Construction law: Breach of trust in the construction industry

Author: | Published: 1 Sep 1997
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Each province of Canada has enacted legislation which creates methods unique to the construction industry for recovering payment of outstanding debts. One of the methods is the creation of trust funds and penalties for the misappropriation of those trust funds. In many provinces, the legislation also pierces the corporate veil and imposes personal liability on directors and officers for breach of trust.

Breach of trust legislation was first enacted by the Province of Ontario. Other provinces subsequently followed with similar legislation.

Trust funds

Trust funds usually fall into one of the following categories:

  • Mortgage trusts. Monies received by an owner, such as an advance under a building mortgage, which are to be used in the financing of construction, constitute a trust fund for the benefit of the contractor. However, the owner may use the borrowed funds to pay for the land and to discharge prior mortgages without breaching the trust.
  • Certificate trusts. On most construction projects, the architect issues progress certificates confirming that a certain portion of the contractor's work has been completed and placing a monetary value on it. The amount so certified, where it is actually in the owner's hands or is received by the owner at any time after certification, constitutes a trust fund for the benefit of the contractor.
  • Substantial performance trusts. Where substantial performance of the contract has been certified, but the owner has only made part payment of the certified amount to the contractor, an amount equal to the unpaid price of the substantially performed portion of the work that is in the owner's hands, or that the owner subsequently receives, is impressed with a trust for the benefit of the contractor.
  • Draws trust. Any monies which are received by, or owing to (whether or not due or payable), a contractor or a subcontractor, on account of the contract or subcontract price, constitute a trust fund for the benefit of the subcontractors and other persons who have supplied services or materials to the improvement. If, for example, a contractor becomes bankrupt at a time when contract monies are in its hands, those monies do not fall into the estate of the bankrupt but must be distributed to the trust beneficiaries.
  • Vendor's trust. In situations involving the construction of a new house, it is common for a developer-owner to conclude a sale of the property before the trades have completed their work and been paid. Where an owner sells his or her interest in the premises, the sale proceeds, less the reasonable expenses arising from the sale, and the amount, if any, paid to discharge any existing mortgages on the premises, constitute a trust fund for the benefit of the contractor.
Trust obligations

Once an owner receives trust monies, he or she is precluded from appropriating all or part of those monies to his or her own use, or to any use inconsistent with the trust. The legislation, however, affords complete protection to an owner where the contractor is paid all amounts owing. Once the owner makes payment in full to the contractor, the owner's trust obligations are discharged. If only a partial payment is made, then the owner's trust obligations are only discharged to the extent of the payment made.

Examples of an owner's breach of his or her trust obligations would be where an owner uses monies advanced under a building mortgage on Project A to pay trades working on Project B; or where the owner uses trust monies to reduce his or her bank indebtedness.

Similarly, where a contractor or subcontractor receives funds impressed with the draws trust, the contractor or subcontractor will not breach the trust so long as he or she pays all subcontractors and other persons who have supplied services or materials to the improvement all amounts owed to them. Once any such payment is made, the contractor or subcontractor, as trustee, is discharged from his or her trust obligations to the extent of the payment made.

Liability for breach of trust

In cases where there has been a breach of trust by a corporation, the court may be permitted by the legislation of some provinces to pierce the corporate veil and to impose liability on the directors and officers of the corporation, and on any person having effective control of the corporation or its relevant activities. Accordingly, because a corporation does not act or make decisions on its own, a trust beneficiary might be well advised to name, as defendants in an action for breach of trust, the persons behind the corporation who may have caused the corporation to deal with trust funds in an unauthorized manner.

What must be demonstrated is that those persons assented to or acquiesced in conduct which they knew or reasonably ought to have known amounted to a breach of trust by the corporation.

Recent cases

Courts in Ontario have recently considered the issue of whether a contractor may use trust funds to pay overhead expenses (such as staff pay and office rent) without breaching the trust. The preponderance of authority holds that payment of general business expenses constitutes a breach of trust so long as subcontractors on the project remain unpaid.

The courts have also held that maintaining only one general bank account, into which payments received in respect of various projects are deposited and from which all business debts are paid, amounts to a breach of trust on the part of the principals of the corporation. Ideally, a separate bank account and separate accounting records should be maintained for each project to avoid liability for breach of trust. General business expenses should be paid out of a separate general corporate account into which are deposited only funds that are no longer impressed with a trust.

Conclusion

Given that ignorance of the law is no excuse, directors and officers of corporations involved in construction in Canada should take active steps to avoid inadvertent breaches of trust. In addition, the corporation's directors' and officers' liability insurance should be reviewed to ensure that breach of trust is not excluded from coverage.

Harvey J Kirsh and Lori A Roth