Along with mechanics liens, bond claims, stop notices, and prompt-pay statutes, state statutes penalizing the misallocation of funds are supposed to make sure construction industry participants are paid what they have earned. Misallocation of funds laws do this by providing penalties designed to keep the project’s funds in the right place – so that they go to the proper parties.
In Texas, the Construction Fund Act codified this type of misallocation of funds provision and provides criminal penalties for missteps. Under the Act, certain construction payments are designated as funds held in trust for the benefit of the project participants, and in certain circumstances a “construction account” is required.
The Construction Trust Fund Act: Requirements
The Act defines most “construction payments” as trust funds. However, fees that are payable to the contractor are excluded from the definition of “trust funds” if:
(1) the contractor and property owner have entered into a written construction contract for the improvement of specific real property in this state before the commencement of construction of the improvement and the contract provides for the payment by the owner of the costs of construction and a reasonable fee specified in the contract payable to the contractor; and
(2) the fee is earned as provided by the contract and paid to the contractor or disbursed from a construction account described by Section 162.006, if applicable.
The outcome of designating payments as trust funds is that there must be beneficiaries to the created trust, as well as trustees that have a fiduciary duty to those beneficiaries. Under the Texas act, a trustee is “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.”
Likewise, beneficiaries of the trust are defined as any “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” and any property owner on a residential construction project.
Further, on residential projects exceeding $5,000 the contractor is required to deposit the trust funds into a “construction account.” A construction account is:
1) an account in a financial institution;
2) named/referred to as a “construction account;”
3) an account into which only trust funds may be maintained; and,
4) managed in accordance with Sec. 162.007 of the trust fund act – which imposes the maintenance of certain specific records.
The basic requirements of the Act are that: no trust funds may be misapplied (as specifically defined) and that construction accounts must be maintained and used appropriated where required.
While a civil cause of action for beneficiaries related to a trustees misapplication of funds is not specifically contemplated by the Act, such suits are allowed by Texas court decisions. However, what may be the real “teeth” of the penalties associated with the Texas Construction Trust Fund Act are the criminal penalties for the breach of its imposed duties.
The potentially applicable criminal penalties are set out below:
- Misapplication of trust funds amounting to $500 or more is a Class A Misdemeanor with a potential fine up to $4,000 and up to one year in jail.
- Misapplication of trust funds amounting to $500 or more with intent to defraud is a Third Degree Felony with a potential fine up to $10,000 and jail confinement for no less than 2 years and no more than 10 years.
- On residential construction projects, failing to establish or maintain a construction account or failing to establish or maintain the proper account record for the construction account is a Class A Misdemeanor with a potential fine up to $4,000 and up to one year in jail.
The above penalties are especially powerful as the Act provides for personal liability, that is the owner/officer/director of a company may be personally liable for the breach of the imposed duties even if the construction participant was a corporation or LLC if a beneficiary establishes that the individual party “directly or indirectly retains, uses, disburses, or otherwise diverts trust funds without first fully paying all current and past due obligations.”
Payment problems on one project can lead to problems on other projects, and the need to keep parties paid can sometimes result in the urge to apply funds to the the most urgent “fires” no matter where the funds originally came from and ‘make it up later’ when additional funds come in. This is a bad idea as the above penalties make perfectly clear.
The take-away here is simple: keep a clear accounting of all funds in an out, and only apply the funds to the proper parties. If you’re in the construction business in Texas, it’s important for you to keep your accounting house in order so that you can stay out of the big house!