Articles

Bank Cannot Set Off Funds Deposited By General Contractor for Benefit of Subs

In a case of interest to owners and subcontractors dealing with financially distressed general contractors, a California Appeals Court recently ruled that if a bank knew or should have known that funds deposited by its general contractor customer were for payments to subcontractors, the bank could not set off those funds to pay a debt owed the bank by the general contractor.

In the case of Chang v. Redding Bank of Commerce, a general contractor had agreed to build a hotel for the owner. The owner paid the general contractor a $2l9,000 progress payment to pay subcontractors for work completed on the project. The general contractor deposited these funds into its business checking account at the bank. The bank had previously made a loan to the general contractor secured by funds in the contractor's checking account, against which the bank could offset in the event of default.

After depositing the check from the owner, the general contractor issued checks to the subcontractors. The checks were initially recorded as paid by the bank but later returned because the bank used the deposit to offset contractor's debt.

Later, the subcontractors filed mechanics liens against the owner's project. The owner settled these claims and brought an action against the bank.

The owner claimed he entrusted the $2l9,000 to the general contractor for the sole purpose of paying the project's subcontractors and suppliers. The owner further claimed that the bank knew or should have known that its customer was a general contractor engaged in work in progress and that the payment was for the benefit of the subs. The bank argued that the contractor's deposit of a progress payment into its general business account did not establish the deposits character as a trust for the subcontractor's benefit.

The trial court ruled for the bank on the ground that the owner, as a non-customer, had no standing to sue the bank. The Appellate Court reversed, holding that progress payments received by a general contractor pursuant to a contract which requires them to be paid to subs are held by the general in trust for benefit of the subs. Moreover, a bank that has knowledge sufficient to require inquiry regarding whether the deposited funds are held in trust cannot set off those funds to pay the general contractor's indebtedness.

There are at least three lessons for the subcontractor to learn from this case:

1. Protect And Pursue Your Mechanic's Lien Rights. The subcontractors in this case got paid despite general contractor's financial problems not because of the trust theory asserted by the owner, but because they had valid lien rights.
   
   
2. Insist on Joint Checks If Possible. Both the owner and the subs could have avoided this problem by using joint checks. In that way, the funds never have to pass through the general contractors' checking account subjecting them to the control of the general contractor's bank.
   
   
3. Don't Give Up. Assuming you don't have a valid lien and joint check or other protective devises are not used, don't give up. Based on this authority, under the right facts, you may have a superior claim to the funds deposited.