The Lien Law Trust Provisions

Article 3-A of the Lien Law creates "trust funds out of certain construction payments or funds to assure payment of subcontractors, suppliers, architects, engineers, laborers, as well as specified taxes and expenses of construction" ( Caristo Constr. Corp. v Diners Fin. Corp., , 21 NY2d 507, 512 [1968]; see Lien Law §§ 70, 71). We have repeatedly recognized that the "primary purpose of article 3-A and its predecessors [is] 'to ensure that those who have directly expended labor and materials to improve real property [or a public improvement] at the direction of the owner or a general contractor receive payment for the work actually performed'" ( Matter of RLI Ins. Co. v New York State Dept. of Labor, , 97 NY2d 256, 264 [2002] [quoting Canron Corp. v City of New York, , 89 NY2d 147, 155 (1996)]; see also West-Fair Elec. Contrs. v Aetna Cas. & Sur. Co., , 87 NY2d 148, 156-157 [1995]). As the Law Revision Commission noted in its 1959 Report recommending numerous amendments to the law,

"enactment of the trust fund provisions was prompted by the frequency of cases in which laborers and materialmen were in fact not paid. The trust concept was intended precisely to forbid that an owner, contractor or subcontractor act merely as entrepreneur and was intended to require that he act, instead, as fiduciary manager of the fixed amounts provided for the operation"

(1959 Report of NY Law Rev Commn, at 214, reprinted in 1959 NY Legis Doc No. 65, at 30).

To ensure this end, the Lien Law establishes that designated funds received by owners, contractors and subcontractors in connection with improvements of real property are trust assets and that a trust begins "when any asset thereof comes into existence, whether or not there shall be at that time any beneficiary of the trust" (Lien Law § 70 [1], [3]; see City of New York v Cross Bay Contr. Corp., , 93 NY2d 14, 19 1999]). Funds received by an owner under building loan contracts and building loan mortgages are trust assets and the statute requires owner-trustees to apply such assets for payment of the "cost of improvement" ( see Lien Law §§ 70 [5] and 71 [1]). Cost of improvement is defined in the Lien Law to encompass "expenditures incurred by the owner in paying the claims of a contractor, an architect, engineer or surveyor, a subcontractor, laborer and materialman, arising out of the improvement, * * * and shall also include * * * sums paid to discharge building loan mortgages whenever recorded" ( id. at § 2 [5]). The use of trust assets for a non-trust purpose -- that is, a purpose outside the scope of the cost of improvement -- is deemed "a diversion of trust assets, whether or not there are trust claims in existence at the time of the transaction, and if the diversion occurs by the voluntary act of the trustee or by his consent such act or consent is a breach of trust" (Lien Law § 72).

The Lien Law further imposes duties upon trustees in the operation of the trust. A statutory trustee must maintain books and records of the trust including entries for trust assets receivable, trust accounts payable, trust funds received and trust payments made with trust assets, and make those records available for inspection by beneficiaries ( see id. at § 75, § 76). In addition, the records must reflect any "[t]ransfers in repayment of or to secure advances made pursuant to a 'Notice of Lending'" ( id. at § 75 [3][E]). The statute expressly vests discretion in the trustee "to determine the order and manner of payment of any trust claims and to apply any trust asset to any purpose of the trust" ( id. at § 74 [1]).

Of special importance in this case, the Lien Law also incorporates a mechanism for trustees to alert beneficiaries to the distribution of trust assets to repay advances made by lenders ( see Postner & Rubin, New York Construction Law Manual § 9.76, at 362). Trustees or lender-transferees may file a "Notice of Lending" to "protect the lender's right to repayment from trust funds" ( id.; see Lien Law § 73). Such notice must be filed in the county clerk's office in the "lien docket" or other official record and indexed by the name of the trustee to whom the advances are made ( see Lien Law § 73 [3][a]). The notice is to be filed within five days of the payment and sets forth the names and addresses of the persons making the advances and to whom or on whose behalf they are made, the date of any advances made prior to the filing for which the filing is intended to be effective and "the maximum balance of advances outstanding to be permitted by the lender pursuant to the notice" ( see id. at [3][b]).

