A general contractor must hold funds paid to it by the owner in trust. They must apply those funds to claims made by its subcontractors above all else, including their own expenses. General contractors who misapply funds are committing theft by contractor, and they could become personally liable and face treble damages. The same analysis applies to upstream subcontractors – they too must use funds received to resolve claims from subcontractors first, above all else.
I have advised owners and contractors on the impact of these draconian statutes and appropriate legal defenses. Contractors underestimate the impact of theft by contractor and other misapplication statutes. The exposure from violating theft by contractor statutes is often far worse than simply being unable to pay a claim on a particular job, or simply going out of business. General contractors and upstream subcontractors are pressured to be highly capitalized and must be prepared to wait a long time to be paid for their work.
A recent Wisconsin appellate court case, St. Croix Med. Ctr. v. Keller (1), discusses the impact of theft by contractor statutes in an arbitration context and how a court may liberally construe a contractor’s obligation to pay its subcontractors above all else. If you would like to learn more about statutory obligations that apply to contractors who subcontract a portion or all their work, please consider reaching out to me to discuss.
The Dispute in St. Croix Med. Ctr. v. Keller
The Plaintiff, St. Croix, hired Keller Construction as the general contractor for a hospital addition (“Project”). The Project involved fourteen draws. Keller was paid in full on Draws 1-12. All subcontractors were reportedly paid on those draws in full without issue (2). The Project appears to have gone off the rails with Draw 13. Keller submitted Draw 13 for $200,000.00. Four subcontractors were among the intended recipients. St. Croix only approved $500.00 for materials and refused to pay the balance because of a dispute regarding the quality of the construction work and adequacy of the installed air handling system. The dispute between Keller and St. Croix was submitted to arbitration and, after approximately one year (3), the arbitrator issued a decision as follows:
- Keller was entitled to an award of $320,295.82 (which included the remainder of Draw 13 – $199,500);
- St. Croix was entitled to an award of $311,163.53, consisting of a $200,000 credit to fix the air handling system and a $111,163.53 credit against Draw 13 for payments made by St. Croix directly to subcontractors.
Despite the nearly offsetting awards and Keller’s receipt of only $9,132.29, the arbitrator directed Keller to satisfy all valid and legally enforceable liens and claims of all subcontractors or suppliers. Keller stipulated to confirmation of the arbitration award, then failed to pay the four subcontractors. Keller argued there were no funds available to pay the subcontractors because it was never paid the money in Draw 13. Four subcontractors had valid liens totaling almost $250,000 against St. Croix’s property. St. Croix settled their claims and then sued Keller Companies Inc. (4) and the owner, Keller, in his personal capacity, for recovery.
Wisconsin’s Theft By Contractor Statute and Typical Application
Theft by Contractor is part of the Wisconsin Construction Lien Law and contained in Wisconsin Stat. § 779.02(5). It is designed to protect subcontractors and material suppliers by making money paid by the owner to the contractors and subcontractors a trust fund. The theft by contractor statute imposes a trust in favor of due or about-to-become-due claims of subcontractors and suppliers on all funds paid by the owner to the contractor. Breach of the trust fund obligation imposes personal liability on the contractor. The fund must only be used for payments for labor and materials used in performing the contract. Using the funds for any other purpose, whether personal or corporate, violates the statute. Personal liability attaches to the officers of the corporation.
Cases have held that a general contractor violates the statute even when it uses the money to pay its own expenses incurred in the ordinary course of the corporation’s business rather than to pay a subcontractor. The typical theft by contractor case was discribed as follows:
“Keller points to Capen Wholesale, Inc. v. Probst, 180 Wis.2d 354, 509 N.W.2d 120 (Ct.App.1993), as a classic example of theft by contractor. In that case, it was undisputed that the subcontractor plaintiff had supplied roofing materials to the general contractor; the general contractor subsequently used those materials in its projects, for which it was paid by its customers; and the general contractor did not pay the subcontractor, instead using the money held in trust for the payment of other corporate expenses like payroll, rent, utilities, and taxes. The Court observed that these undisputed facts established all elements of theft by contractor under Wis. Stat. § 779.02(5).”
