United States: Bankruptcy Plan Can Restore Allegedly Diverted Trust Funds To Escape Liability Under New York's Lien Law

A recent case1 decided by Judge Stuart Bernstein of the United States Bankruptcy Court for the Southern District of New York demonstrates that a developer's properly crafted chapter 11 plan of reorganization can effectively "restore" trust funds that it previously had "diverted" under the New York Lien Law.

In this case, before filing its bankruptcy case, a hotel condominium developer Waterscape Resort LLC ("Developer") had used commercial loan proceeds and proceeds of sales of condominium units to repay project debt instead of remitting those funds to its general contractor ("GC") as required under the NY Lien Law.  The GC sued and filed a motion for summary judgment on two counts of its complaint, seeking to establish that loan and sales proceeds used by the debtor for non-trust purposes were "trust funds" and that those funds should be recovered for the benefit of the GC and other trust fund beneficiaries.  Although the bankruptcy court found that the funds constituted "trust funds" in which the debtor's estate held only bare legal title and no equitable interest, it permitted the debtor to avoid liability under the NY Lien Law by funding an $11M trust account dedicated to pay Lien Law and other trust fund claims pursuant to the Debtor's chapter 11 plan.

Overview of a Contractor's Rights under the NY Lien Law

Under the NY Lien Law, a project owner must hold in trust funds received in connection with a contract for the improvement of real property in order to pay claims of trust fund beneficiaries.  Trust claims include claims of general contractors and subcontractors, and claims incurred for any payment or expenditure defined as a "cost of improvement" under the Lien Law.  The trust continues until all trust claims have been paid or otherwise discharged.  

A party's demonstration that trust funds have been used for unauthorized purposes may establish a "diversion" and a breach of trust, unless the trustee has a defense.  

One defense would include a demonstration by a trustee or its assignee that the funds have been "restored" so that cash is available to pay future claims of trust beneficiaries.  This defense is intended to prevent creditors from receiving a windfall that might arise if a penalty were to be imposed upon the trustee under circumstances where funds were available to pay trust fund claims.

Facts of Waterscape


In June 2007, a lender (the "Bank") provided financing to refinance the Developer's existing debt and to construct a hotel project in Manhattan (the "Project").  The Bank's financing included a secured construction loan in the principal amount of approximately $100 million ("Construction Loan") and a secured Project Loan in the principal amount of approximately $9.1 million ("Project Loan").  The Developer and the GC signed a construction contract (the "CM Agreement") under which the GC was appointed construction manager for the Project.

Proceeds of the Construction and Project Loans were intended to be advanced monthly as progress payments on the Project.  The Construction Loan was intended to pay for "hard" costs and the Project Loan was intended to pay for certain indirect construction costs that did not qualify as "costs of improvements" under the Lien Law.

The Bank advanced money on a monthly basis to fund construction of the Project pursuant to certified requests for advances submitted by the Developer.  The Developer certified to the Bank that advances would be used as specified in its requests for advances.

The Developer allegedly received loan proceeds and proceeds from sales of condo units and paid these proceeds to the Bank in repayment of the Project Loan.   The Construction Loan remained largely unpaid before the Debtor's bankruptcy filing.


After the Developer commenced its voluntary chapter 11 bankruptcy case, pursuant to a bankruptcy court order (the "Condo Sale Order"), it sold four condominium units, free and clear of liens, claims, interests and encumbrances which attached to the proceeds of sale. The Debtor was permitted to consummate future condominium unit sales on the same terms.  Net proceeds were to be held in a separate escrow account pending further order of the bankruptcy court.  The Bank and mechanics lienors were required to deliver releases of recorded liens at closing.

Subsequently, the GC filed a proof of secured claim in the amount of approximately $10.8 million and shortly thereafter commenced its adversary proceeding in which it alleged that certain payments in the amount of approximately $4.45 million ("Shortfall") were diversions of trust funds in violation of the NY Lien Law.   The GC sought partial summary judgment, seeking a declaratory judgment that the proceeds constituted trust funds and that all such funds be returned for the benefit of trust fund claimants.

Next, the Debtors confirmed their plan of reorganization (the "Plan").  Under the Plan, the Project was to be sold free of all liens, claims, interests and encumbrances.  As originally drafted, the Debtor's proposed plan entitled the Bank's Class 1 secured claim to all sales proceeds but through negotiation, the Plan was amended to provide Class 1 with all sales proceeds less $14 million. Approximately $11 million of such proceeds was to be set aside in a Trust Fund Account to satisfy allowed claims of Class 3 Lien Law/Trust Fund claimants, and $3 million was to fund a Class 5 Reserve Account to satisfy allowed general unsecured claims.   

The Plan became effective when the sale of the hotel closed.  At that time, the Bank was paid $109M, and the $11M Trust Fund reserve account and $3M Class 5 Reserve Account were funded with sales proceeds from the disposition of the hotel and certain condo units.

The Bankruptcy Court's Decision

The court granted partial summary judgment to the GC, and issued a declaration that the Debtor's estate held only bare legal title to any and all trust funds, and would have no equitable interest in them until the claims of the GC and other trust fund claimants were fully paid and satisfied.  The court denied summary judgment on the GC's claim alleging diversion of trust funds and seeking to compel the Debtor's estate to return all such trust funds for the benefit of the GC and other trust beneficiaries.  Because the Debtor effectively had restored $11M of such funds pursuant to the Plan, the bankruptcy court held that it should not suffer any undue penalty.


This case demonstrates another broad power that the Bankruptcy Code confers upon a debtor.  Under a confirmed chapter 11 plan, in addition to restructuring its balance sheet and selling unwanted assets, a debtor effectively can cure pre-petition breaches of state law trust fund requirements by "restoring" allegedly "diverted" assets.


1 Pavarini McGovern, LLC v. Waterscape Resort LLC (In re Waterscape Resort LLC), Case No. 11-11593, Adv. Proc. No. 11-02248 (SMB)(Bankr. S.D.N.Y. 2012)

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

In association with
Related Topics
Related Articles
Related Video
Up-coming Events Search
Font Size:
Mondaq on Twitter
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
Email Address
Company Name
Confirm Password
Mondaq Topics -- Select your Interests
 Law Performance
 Law Practice
 Media & IT
 Real Estate
 Wealth Mgt
Asia Pacific
European Union
Latin America
Middle East
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.


The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.


Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions