The Surety and Trust Funds: Forms of Trusts
June 20, 2023
In this Surety Today Blog post we continue with our second post of a multi-part series on the surety and trust funds. In the first post, we discussed the nature of trusts, the formation of trusts and the elements of an express trust. In this blog post we will look at the various forms of trusts, such as statutory trust funds, contractually created trusts and trusts at common law. As we noted in the first post, one of the tools that every surety claims handler needs to be familiar with are trusts and developing a solid understanding of the law of trusts is essential for the surety to be able to identify and assert such rights in the myriad of circumstances in which they may be useful.
In the construction industry, trusts can arise in three primary ways: (1) by contractual agreement, whether in the prime contract, a subcontract or in the indemnity agreement; (2) by statute, through a construction trust fund act or similar legislation or (3) by implication from the law as in the case of a constructive or resulting trust.
A. Statutory Trust Fund Provisions
Many jurisdictions have some form of construction trust fund legislation that may be applicable to a bonded project. However, while many states have such statutes a majority of states do not. Accordingly, the surety must first determine if the applicable jurisdiction has such a statute. See Robert F. Carney & Adam Cizek, Payment Provisions in Construction Contracts and Construction Trust Fund Statutes: A Fifty State Survey (paper presented at the Fifteenth Annual Northeast Surety and Fidelity Claims Conference). If the particular jurisdiction does have some form of trust fund statute, the surety must still carefully explore a number of issues to determine if the applicable legislation can be useful to the surety.
Initially, the scope of the applicable provision must be analyzed. For example, some of the trust fund statutes are limited to private projects and would not apply to governmental projects where most significant bonding arises. Other statutes are limited to residential construction projects which are typically not bonded. Still other statutes are limited to criminal penalties and may not give rise to enforcement or recovery by the surety or even permit a private right of action. Such statutes may not constitute a trust at all. Moreover, some statutes only permit recovery by a limited classification of persons which may not include the surety. Finally, some statutes have exceptions which may preclude or limit the use of the statute by the surety. For example, one construction trust statute has an exception which excuses the operation of the trust if the party holding the funds has furnished a payment or performance bond. Finally, the mere fact that a statute might require certain contract funds to be held may not give rise to a valid and enforceable trust in all circumstances, research into the specific statutory provision and the particular jurisdiction’s interpretation of that provision is required.
B. Trust Fund Provisions in the General Agreement of Indemnity
As a part of the underwriting process a typical surety will require the principal and one or more individual officers, owners and/or directors and their respective spouses to execute a General Agreement of Indemnity (“indemnity agreement”). Indemnity agreements are common and are uniformly sustained and upheld by the courts. The primary purpose of the indemnity agreement is to define the terms and conditions upon which the surety will agree to provide bonds. In addition, such agreements provide the surety with a wide variety of rights and remedies and impose a wide variety of duties and obligations on the indemnitors so that the surety can recover any damages or losses that the surety may incur by reason of having issued bonds for the principal. Among the duties and obligations generally imposed on the indemnitors is the obligation to hold bonded contract funds in trust for the benefit of the surety and the subcontractors, materialmen, suppliers and labors that performed work on the bonded project.
Whether the trust fund provision of the indemnity agreement constitutes an express trust and operates to provide a surety with enforceable interests must be determined under state law. Because the law of trusts for each state varies, often in important respects, and because the terms of the indemnity agreements vary, the surety must measure the specific indemnity agreement against the relevant trust law of the jurisdiction where the matter is at issue to determine if the trust fund provision of the indemnity agreement meets the required elements of a valid trust. The declaration of a trust and intention to create a trust, as well as its purpose, is typically readily apparent from the language of the trust fund provisions of most standard indemnity agreements. Clearly, where the language of the trust fund provision explicitly sets forth the exact nature of the trust relationship and the purpose of the trust, the intention to create a trust should be held to be established.
With respect to the trust property or res, the indemnity agreements typically identify the bonded contract funds as constituting the trust property. For example, a trust provision in an indemnity agreement might provide, “[a]ll money paid, or any securities, warrants, checks or evidences of debt, plus any proceeds thereof, given under that bonded contract shall be impressed with a trust in the hands of the Indemnitors.” While the trust property is clearly identified for purposes of satisfying the elements of a valid trust, a significant issue arises with respect to whether the trust property is in existence at the time that the trust is created. Some courts have held that if the bonded contract funds are not in existence at the time the indemnity agreement is executed a valid trust cannot be created. Other courts and commentators have held and observed that the mere fact that the trust property would be created later is not fatal to the establishment of the trust. Fed. Ins. Co. v. Fifth Third Bank, 867 F.2d 330, 334 (6th Cir. 1989); In re Smith, 238 B.R. 664 (Bankr. W.D. Ky. 1999); Restatement (Second) of Trusts § 26 (1959); George G. Bogert & George T. Bogert, The Law of Trusts and Trustees Ch. 7 § 112 (rev. 2d ed. 1984). A contract to create a trust for a future res when acquired is appropriate if the settlor receives sufficient consideration. In the typical circumstance, the surety’s issuance of the bonds for the principal as settlor of the trust in reliance upon the agreement of indemnity and its provisions should constitute fair and adequate consideration. In re Smith, supra. Supported by this consideration, the agreement of indemnity should be construed as a contract to hold the property (the contract funds) in trust when acquired and as giving the beneficiaries equitable rights in such property from the moment of its acquisition.
The trust fund provisions of most indemnity agreements generally clearly set forth the trust’s beneficiaries and identifies a trustee. For example, one common provision provides that the bonded contract funds shall be impressed with a trust in the hands of the indemnitors, “in favor of Surety for the purpose of satisfying the conditions of that bonded contract . . .” From such provisions, the specific identity of the beneficiaries may be ascertained. Moreover, the settlor of the trust, in this example the principal, can be identified as the trustee from the language of the trust fund provisions.
