The United States District Court for the Eastern District of New York issued a decision in July, 2017 that holds banks liable for diversion of funds in violation of New York’s lien law, when it should have known of the trust nature of the funds it receives. In Delco Electrical Corp. v. Wells Fargo Capital Finance, Inc., 2017 WL 3311224 (E.D.N.Y. July 31, 2017), Teltronics, Inc. (“Teltronics”) contracted with the New York City Department of Education to make telecommunications-related improvements at public schools from 2007-2011. Teltronics hired several sub-contractors, including, among others, Delco Electrical Corp. (“Plaintiffs”), to perform improvements on the public school buildings valued at more than $1.7 million. Teltronics had a lockbox account at Wells Fargo which was used exclusively for receiving payments from Teltronics customers, such as the New York City Department of Education. Teltronics also had a lending relationship with Wells Fargo through a revolving credit loan and term loan facility. Wells Fargo had 100% control over the lockbox account and Wells Fargo received as “daily sweeps” whatever funds were deposited in the lockbox accounts as payment against loans Wells Fargo issued to Teltronics. These payments far exceeded the $1.7 million the Plaintiffs were owed for subcontract work they performed for Teltronics. Wells Fargo did not use or apply the funds in the lockbox account to pay Plaintiffs for the work performed, and Wells Fargo did not maintain records identifying what portion, if any, of any deposit into the lockbox account was payment for work the Plaintiffs performed on the schools.

Teltronics eventually filed for bankruptcy in 2011 and each of the Plaintiffs, but for one, was a member of the Official Committee of Unsecured Creditors. The Plaintiffs had notice of a “Final Order” in the bankruptcy case and they did not object to Wells Fargo’s prepetition claims or assert a claim or demand on Wells Fargo. Plaintiffs also had notice of the “Confirmation Order” issued in the bankruptcy case which contained a release provision for Wells Fargo. After the bankruptcy case, the Plaintiff brought suit against Wells Fargo for violations of New York’s Lien Law and common law conversion, and sought a judgment against Wells Fargo for the $1.7 million the Plaintiff’s claimed they were owed.

The Court held that Wells Fargo was liable for the diversion of the funds even though Wells Fargo claimed it was not a “knowing participant” in the diversion, but rather served as a “mere conduit” following instructions from Teltronics. On the conversion claim, the Court found that by virtue of the Lien Law, the payments made to the lockbox account were trust fund money, over which the Plaintiffs had an interest as beneficiaries, that Wells Fargo exercised dominion and control over those trust funds, and that Wells Fargo diverted those funds as payment for Teltronics’ loans in derogation of Plaintiffs’ rights and without their consent. The court also held that Wells Fargo was liable under the Lien Law because “the facts demonstrate that [Wells Fargo] should have known – through appropriate inquiry – of the trust nature of funds it received…through the Lock Box Account, particularly given its awareness that Teltroncis was a telecommunications contractor to…public entities in New York, and that Teltronics contracts serving as collateral for Teltronics loans included contracts for construction of New York City public schools.” The court also reasoned that Wells Fargo should have known, upon appropriate inquiry, of the trust nature of the funds it received in the lockbox account given: (1) the sophisticated banking relationship that it established with Teltronics and Wells Fargo’s affiliate; (2) that its affiliate was aware that Teltronics was a telecommunications contractor serving public entities in New York; and (3) that Wells Fargo was aware it received millions of dollars in the lockbox account as payments from public entities in New York on behalf of Teltronics, a customer it must have known was a telecommunications contractor for public entities in New York. Importantly, the Court found that Wells Fargo, as a sophisticated financial institution, cannot shield itself from liability “by conveniently ignoring the New York Lien Law and the trust nature of the funds at issue.”

The court found that the Plaintiffs had not waived their claims against Wells Fargo by virtue of the bankruptcy case because the “final order” did not clearly establish deadlines, and the Plaintiff’s claims against Wells Fargo were distinct from those related to the bankruptcy estate. The court also dismissed Wells Fargo’s argument that the statute of limitations had expired.

Based on the Eastern District of New York’s decision, banks and other lending institutions should be aware that they might be held liable for common law conversion and diversion of trust funds in violation of New York Lien Law in certain situations involving customers that are contractors.