Personal Liability for Failure to Pay Subcontractors, Suppliers

The owners, officers and directors of a construction company can be personally liable when their company, after receiving payment on a residential project, fails to pay subcontractors or suppliers as required by Arizona law. As construction activity and its inevitable disputes continue to rebound, that conclusion by the Arizona Court of Appeals, in its 2010 ruling in Arizona Tile LLC v. Berger , is worth reviewing.

Background. Designer Surfaces, Inc., was a supplier of residential countertops. Much of its business came via large retailers, such as Costco and Lowe’s. The retailers contracted with customers and then subcontracted the work to Designer Surfaces, which purchased materials on an open account from, among other suppliers, Arizona Tile.

Designer Surfaces became insolvent and stopped paying Arizona Tile, even though the retailers had paid Designer Surfaces for the jobs that Arizona Tile had supplied. Arizona Tile filed a lawsuit and obtained a default judgment against Designer Surfaces.

Arizona Tile also sued Designer Surfaces’ directors personally, claiming a breach of fiduciary duty based on A.R.S. § 33-1005. Arizona Tile argued that the directors had diverted to other uses the $26,800 that Designer Surfaces had collected from the retailers and that should have been “held in trust” for payment to Arizona Tile.

A.R.S. § 33-1005 states in part: "Monies paid by or for an owner-occupant ... to a contractor ... as payment for labor, professional services, materials, machinery, fixtures or tools for which a lien is not provided ... shall be deemed ... to be paid in trust and shall be held by the contractor for the benefit of the person or persons furnishing such labor, professional services, materials, machinery, fixtures or tools. Such monies shall neither be diverted nor used for any purpose other than to satisfy the claims of those for whom the trust is created ... [.]" (Emphasis added.)

It is important to note that this statute does not apply to commercial or other non-residential construction. It applies specifically to residential projects, where lien rights exist only for contractors who have a direct contract with the owner-occupant.

The Superior Court judge ruled that A.R.S. § 33-1005 applied to the facts in this case and issued a summary judgment against Designer Surfaces and its directors personally. The directors appealed the trial court’s ruling.

Personal Liability. In upholding the trial court’s summary judgment, the Arizona Court of Appeals ruled that “... a corporation’s breach of its trust obligation ... can result in the personal liability of a corporate officer or director.”

The Court cited the Ninth Circuit Bankruptcy Appellate Panel (BAP) 1990 In re Baird ruling. In that case, the BAP refused to allow the sole owner of a construction company to discharge, in his personal bankruptcy, a debt created when his company failed to pay a subcontractor on a residential project, despite being paid for that subcontractor’s work. The BAP held that the general contractor breached the trust obligation created by the aforementioned A.R.S. § 33-1005 and thus, was personally liable for the debt.

Why Arizona Tile Matters. The Court of Appeals’ ruling in Arizona Tile provides a point-by-point warning for any contractor whose company, after receiving payment on a residential project, does not pay a subcontractor or supplier as required by law:

• “Designer Surfaces was obliged ... to treat as funds held in trust the monies received on behalf of suppliers like Arizona Tile.”

• “The corporation breached its trust obligations by failing to hold those funds for the benefit of its suppliers, by failing to pay those funds over to the suppliers when due, and by using those funds ‘for any purpose other than to satisfy the claims of those for whom the trust [was] created.’”

• “[The directors] authorized these wrongful actions and ... can be personally liable for the damage caused by the corporation’s breach of trust.”
  

The bottom line for contractors: When you receive payment on a residential job, the portion of that payment that is owed to suppliers or subcontractors is not your money to be used as you wish. It is money “held in trust” for the benefit of other parties, and your failure to pay over the amounts due can make you personally liable for payment.

For subcontractors, if an upper-tier contractor diverts money owed to you on a residential project, that company’s officers or directors cannot rely on the personal liability protection that a corporation or LLC normally provides.