Hands Off My Money — Construction and Oilfield Receivables and the “Lender” Exception to the Trust Fund Statute

Lee A. Collins

February 20, 2014

The lawsuit styled Performance Insulation Contractors, Inc. v. L&S Industrial Services, LLC, Case No. 2011-181303 in the 61stJudicial District Court of Harris County, Texas has set the stage for the First Court of Appeals to decide the right to funds owed an upstream contractor between competing claims of a factor and downstream construction contractor.  The issue concerns the interface between the Texas Uniform Commercial Code (UCC) and the Texas Trust Fund Statute (Trust Fund Statute), and will have an impact on Texas’ construction, oilfield services and factoring industries.

Factoring is known as the sale of accounts receivables at a discount of their stated amount to a factoring company, often called a “factor” — the sale of such receivables is governed by the UCC, Article 9.  Through the purchase, the factor assumes the risk on the receivables, and collects some or all of the difference between the invoice amount and the amount paid to the factoring client as its profit.  Factoring is a key mechanism by which small and medium companies are able to obtain liquidity for their operations.  While factors do have agreed upon mechanisms to protect their positions, they can find themselves in risky situations when the purchased invoices become subject to dispute or offset, or when another party asserts a competing claim to the invoice payments.  One such situation is exemplified by the application of the Texas Trust Fund Statute to invoices factored on construction projects under the UCC.

The Trust Fund Statute, codified at 162.001 et seq. of the Texas Property Code, creates an identifiable construction fund for the sole purpose of protecting payments due downstream subcontractors and suppliers from being diverted or misappropriated by upstream parties. Any party found to have wrongfully diverted funds due downstream subcontractors is potentially liable for the funds pursuant to the Trust Fund Statute.  The act deems any individual owner, officer, director, or agent a trustee that owes downstream contractors a fiduciary duty to act with the utmost good faith, candor, integrity of the highest kind, and fair and honest dealing. Because the Act confers “trustee status” on individuals and not just companies, personal liability can also fall to the individual, even if they were acting solely in the course and scope of their employment and in furtherance of their employer’s business.  Notably, however, “banks, savings and loans, and other lenders” are exempted from the provisions of the Trust Fund Statute.

The intersection of the UCC and Trust Fund Statute presents a circumstance where factors that have purchased a position in invoices of an upstream construction contractor are forced to compete with subcontractor claims to money due on a subcontract.  The upstream contractor who sells its invoices to a factor, may take or use the sale proceeds such that downstream subcontractors are not able to collect payments.  When the property owner is put on notice under the UCC to pay the purchased account to the factor, and not the upstream contractor, the downstream subcontractor often intercedes claiming that the funds are “trust funds” within the meaning of the Trust Fund Statute.  The downstream subcontractor often takes the position that the factor is an agent of the upstream contractor or that said funds are constructively being paid to the upstream contractor notwithstanding their receipt by the factor.   A factor’s response is often that they are a “lender” exempted from the Trust Fund Statute’s provisions; however, there is no definitive Texas case law as to whether a factor falls under such classification.

The Performance Insulation case presents the aforementioned circumstances.  Catalyst Financial Company (Catalyst), a factor, purchased invoices of a general contractor, L&S Industrial Services (L&S) on a construction project.  L&S allegedly did not pay its subcontractors with the sale proceeds, but instead used the money for other purposes.  When Catalyst later sued to collect the funds, subcontractors, including Performance Insulation, also filed suit asserting the funds due from the owner were trust funds properly payable to the subcontractors.  The subcontractors also sued Catalyst, L&S and its owners asserting misappropriation of trust funds, and contending that L&S’s diversion of previous contact payments to Catalyst was a trust fund violation giving rise to liability against L&S and its owners.  L&S’s legal contention was that the funds paid to Catalyst were “constructively” paid to L&S through Catalyst, as agent for L&S.  Catalyst, L&S and its owners contended that funds previously paid Catalyst were not “trust funds” because Catalyst was not L&S’s agent, rather, as financier of L&S’s accounts receivables, Catalyst fell within the “lender” exception to the Trust Fund Statute, and thus, the transaction between Catalyst and L&S was exempt from trust fund liability.

Most of the claims in the case were eventually settled, with the exception of Performance Insulation’s claims against L&S and its owners.  The case was tried on a stipulated set of facts, and the trial court found in favor of Performance Insulation and against L&S and its owners.  L&S and its owners appealed the decision, and one such ground is whether a factor properly qualifies as a “lender” under the Trust Fund Statute.  The matter is pending before Texas appellate courts.

The ultimate decision of whether a factor qualifies as a “lender” could have practical, far-reaching effects on the commercial real estate, oilfield services and factoring industries.  If factors are considered lenders, it poses the potential to prejudice the rights of construction and oilfield subcontractors who will likely become less willing to perform work on account, or without collateral of some kind, when working for an upstream contractor that utilizes a factor.  However, if factors are not considered lenders, factors are less likely to become involved in large construction projects, when subcontractors would presumably prevail on claims to funds due on a factor’s purchased accounts.  The result to Texas’ construction, oilfield services and factoring industries is significant.  The industries potentially face:

(i) decreased liquidity for contractors with a blow to the factoring industry, if factors are not afforded protection as lenders under the Trust Fund Statute; or

(ii) increased risk to subcontractors who face potential non-payment for services and materials rendered.