The Texas Construction Fund Act

Texas law on mechanic’s liens is not favorable to subcontractors, particularly those from out of state. Perfection of a mechanic’s lien requires subcontractors to provide repeated monthly notice to prime contractors and owners on an accelerated timetable, with notice deadlines often coming (and going) before payment issues become apparent. For example, first-tier contractors (that is, subcontractors who contracted with the prime), must send a letter by certified mail, return receipt requested, to the owner and the original contractor informing them of the unpaid claim not later than the 15^th day of third calendar month following each month in which labor was performed or material delivered. Tex. Prop. Code § 53.056(b) (the so-called “Third Month Notice”). Failure to send a Third Month Notice (or multiple Notices, as the case may be), will result in lien non-perfection, even if the terms of the subcontract do not require payment at that point (if, for example, the subcontractor begins work on a six-month project in January and is not due to be paid until after the work is completed in June of the same year).

Further, to properly “trap” unpaid project funds in the hands of the owner (such that they are available to satisfy a mechanic’s lien), the Notice must contain specific statutory language set out in Section 53.056(d). Failure to send a timely Notice (or Notices), or to include the required statutory language, will result in no funds being “trapped” in the hands of the owner. And an owner’s liability on a mechanic’s lien is limited to funds properly “trapped.”

We frequently encounter situations where a subcontractor (particularly an out-of-state subcontractor) fails to comply with these strict requirements and is left without recourse against the owner. The only way to ensure valid perfection is to send multiple Third Month Notices, even if no payment obligations have arisen under the terms of the subcontract. For business-relation reasons, many subcontractors are reluctant to take this step.

Fortunately, the Texas legislature has balanced the scales somewhat with the Texas Construction Fund Act (the “Act”). The Act applies to those furnishing labor or materials for the construction or repair of a house, building, or improvement on real property, and provides that any funds paid to a contractor, subcontractor, or supplier made in payment of labor or materials are held in trust for all parties in the construction chain. Tex. Prop. Code §§ 162.002 and 162.003. The Act acknowledges a basic reality of modern construction projects: that prime contracts generally deposit project monies into a few common accounts, and it allows subcontractors and suppliers to recover from these funds without first pleading entitlement to these funds. See Holladay v. CW&A, Inc., 60 S.W.3d 243, 246 (Tex. App.—Corpus Christi 2001, pet. denied).

The Act accomplishes this goal in four ways. First, it treats “construction payments”—defined as payments made to a contractor or subcontractor, or an officer, director, or agent of a contractor or subcontractor, under a construction contract for the improvement of specific real property in Texas—as trust funds. Tex. Prop. Code § 162.001.

Second, the Act treats certain recipients of construction payments as trustees. The universe of potential trustees is broad, and includes contractors, subcontractors, or owners, or officers, directors, or agents of a contractor, subcontractor, or owner who receives trust funds or who has control or direction of trust funds. Tex. Prop. Code § 162.002.

Third, it provides an expansive definition of beneficiaries, which includes any artisans, laborers, mechanics, contractors, subcontractors, or materialmen who labors or who furnishes labor or material for the construction or repair or an improvement on specific real property in Texas. Tex. Prop. Code § 162.003(a).

Fourth—and most importantly—the Act allows for civil and criminal liability for any trustee who intentionally, knowingly, or with intent to defraud “directly or indirectly retains, uses, disburses, or otherwise diverts trust funds without first fully paying all current or past due obligations incurred by the trustee to the beneficiaries of the trust funds. Tex. Prop. Code § 162.031(a).

It is not difficult to imagine circumstances constituting misapplication. For example, a prime contractor who uses progress payments from an owner for Job A to pay subcontractors and vendors on Jobs B and C has misapplied those progress payments, even if the payments on Jobs B and C were not made with an express intent to defraud. Under such circumstances, an unpaid subcontractor on Job A can bring a civil claim not just against the contractor, but also its owners, officers, directors, and agents of the contractor (as well as anyone else at the contractor who had control or direction of the payment of the construction fund), and expose these individuals to personal liability.

Obviously, a claim under the Trust Fund Act is not a silver bullet. Recovery depends on the ability to prove misapplication, there are certain affirmative defenses available to the defendants, and the some or all of the defendants may be judgment proof. In this sense, it is not equivalent to a properly perfected mechanic’s lien, which allows the subcontractor to recover “trapped” project funds though a simple foreclosure process.

That said, a Fund Act claim is a powerful tool, as it exposes individual defendants to personal liability, and the threat of such a claim can be a very powerful motivation to encourage contractors to resolve unpaid subcontract amounts.