Keller’s Defenses and Draconian Impact of Theft By Contractor Claims
Keller attempted to distinguish his case from the typical theft-by-contractor case by arguing he only received $9,000 in arbitration from Draw 13 and need only to apply those funds to those claims. However, this argument ignored the express language in the arbitration decision. The Arbitrator awarded Keller payment in full on Draw 13. It was of no consequence to the theft-by-contractor analysis that Keller also lost a claim for deficient construction work. Further, the arbitration order expressly required Keller to resolve any liens and claims related to that draw.
Importantly, Keller wrongly attempted to limit its obligation to Draw 13, ignoring the trust fund obligation that applied under 779.02(5) to all funds received from all draws. Keller received $4.4M in payments during the Project and retained $1.2M. $3.2M was paid to subcontractors and suppliers. The subcontractors that were unpaid by $250K filed suit and obtained a settlement on their lien claims. As such, there were enough funds paid to Keller on the job to satisfy those lien claims. It is important to remember that ALL funds paid to any prime contractor constitute a trust fund that must be applied to claims, and the trust fund obligation continues until ALL claims have been paid.
Contractor Profits and Covering Overhead
A contractor who subcontracts all or part of its work is not entitled to profit on every job. The point is worth repeating because I often have this discussion with small general contractors. This requirement is generally consistent across jurisdictions. If the job pays $1M but subcontractors cost the general contractor $1.2M, the general contractor must pay all the $1M to the subcontractors to avoid liability under the theft by contractor statutes. The contractor cannot pay its overhead, employees, or other expenses first. It may be responsible for the additional $200K under other theories of recovery, such as breach of contract, but likely has an opportunity to defeat the draconian personal liability and treble damages claims under the theft by contractor statute.
This obligation is clearly terrible for prime contractors’ cash flow but is required and is actionable under Wisconsin Lien Law. I find small, undercapitalized general contractors may be more likely to run into criminal liability here. It can be very challenging to bid every job perfectly, and no job goes fully according to plan. Small contractors need to ensure they are properly capitalized and can survive receiving zero profit from a job.
Policy-Based Defenses to Theft by Contractor
Keller also made a policy-based legal argument that my clients who are general contractors or upstream subcontractors often repeat. They believe the “practical realities” and “industry standards” in construction as such that the theft by contractor statute improperly requires the contractor to have an independent source of income to fund all aspects of the job until completion. Small contractors argue “this is how it is done” and “nobody can do it this way”. There is a strong argument that the theft by contractor statute operates to unfairly penalize small businesses. However, the Keller court quickly and summarily dismissed this argument. The theft by contractor statute is not concerned with these particular financial problems of general contractors. The Court suggests policy decisions such as these are for the legislature to make.
Defend Theft By Contractor Claims With Clean Books
I sometimes find small contractors commingling funds between different jobs. They pay subcontractor bills as they come in and from their general fund. They keep one job afloat by taking some funds from another job before it is completed, and vice versa. This is a recipe for disaster. If you find yourself doing this, please stop and immediately contact me or another attorney and discuss. Also, if your books are not clean enough to immediately prove that you are NOT commingling funds, I also ask that you immediately contact me to discuss.
For contractors who subcontract any portion of their work, and those with potential claims against upstream contractors, it is important to understand how the theft by contractor statute may affect your legal rights. Upstream contractors who do not use funds received to resolve liens and claims from subcontractors first, above all else, risk criminal liability, personal responsibility, and treble damages. If the prime contractor or subcontractor is a corporation, LLC, or other legal entity other than a sole proprietorship, the misappropriation is also deemed theft by any officers, directors, members, partners, or agents responsible for the misappropriation. Your LLC will not limit your personal liability. If you believe this analysis could affect you, please consider contacting me to discuss.
(1) St. Croix Reg’l Med. Ctr. v. Keller, 371 Wis.2d 564 (Wis. App. 2016).
(2) A small portion of Draw 11 was withheld from Keller, but Keller’s subcontractors were paid in full from the portion of Draw 11 that was approved by St. Croix.
(3) Arbitration is faster than litigation on average, but each case is a little different and arbitration is often not a rapid resolution.
(4) The corporate entity St. Croix contracted with was not Keller Companies, Inc. However, St. Croix alleged the new entity was created to prevent St. Croix from collecting a judgment. I have written about corporate successor liability and the potential problems created when an owner shuts down one company and continues under a different corporate name. Here, the Court did not spend much time on the issue, and it may be that Keller did not dispute corporate successor liability because he was, in fact, found personally liable for the claims brought by St. Croix.