In an effort to minimize the amount of financial risk subs and suppliers take on, several states have enacted their own trust fund statutes. Each of the 15 states that have such statutes vary in their degrees of requirements and applicability. It’s important to understand the effects of these statutes since they have a significant impact on a project’s cash flow and remedies in case of non-payment.
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Arizona Trust Fund Overview
Arizona’s trust fund statute is narrowly tailored to specific construction projects. It does not contain any overly burdensome requirements but does impose some notable liability on behalf of the general contractor. The Arizona construction trust fund requirements are set out in Ariz. Leg. §33-1005. This statute states:
Monies paid by or for an owner-occupant to a contractor as payment for labor, services, materials… for which a lien is not provided… shall be deemed for all purposes to be paid in trust and shall be held by the contractor for the benefit of the person who furnished labor, services, materials…
Such monies shall neither be diverted nor used for any purpose other than to satisfy the claims of those for whom the trust is created and shall be paid when due to the person entitled thereto.
This effectively converts those payments received by the general contractor into trust funds. The money is “held in trust” in favor of those who furnished the corresponding labor or materials for which the payment is made. Which means it expressly prohibits the diversion or use of the funds for any other purpose, other than to satisfy the claims of those for whom the trust is created.
For further reading on trust fund statutes:
When does this requirement apply?
Unlike other state trust fund statutes, this is not a blanket rule for every project. This statute applies only to residential, owner-occupied construction projects.
Residential, owner-occupied projects
So the Arizona trust fund statute only applies to owner-occupied residential projects. But what exactly is that? The AZ statutes explicitly define what an owner-occupied dwelling is under §33-1002. The term owner is pretty straightforward; anyone who before construction holds legal or equitable title to the property. The property becomes occupied by the owner when they:
“reside or intend to reside in the dwelling at least 30 days during the 12 months immediately following completion of the construction or improvement… and does not intend to sell or lease it to others.”
Residence or intent to reside in the property include things such as keeping personal belongings or furniture in the dwelling, or actual occupancy by the person or a member of their family. If working on a project that matches this description, the trust fund statute requirements will apply.
Trust fund requirements apply because lien rights aren’t available
“no lien shall be allowed against the dwelling of a person who became an owner-occupant prior to construction… except by a person having executed in writing a contract directly with the owner-occupant.”
Therefore, unless the contractor has a direct contractual relationship with the owner occupying the dwelling, they will be unable to file a mechanics lien. And therein lies the problem.
Subcontractors and suppliers working on these types of projects aren’t afforded lien rights to protect themselves against nonpayment. So the legislature decided to take matters into their own hands by enacting this statute. To add some sort of protection and liability on the prime contractor in charge of dispersing project funds from the owner.
Arizona construction trust fund requirements
When a prime contractor receives money from the owner on an Arizona residential project, the trust fund statutes are automatically applied. The payments are then held in a fiduciary capacity by the GC for the benefit of the subs and suppliers to the project. This not only imposes specific requirements on the prime contractor but also some significant liabilities.
Fiduciary duty imposed
It has been established that these statutes create an express or technical trust sufficient to establish a fiduciary relationship according to the case of In re Baird. This imposes a fiduciary duty on the contractor. Thus, the contractor (fiduciary) is required to act in the financial best interests of the beneficiaries. The beneficiaries being, under the Arizona trust fund provision, subcontractors and suppliers who provided the labor or materials for which the payments are being made.
That’s the only real requirement. Many other states impose the obligation to keep the funds in a separate account for accountability purposes. Not in Arizona, just hold the funds in trust and distribute them to those who earned it.
Effect of contractor bankruptcy
When a contractor files for bankruptcy, recovering payment can become a nightmare. Which also happens to be the biggest advantages of having the funds held in trust. Trust funds are immune; not only from third-party creditors but also any bankruptcy proceedings.
Once the payments are converted into trust funds, they are provided a certain level of protection. According to U.S. v. Whiting Pools, Inc., any property held in trust at the time of filing its bankruptcy petition is excluded from the bankruptcy estate. That money is specifically held in trust for the benefit of the subs and suppliers who earned it. This goes the same for construction trust fund payments received after filing bankruptcy, as the payments are automatically converted to trust funds.
This is where the rubber meets the road. Any contractor who violates these requirements can be held personally liable for any defalcation or misuse of the construction funds. Defalcation is a fancy legal term. But it basically means the failure of a party to account for money that has been entrusted to them. This includes any misuse of funds that is intentional or not.
Furthermore, it will also expose individual corporate officers, directors, or owners to personal liability for misappropriation of funds. Typically, corporate officers are shielded from the personal liability of their company.
However, it was established in Arizona Tile LLC v. Berger that if a high-tier contractor diverts money owed to you on a residential project, that company’s officers or directors cannot rely on personal liability protection that a corp or LLC normally provides. Therefore, even if they were acting on behalf of the corporation, they will still be personally responsible for the misappropriated project funds.
Understanding your state’s construction trust fund statute is important for contractors, subs, and suppliers on owner-occupied residential projects in Arizona. Any statute that impacts the cash flow and payments on a construction project is worth noting. Without the protection of mechanics liens to fall back on, the Arizona legislature imposed this rule to protect lower tier party from the misappropriation of construction funds.