Contractors Joint-check Agreements Use at Your Peril

Contractors Joint-check Agreements Use at Your Peril

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Joint checks are often used in the construction industry to ensure that material suppliers get paid and to manage potential lien claims.2 Typically, a general contractor, subcontractor and material supplier will enter into a "joint-check agreement" that requires the general contractor to issue a check payable jointly to the subcontractor and the material supplier.3 The general contractor and the subcontractor do this believing the joint check will ensure that the material supplier gets paid because the joint check must be endorsed by both parties. Usually, the subcontractor takes part of the balance and the material supplier retains the balance. Id. at 242. Unfortunately, the protection of such an agreement may be illusory if the subcontractor ends up in bankruptcy. When a subcontractor goes bankrupt, there is substantial doubt that the material supplier can demand its portion of the joint check because the entire joint check may become property of the bankruptcy estate.

Property of the Estate

A bankruptcy estate is comprised of "all legal or equitable interests of the debtor in property as of the commencement of the case." 11 U.S.C. §541(a)(1). Therefore, the analysis begins by determining which parties have an equitable or legal interest in the joint check. When a subcontractor files for bankruptcy protection, it is clear that its bankruptcy estate has legal title to the joint check because the debtor's name on the check as payee gives the debtor an apparent right of ownership and possession. Southern Carbon Co. v. State, 13 N.Y.S.2d 7, 9 (1940). It is, however, unclear whether the debtor's estate has equitable title. In addition, "property held by the debtor solely for the benefit of another does not constitute property of the estate." 11 U.S.C. §541(b). Such property is considered to be held in trust by the debtor for the beneficiary. In re Golden Triangle Capital Inc. 171 B.R. 79, 81 (9th Cir. BAP 1994); see, also, 5 Collier on Bankruptcy (15th ed.), §541.11 at 541-59 (2000) ("[w]hen property of the estate is alleged to be held in trust, the burden rests upon the claimant to establish the original trust relationship."). As one might expect, the legal result depends on the facts and circumstances of each particular case, yielding a fair amount of uncertainty and wiggle room for the creative litigator.


A joint-check agreement is not a poor man's substitute for a real credit enhancement.

Joint Checks and the Bankruptcy Estate

A joint check is insufficient, by itself, to establish a constructive trust in favor of the subcontractor. Georgia Pacific Corp. v. Sigma Service Corp., 712 F.2d 962, 972 (5th Cir. 1983). In Georgia Pacific, the general contractor/debtor, Sigma, requested that Georgia Pacific, the project owner, issue joint checks to its general contractor, Sigma and its material suppliers. Subsequently, Sigma did not endorse the checks to the material suppliers and filed for bankruptcy protection. The court found that the unilateral joint-check agreement placed no affirmative duties on the debtor in relation to the suppliers. Id. at 971-72.

Because of the limitation in Georgia Pacific's holding that a joint check "by itself" does not establish a constructive trust, application of Georgia Pacific requires a fact-specific analysis. Courts have found that joint checks are not part of the bankruptcy estate in two circumstances: (1) where the debtor acted as a trustee or a mere conduit, and (2) where the material supplier acted in reliance on the joint-check agreement in supplying the debtor with materials.

Mere conduit. Where property was never intended for the debtor and was held by the debtor solely for the benefit of another, this property is not part of the estate. See, e.g., Golden Triangle, 171 B.R. at 81-82 (9th Cir. BAP 1994) citing 11 U.S.C.A. §541(a), and In re Unicom, 13 F.3d 321 (9th Cir. 1994). A subcontractor was found to be a "mere conduit" when the debtor's sole role was to endorse the check and pass it on to the material supplier. Mid-Atlantic Supply v. Three Rivers Aluminum Co., 790 F.2d 1121, 1127 (4th Cir. 1986). In this situation, the contractor sent two checks to the subcontractor. Id. The first check was a joint check to the subcontractor and the material supplier covering the amounts owed to the material supplier; the monies intended for the subcontractor were sent in a separate check that only covered the amounts owed to the material supplier. Id. Similarly, in a widely cited Ninth Circuit case, the court found that joint checks payable from a project owner to a debtor contractor and subcontractor/lien claimant never became part of the debtor's estate as the debtor "merely endorsed" the check. Jackson v. Flohr, 227 F.2d 607, 610-11 (9th Cir. 1955). The court found the endorsement to be analogous to using a messenger to deliver the check from the client to the material supplier. Id. The Tenth Circuit held that funds paid by the general contractor to the material supplier with a joint check were "excluded from the bankruptcy estate under the doctrine of earmarking" and that the debtor/subcontractor is "merely deemed to be a conduit for those funds which did not become the property of the debtor's estate." In re Davidson Lumber Sales Inc., 66 F.3d 1560, 1568 n. 10 (10th Cir. 1995). The court said that by requiring dual endorsement before the check could be cashed, the funds were "earmarked funds on the specific condition that a joint payee shall receive the proceeds." Id. The courts typically follow this reasoning where all of the funds are to go to the material supplier, and the debtor party has no economic interest in the check.

The result is different if both payees have an economic interest in the check. For example, a Pennsylvania district court found that the debtor party to a joint check agreement involving subcontractors and material providers was more than a "mere conduit" when the joint-check agreement that provided that the debtor would endorse checks from the general contractor and deliver them to the material supplier who would refund to the debtor any amount in excess of what the debtor owed to the supplier. In re Anthony P. Buono, 119 B.R. 498 (W.D. Penn. 1990). The court in that case reasoned that the debtor had a property interest in the joint checks because he was entitled to payment upon the completion of the work and because he was a joint payee. Id. Thus, if there is any money owed to the subcontractor in excess of what is owed to the material supplier, it would appear to create a substantial risk that the whole check will become property of the estate.

Reliance. The second situation in which the courts have found that the proceeds of a joint check are not part of the bankruptcy estate is where the material supplier "relied" on the joint-check agreement. In Keenan Pipe & Supply Co. v. Shields, 241 F.2d 486, 489-90 (9th Cir. 1956), the material supplier expressly waived its statutory lien rights in exchange for the joint-check arrangement. This reliance on the joint-check agreement provided the court with a stronger equitable argument that a constructive trust should be imposed and the joint check funds should not be considered part of the debtor's estate. These dedicated funds of the general contractor could not be reached by other creditors of the subcontractor, except the supplier. Mullins v. Noland Co., 406 F.Supp 206, 210 (N.D. Ga. 1975), also followed this line of reasoning.

In Mid-Atlantic Supply, there was abundant evidence that the material supplier, TRACO, was induced to supply windows for the construction project only after the general contractor, who had a better credit history, agreed to the joint-check arrangement. 790 F.2d at 1125-27. TRACO would not even draft shop drawings until the agreement was signed. Id. The Fourth Circuit found that TRACO's sale to the subcontractor was based on the credit of the primary contractor, and their materials were to be paid by the primary contractor through a joint check with the subcontractor. Id. Based on this level of reliance on the joint-check agreement, the court held that a constructive trust was established by the joint check in favor of the material supplier. Id. Although the subcontractor held legal title to the check, the equitable title belonged to the material supplier, and therefore, the joint check was not part of the bankruptcy estate. Id.

The "reliance" cases show how far courts will stretch to achieve a result they perceive to be equitable. In our view, they are wrong. There are many legally cognizable ways that a supplier may ensure payment, such as requiring direct payment, getting a guaranty, obtaining a security interest in the subcontractor's receivable or enforcing its lien rights.4 It seems unfair to other creditors to allow a party that failed to follow applicable law to benefit from what is, in effect, an attempt to create a secret lien.

Preferential Treatment of Joint-check Creditor

The interest of a material supplier in a joint check could be viewed as an attempt to obtain a security interest in the subcontractor's receivable from the general contractor without following the requirements of Article 9 of the Uniform Commercial Code.5 As a result, payments to material suppliers under joint-check arrangements could be preferences under the Bankruptcy Code. 11 U.S.C. §547. In Buono, the court found that the joint-check creditor had no special security interest and had to line up with the other creditors who are similarly situated. The court reasoned that to allow these other parties to be paid less would be contrary to the philosophy of the Bankruptcy Code. 119 B.R. 498 (W.D. Penn. 1990).6 Following this reasoning, pre-petition payments to material suppliers under joint-check arrangements may be subject to attack as preferential transfers. 11 U.S.C. §547.

Conclusion

Where a creditor of a bankruptcy estate is a co-payee on a joint check, the creditor's interest in the check depends on the bankruptcy estate's claim of equitable title. The strength of the bankruptcy estate's claim depends on the facts of the situation, in particular whether the debtor was acting as a "mere conduit" and whether the creditor extended credit to the debtor in reliance on the joint-check agreement.

A joint-check agreement is not a poor man's substitute for a real credit enhancement. The use of a joint-check agreement will not perfect a security interest, and the beneficiary of a joint-check may well have to stand in line with all other unsecured creditors in a bankruptcy case. Further, they may have to return funds received during the preference period. A material supplier that is concerned about a subcontractor's solvency is well advised to consider other ways of protecting its interest.


Footnotes

1 Mr. Lubic is a partner is the Los Angeles and Palo Alto offices of McCutchen, Doyle, Brown & Enersen LLP, where he practices in the areas of bankruptcy, insolvency and creditors' rights. Ms. Phelps is a litigation associate in McCutchen's Los Angeles office. Return to article

2 Moss, Rodney, "Joint Checks: Practices in the Construction Industry," J. State Bar Cal. 242, 259 (1968). Return to article

3 Sometimes, the project client issues joint checks to its general contractor and material supplier. Return to article

4 An interesting issue arises when a materialman's lien against a property owner is relased upon payment by someone other than the property owner. It would appear that, because the payor's property is not subject to the lien, the payee is not a secured creditor of the payor, and the payment therefore is subject to attack as a preference in the event of a subsequent bankruptcy filing by the payor. Return to article

5 Under the "strong-arm clause," a bankruptcy estate may avoid asserted security interests that are not properly perfected. 11 U.S.C. §544. Return to article

6 However, in an Eleventh Circuit case where the entire amount of the check was found to be held by the debtor in trust for the material supplier, a bank's perfected security interest was not superior to the trust. In re Inca Materials Inc., 880 F.2d 1307 (11th Cir. 1989). In another case in which the debtor only had bare legal title, it has been held that the debtor has an affirmative duty to endorse the check and pass the equitable interest to the rightful party, a.k.a. the material supplier. See In re Temp-Way Corp., 80 B.R. 699 (Bankr. E.D. Pa. 1987) (basing the decision on pre-1978 cases and Georgia and Maryland state laws). The court reasoned that the bankruptcy estate's interest in the property was co-extensive with its title. Id. If the estate did not have any equitable title in the check, then there was an affirmative duty to transfer the funds to the material supplier. Id. Return to article


Journal Date: 
Thursday, March 1, 2001