when dealing with a bankrupt company that won t be completing the job) after the bankruptcy might, or might not, be subject to the trust. Part of this may depend on the legal conclusions of the courts in that province (since the courts in some provinces are adopting differing approaches). Part of this may also depend on facts about how funds were dealt with before bankruptcy. The problem is that either of those things may not be known until far after the project funds are received by a bankruptcy trustee. The safest course of action, certainly for the trustee and likely also for the other stakeholders, is to set any new project funds aside until the trust issues are either resolved by the stakeholders or until a court rules on the issue. This can (and should) be done in a way that does not necessarily admit that the trust does or does not apply and instead will just preserve rights until more is known. 4 To give credit where credit is due, bonding companies such as Guarantee Company of North America have been quite active in trying to argue that trust obligations should continue after bankruptcy.