Should a Subcontractor be allowed to assign, sell, or otherwise transfer (factor) an account receivable due from a general contractor for work performed on a construction project? We say, absolutely not. Here’s the problem.
Construction funds are trust funds. Texas Property Code §162.001(a) (commonly referred to as the “Trust Funds Statute”). Even loan receipts are trust funds. Texas Property Code §162.001(b).
A contractor, subcontractor or owner, or an officer, director, or agent of a contractor, subcontractor, or owner, who receives trust funds or who has control or direction of trust funds, is a trustee of the trust funds. Texas Property Code §162.002.
An artisan, laborer, mechanic, contractor, subcontractor, or materialman who labors or who furnishes labor or material for the construction or repair of an improvement on specific real property is a beneficiary of any trust funds paid or received in connection with the improvements. Texas Property Code §162.003.
A general contractor is a trustee of construction funds paid to it by the owner. A subcontractor would be a beneficiary of the trust funds paid to the general contractor in connection with the improvements at the project. In turn, once paid, the subcontractor becomes a trustee.
A trustee who, intentionally or knowingly or with intent to defraud, directly or indirectly, retains, uses, disburses, or otherwise diverts trust funds without first fully paying all current or past due obligations incurred by the trustee to the beneficiaries of the trust funds, has misapplied the trust funds. Texas Property Code §162.031.
A trustee who misapplies trust funds amounting to $500 or more in violation of Chapter 162, with intent to defraud, commits a felony of the third degree. Texas Property Code §162.032 (b). If the misapplication of trust funds by a trustee constitutes another offense punishable under the laws of this State, the State may elect the offense for which it will prosecute the trustee. Texas Property Code §162.033.
Under Section 9.406 of the Texas Business and Commerce Code, once the account debtor (General Contractor) receives notification of the assignment of an account (invoice), the account debtor cannot discharge its obligation by paying the assignor (Subcontractor). After receipt of the notification, the account debtor (General Contractor) may discharge its obligation only by paying the assignee (Factor Company).
This situation results in a legal paradox.
1. On the one hand, Subcontractor has relieved itself from the implications of the Trust Fund Statute. Subcontractor is no longer receiving “trust funds” for its services provided at the construction project. It is receiving funds for the work from a third source, Factor Company. After receipt of these funds, Subcontractor can “retain, use or disburse” those funds any way it chooses without worry of the implications imposed by the Trust Fund Statute.
2. Factor Company would argue that it is not a Trustee, subject to the Trust Fund Statute. Thus, after receiving payment of trust funds from the account debtor, it does not have to pay any beneficiaries of Subcontractor.
3. On the other hand, General Contractor is required to pay Subcontractor under the Trust Fund Statute. If General Contractor pays Factor Company, General Contractor, its owners, or officers, or directors face potential criminal liability. Further, if General Contractor pays Factor Company, and Factor Company does not pay Subcontractor beneficiaries, the project is subject to lien. If General Contractor does not pay Factor Company, then General Contractor is subject to liability under Section 9.406 of the Texas Business and Commerce Code.
By factoring the accounts receivable, Factor Company, Subcontractor, its owner or officers, and directors have circumvented the trust fund statute, is not a trustee, and thus can use those funds for any purpose thus avoiding a criminal penalty. This unintended result cannot be tolerated in the construction setting.
Keeping an owner’s construction project property free and clear of liens is a constant concern for general contractors. Because subcontractors typically purchase materials to be incorporated into the construction project from third parties, it is important that the flow of funds from the owner to the general contractor to the subcontractor make their way to the suppliers to prevent liens filed by these outside third party suppliers. If a subcontractor were allowed to assign (factor) its account receivable due under a construction contract, and if payment would have to be made to the assignee, how would the assignor’s (subcontractors) suppliers, materialmen, and laborers be paid to prevent liens?
It could be argued that Subcontractor could (and should) pay the funds it receives from the factor to the beneficiaries. However, in the real world that does not happen. That’s why we have the Trust Fund Statute. It is for these reasons that the factoring, sale, or assignment of a right to payment under a construction contract for construction or repair of an improvement on specific real property in this State be declared void as against public policy. A seemingly legal means to avoid criminal prosecution should not be tolerated and in the interest of public policy should be invalidated and voided.