A recent case1 decided by Judge Stuart Bernstein of the United States Bankruptcy Court for the Southern District of New York demonstrates that a developer's properly crafted chapter 11 plan of reorganization can effectively "restore" trust funds that it previously had "diverted" under the New York Lien Law.

In this case, before filing its bankruptcy case, a hotel condominium developer Waterscape Resort LLC ("Developer") had used commercial loan proceeds and proceeds of sales of condominium units to repay project debt instead of remitting those funds to its general contractor ("GC") as required under the NY Lien Law.  The GC sued and filed a motion for summary judgment on two counts of its complaint, seeking to establish that loan and sales proceeds used by the debtor for non-trust purposes were "trust funds" and that those funds should be recovered for the benefit of the GC and other trust fund beneficiaries.  Although the bankruptcy court found that the funds constituted "trust funds" in which the debtor's estate held only bare legal title and no equitable interest, it permitted the debtor to avoid liability under the NY Lien Law by funding an $11M trust account dedicated to pay Lien Law and other trust fund claims pursuant to the Debtor's chapter 11 plan.

 Overview of a Contractor's Rights under the NY Lien Law

Under the NY Lien Law, a project owner must hold in trust funds received in connection with a contract for the improvement of real property in order to pay claims of trust fund beneficiaries.  Trust claims include claims of general contractors and subcontractors, and claims incurred for any payment or expenditure defined as a "cost of improvement" under the Lien Law.  The trust continues until all trust claims have been paid or otherwise discharged.  

A party's demonstration that trust funds have been used for unauthorized purposes may establish a "diversion" and a breach of trust, unless the trustee has a defense.  

One defense would include a demonstration by a trustee or its assignee that the funds have been "restored" so that cash is available to pay future claims of trust beneficiaries.  This defense is intended to prevent creditors from receiving a windfall that might arise if a penalty were to be imposed upon the trustee under circumstances where funds were available to pay trust fund claims.

Facts of Waterscape 

Pre-Bankruptcy

In June 2007, a lender (the "Bank") provided financing to refinance the Developer's existing debt and to construct a hotel project in Manhattan (the "Project").  The Bank's financing included a secured construction loan in the principal amount of approximately $100 million ("Construction Loan") and a secured Project Loan in the principal amount of approximately $9.1 million ("Project Loan").  The Developer and the GC signed a construction contract (the "CM Agreement") under which the GC was appointed construction manager for the Project.

Proceeds of the Construction and Project Loans were intended to be advanced monthly as progress payments on the Project.  The Construction Loan was intended to pay for "hard" costs and the Project Loan was intended to pay for certain indirect construction costs that did not qualify as "costs of improvements" under the Lien Law.

The Bank advanced money on a monthly basis to fund construction of the Project pursuant to certified requests for advances submitted by the Developer.  The Developer certified to the Bank that advances would be used as specified in its requests for advances.

The Developer allegedly received loan proceeds and proceeds from sales of condo units and paid these proceeds to the Bank in repayment of the Project Loan.   The Construction Loan remained largely unpaid before the Debtor's bankruptcy filing.

Post-Bankruptcy

After the Developer commenced its voluntary chapter 11 bankruptcy case, pursuant to a bankruptcy court order (the "Condo Sale Order"), it sold four condominium units, free and clear of liens, claims, interests and encumbrances which attached to the proceeds of sale. The Debtor was permitted to consummate future condominium unit sales on the same terms.  Net proceeds were to be held in a separate escrow account pending further order of the bankruptcy court.  The Bank and mechanics lienors were required to deliver releases of recorded liens at closing.

Subsequently, the GC filed a proof of secured claim in the amount of approximately $10.8 million and shortly thereafter commenced its adversary proceeding in which it alleged that certain payments in the amount of approximately $4.45 million ("Shortfall") were diversions of trust funds in violation of the NY Lien Law.   The GC sought partial summary judgment, seeking a declaratory judgment that the proceeds constituted trust funds and that all such funds be returned for the benefit of trust fund claimants.

Next, the Debtors confirmed their plan of reorganization (the "Plan").  Under the Plan, the Project was to be sold free of all liens, claims, interests and encumbrances.  As originally drafted, the Debtor's proposed plan entitled the Bank's Class 1 secured claim to all sales proceeds but through negotiation, the Plan was amended to provide Class 1 with all sales proceeds less $14 million. Approximately $11 million of such proceeds was to be set aside in a Trust Fund Account to satisfy allowed claims of Class 3 Lien Law/Trust Fund claimants, and $3 million was to fund a Class 5 Reserve Account to satisfy allowed general unsecured claims.   

The Plan became effective when the sale of the hotel closed.  At that time, the Bank was paid $109M, and the $11M Trust Fund reserve account and $3M Class 5 Reserve Account were funded with sales proceeds from the disposition of the hotel and certain condo units.

The Bankruptcy Court's Decision

The court granted partial summary judgment to the GC, and issued a declaration that the Debtor's estate held only bare legal title to any and all trust funds, and would have no equitable interest in them until the claims of the GC and other trust fund claimants were fully paid and satisfied.  The court denied summary judgment on the GC's claim alleging diversion of trust funds and seeking to compel the Debtor's estate to return all such trust funds for the benefit of the GC and other trust beneficiaries.  Because the Debtor effectively had restored $11M of such funds pursuant to the Plan, the bankruptcy court held that it should not suffer any undue penalty. 

Conclusion

This case demonstrates another broad power that the Bankruptcy Code confers upon a debtor.  Under a confirmed chapter 11 plan, in addition to restructuring its balance sheet and selling unwanted assets, a debtor effectively can cure pre-petition breaches of state law trust fund requirements by "restoring" allegedly "diverted" assets.