A few months ago, I wrote about a recent Colorado Court of Appeals decision that gave a broad interpretation to the Colorado Trust Fund Statute. That decision highlighted the importance of maintaining strict accounting practices and segregating funds for each separate construction project. As a follow up to that post, I would like to highlight a particular accounting practice that has the potential to create liability under the Trust Fund Statue while also invalidating mechanics’ liens filed by subcontractors.
General contractors often use the same supplier or subcontractor on multiple projects. Sometimes a newer project will pay out much quicker than an older project, whether because of construction issues that need to be resolved or delays in payment from the property owner. In these situations some contractors decide to enter into arrangements with their subcontractors whereby invoices get paid based on aging rather than on a project by project basis. This might be because neither the contractors nor the subs like to show past due accounts payable/receivable on their financial statements, or maybe the subcontracts provide for steep interest payments on past due invoices.
Whatever the motivation, the contractor and the sub often view this practice as harmless. However, upon closer scrutiny, these types of arrangements can become disastrous for both contractors and subcontractors. For example, if an older project never pays out as expected and the contractor is left with a shortage of funds, then that contractor will likely face liability under the Trust Fund Statute (to a property owner and/or other subcontractors) for diverting funds from one project to pay for the expenses of another.
Meanwhile, the subcontractor whose invoices were paid based on aging, rather than on a project by project basis, is likely to have some unpaid invoices. In such a case a subcontractor would usually protect itself by filing a mechanics’ lien against the property for which it did work and did not get paid. However, this subcontractor will have a difficult time enforcing a mechanics’ lien for the newer “unpaid” invoices because it in fact already got paid with funds from that very project – those funds were simply misapplied to an older invoice for a different project.
While it can be tempting to maintain informal accounting practices with long standing and trusted subcontractors or suppliers, both sides need to ensure that they properly account for all funds so as not to run afoul of the Colorado Trust Fund and Mechanics’ Lien statutes.
Photo by laffy4k (Flickr)