The Difference Between Contracts, Liens, Bonds and Trust Funds
It is important to get signed contracts to help collect your receivable. It is even more important to preserve mechanic's lien, payment bond and trust fund rights in troubled economic times. Contracts, mechanic's liens, payment bonds and trust funds are each very different concepts legally, however. Each of these legal mechanisms could be useless in any particular situation, but exactly what you need in the next situation. Understanding the difference will help you evaluate your credit risk with each customer, improve your position in marginal projects and effectively enforce your rights at the first sign of trouble.
When you purchased your last home or automobile, the bank required you to sign at least two pieces of paper. One was your promissory note. This was your 'contract' with the bank in which you agreed to make certain monthly payments. This is your 'personal promise to pay.' This allows the bank to sue you personally in the event of default, obtain a judgment and then attach your assets.
The other paper you signed was a mortgage, deed of trust or other 'security agreement.' Your security agreement provides the bank rights against the 'security property.' In the event of default, the bank can foreclose upon the security property, whether it's a house, automobile or other property.
If the debtor is solvent, security is not as important. The creditor will be able to go against the debtor on the 'contract.' The creditor will still be able to obtain a personal judgment against the debtor and will then be able to attach all assets owned by the debtor.
If the debtor is insolvent or disappears, security becomes critical. The contract or promise to pay will be worthless if the debtor cannot be found or has no assets. If the creditor has security, however, the creditor will be able to sell the security property to help obtain repayment. Insolvency or bankruptcy is the same as a debtor disappearing. If a debtor stops doing business or does not have assets, the contract or promise to pay may be worthless. The creditor will not collect unless the creditor has security.
Personal guaranties are another type of contract right. The advantage is that the creditor has a second debtor to sue personally in the event of default. If the second debtor (guarantor) also becomes insolvent, however, the second contract or promise to pay in the guaranty may also be worthless. A guaranty is not actually 'security' in a piece of property. The guaranty simply provides a second contract right to help the creditor collect its claim from the guarantor.
Payment bonds in the construction industry are similar to a guaranty, providing contract rights against a second debtor. The difference here is that the second debtor is usually a large insurance company, less likely to become insolvent.
Security Interests and Liens
Security is the conventional method by which creditors establish priority. Debtors can agree to voluntary security interests or 'consensual security' in accounts receivable, vehicles, equipment or real estate. On default, the creditor can 'foreclose' and sell the security property to obtain payment. Creditors can obtain a Uniform Commercial Code (UCC) security interest in accounts receivable, vehicles or other 'personal property' by getting the debtor to sign a security agreement and then file a UCC-1 Financing statement with the state.
A mortgage on real estate is another example of a consensual security interest. Mortgages are a very helpful type of security interest that are an option, even for trade creditors. However, mortgages are a state law matter and the mechanism varies from state to state. Assistance from a lawyer is normally necessary.
Mechanic's lien laws can help a construction industry creditor establish security in real estate. The creditor obtains a lien in the real estate where the creditor supplied labor or material. This lien has many similarities with a mortgage lien. If the creditor can establish mechanic's lien rights, the creditor can eventually foreclose on the real estate. Unlike a consensual security interest, however, the debtor does not agree to the mechanic's lien. Instead, the creditor must follow a procedure that varies from state to state to perfect and enforce the mechanic's lien.
Trust Fund Laws and Agreements
Trust fund laws or agreements are theoretically different from a security interest. Technically, the trust beneficiary is not a secured creditor; instead, it is something even better. If there is a trust, the receivable or 'trust asset' is simply not property of the debtor.
You may be familiar with a 'contract for deed' or an 'installment contract' in a real estate sale. In this arrangement, the debtor makes payments each month for several years. When the payments are complete, the seller then deeds the property to the buyer. The debtor does not 'own' the property until he is finished making payments. This same transaction could be structured as a mortgage where the seller deeds the property now and takes back a security interest. If the debtor defaults on the loan, the creditor must foreclose on the security property. It is safer for the creditor if the debtor never owns the property.
Some states have trust fund statutes or laws to protect owners, contractors and suppliers in the construction industry. Summaries of some of these state laws are provided below. In general, when a general contractor receives payment from the construction project owner, the general contractor holds funds in trust for the benefit of the subcontractors and suppliers. In some states, subcontractors then hold funds in trust for their suppliers and sub-subcontractors.
In the event of bankruptcy, the trust funds held for the benefit of others do not become a part of the bankruptcy estate. The trustee is merely 'holding' the trust beneficiary's money. While the creditor may need to get appropriate bankruptcy court orders, the creditor may be entitled to payment directly from an owner, general contractor or from the bankruptcy estate. This concept can also be a very important defense to a preference claim in bankruptcy.
Since a debtor-trustee is never the owner of trust funds, it is also impossible for the debtor to sell, grant a security interest or otherwise transfer trust property. The trustee could not give away or sell trust property, since a trustee does not have title for (does not own) trust property. By the same token, a trustee cannot grant an effective security interest in trust property.
Even if a trust fund law does not apply, it is possible for many creditors in many types of business to create a trust fund relationship by agreement. It is possible to add trust language to a contract, joint check agreement or credit agreement with just a few sentences. Voluntary or consensual trust fund agreements are also discussed in this chapter.
Contracts, mechanic's liens, payment bonds and trust funds are each discussed in detailed chapters in the Free 720 page online Construction Law Survival Manual at www.FullertonLaw.com