These filing provisions promote the legislative intent to assure "public notice of any transaction of the owner, contractor or subcontractor that may lead to depletion of funds available for future trust claims, even where the depletion merely repays advances that were in fact used to pay trust claims accruing at an earlier [d]ate" (1959 Report of NY Law Rev Commn, at 216). Such record notice provides "persons who furnish materials and services in reliance on the trust assets receivable by the trustee at a later stage of the improvement * * * notice that those assets have been anticipated for current expense" ( id.).

Pursuant to section 73 of the Lien Law, the proper filing of a "Notice of Lending" is an affirmative defense to an action charging a trustee with a diversion of trust assets or an action to recover diverted assets from a transferee. In an action against a trustee, the Notice of Lending evidences that the alleged diversion "was made as security for or in consideration of or in repayment of advances made to him as trustee or on his behalf as trustee * * *, and that such advances were actually applied for a purpose of the trust" ( id. at § 73 [2]).

Application of the Statute

Under Lien Law article 3-A, the funds NYCHA owed Berry Street under the turnkey sale contract were trust assets subject to the rights of trust beneficiaries and it is undisputed that plaintiffs, as subcontractors on the project, are trust beneficiaries ( see Lien Law §§ 70, 71). Berry Street assigned its rights under the NYCHA contract to Fleet and, as a result, NYCHA's direct payment of the sale proceeds to Fleet rendered Fleet a statutory owner-trustee. As a statutory trustee, Fleet was obligated to act "as a fiduciary manager" of the funds (1959 Report of NY Law Rev Commn, at 214). Fleet therefore owed the beneficiaries a duty of loyalty and was required "to administer the trust solely in the interest of the beneficiaries" (IIA Fratcher, Scott on Trusts, at § 170 [4th ed]; Rest. 3rd, Trusts § 170 [1]).

In these circumstances, Fleet's application of the trust assets to repay its loans to Berry Street -- without acknowledging its status as trustee and providing notice to trust beneficiaries of the transfer -- constituted a breach of its fiduciary duty. Fleet asserts that the inclusion of the reference to the assignment in its mortgages was the equivalent of record notice to potential claimants of Fleet's priority interest in the trust assets. There is no question that by complying with the filing and covenant requirements of Lien Law §§ 13 (2) and 22, Fleet's building loan mortgages obtained priority over subsequently filed mechanics' liens.

This argument overlooks the important fiduciary considerations adopted by the Legislature to safeguard trust beneficiaries. Potential trust beneficiaries might have been able to ascertain Fleet's claim of priority as a secured mortgage lender but nothing in the mortgage documents identified Fleet as a trustee of the article 3-A assets. Indeed, Fleet's own posture during the early stages of this litigation denied that the assignment rendered it a trustee. In essence, Fleet seeks to escape the effect of the assignment by arguing that plaintiffs should have appreciated the implications that Fleet itself refuted. Even if plaintiffs had surmised Fleet's role as the trustee by examining the mortgage documents, those filings would not have informed beneficiaries that Fleet planned to use trust assets to repay itself.

We conclude that the filing by Fleet of a Notice of Lending -- although not necessarily the only device available -- would have satisfied Fleet's fiduciary duty to provide notice to the trust beneficiaries of its use of trust assets to discharge Berry Street's debt. Such a filing would fulfill the legislative purposes of article 3-A and eliminate any taint of self-dealing by a trustee who is also a trust beneficiary. Notably, had Fleet filed a Notice of Lending regarding its use of the trust assets to repay itself, the beneficiaries could have ascertained that (1) the trust assets were being depleted and (2) Fleet was a trustee acting as both transferor and transferee of those funds ( see 1959 Report of NY Law Rev Commn, at 216; Lien Law § 73). Nothing in the filings relied upon by Fleet imparted this information to trust beneficiaries.[3] Hence, Fleet failed to file any document that served as adequate notice to beneficiaries of its status as a trustee and its depletion of trust funds to repay its loans.

Although Fleet breached its fiduciary obligation, the issue of damages for such a breach is not before us because the parties stipulated to damages prior to this appeal. Thus, we have no occasion to address the conclusion reached by the lower courts that Fleet's repayment to itself invalidated its statutory priority as a secured mortgage lender and rendered Fleet liable to plaintiffs for the full amount of the transferred trust funds.

Accordingly, the judgment appealed from and the order of the Appellate Division brought up for review should be affirmed, with costs.