With respect to the requirement of delivery of the trust property, some courts hold that in order to create a completed and enforceable trust of personalty, such as the contract funds, there must be delivery, or the equivalent of delivery, of the trust res to the trustee. Other courts hold that delivery is not required if the settlor declaring a trust is also the trustee. In re Eljay JRS., Inc., 106 B.R. 775 (Bankr. S.D.N.Y. 1989), aff’d 123 B.R. 961 (S.D.N.Y. 1991); Coleman v. Golkin, Bomback & Co., Inc., 562 F.2d 166, 69 n. 5 (2d Cir. 1977). “[Where] there is a written trust declaration…. delivery is not necessary to constitute a valid trust. The owner has declared that he, himself, holds the property in trust for the person designated. A writing creating a trust, kept by the donor without delivery to anyone, will be given effect as such by the courts.” In re Mackintosh’s Estate, 249 N.Y.S. 534, 536 (N.Y. Sur. Ct. 1931); Restatement (Second) of Trusts § 17 cmt. a (1959); A.W. Scott & W.F. Fratcher, The Law of Trusts § 32.5, at 369 (4th ed. 1987). Logically, once the contract funds are paid to the principal, any delivery requirement has been satisfied and the contract funds must be held in trust.
Courts in a variety of jurisdictions under a variety of facts and circumstances have held that the trust fund provisions of the surety’s indemnity agreement operate to create a valid and enforceable trust. Favre v. Lyndon Prop. Ins. Co., 2008 WL 3271100 (S.D. Miss. Aug. 6, 2008); Safeco Ins. Co. of Am. v. Hastings (In re Hastings), 2008 WL 5383586 (Bankr. N.D. Ala. Dec. 23, 2008); In re Fox, 357 B.R. 770 (Bankr. E.D. Ark. 2006); In re: Maxon Eng’g Servs., Inc., 332 B.R. 495 (Bankr. D.P.R. 2005); In re McIntosh, 320 B.R. 22 (Bankr. M.D. Fla. 2005); In re McCormick, 283 B.R. 680 (Bankr. W.D. Penn. 2002); In re Herndon, 277 B.R. 765 (Bankr. E.D. Ark. 2002); In re Wright, 266 B.R. 848, 851 (Bankr. E.D. Ark. 2001); Cumberland Sur. Ins. Co. v. Smith (In re Smith), 238 B.R. 664, 672 (Bankr. W. D. Ky. 1999); In re Alcon Demolition, Inc., 204 B.R. 440 (Bankr. D.N.J. 1997); Gillespi v. Jenkins (In re Jenkins), 110 B.R. 74, 76-77 (Bankr. M.D. Fla. 1990). However, some courts in other jurisdictions have refused to hold that the indemnity agreement creates a valid trust for various reasons. In re Suprema Specialties, Inc., 370 B.R. 517 (S.D.N.Y. 2007), aff’d, In re Suprema Specialties, Inc. v. Bank of Am. N.A., 2009 U.S. App. LEXIS 3359 (2d Cir. 2009); In re Constr. Alternatives, 2 F.3d 670, 676-677 (6th Cir. 1993); In re Wm. Cargile Contractor, Inc., 151 Bankr. 854, 859-860 (Bankr. S.D. Ohio 1993); Acuity, A Mut. Ins. Co. v. Planters Bank, Inc., 362 F. Supp. 2d 885 (W.D. Ken. 2005); E. Concrete Paving Co. v. Jacob’s Elec. Constr., Inc., 293 B.R. 704 (E.D. Mich. Bankr. 2003).
C. Trust Fund Provisions in Contracts
In addition to creation of trusts by statute and in indemnity agreements, trusts can also arise from the terms of the underlying contract, whether it’s the prime contract between an owner and general contractor or a subcontract between a general contractor and a subcontractor or supplier or a lower tier sub-subcontract. It is not uncommon for the parties to provide for the creation of a trust with respect to monies paid to provide a measure of protection and responsibility with respect to the contract funds.
Although the surety is not a party to prime contracts or subcontracts on most construction projects, the surety can still take advantage of such trust provisions through its equitable rights of subrogation. In addition, in some jurisdictions where the bond incorporates the underlying contract by reference courts have held that surety’s are bound by the terms of the underlying contract. In such jurisdictions the surety might be able to argue that it is entitled to seek enforcement of the provision even if the surety may not be a specific beneficiary of the trust. Moreover, such provisions in the underlying contract when combined with the provisions in the indemnity agreement and any applicable trust fund statute create a powerful implication that the contract funds are impressed with a trust and that the surety is entitled to enforce such a trust or benefit from such a trust. At the very least the combination of such provisions should provide a strong argument for the imposition of a constructive or resulting trust in the proper circumstances. Accordingly, it is important for the surety to investigate the trust fund provisions of the applicable underlying contracts to determine if any rights or benefits can be obtained. Courts have routinely upheld trusts formed in such construction contracts. In re Gonzales, 22 B.R. 58 (B.A.P 9th Cir. 1982); In re Marrs-Winn Co., 103 F.3d 584 (7th Cir. 1996); Fed. Ins. Co. v. Fifth Third Bank, 867 F.2d 330 (6th Cir. 1989),
D. Implied Trusts
- Constructive Trusts
Constructive trusts have been defined as:
[A] trust by operation of law which arises contrary to intention and in invitum, against one who, by fraud, actual or constructive, by duress or abuse of confidence, by commission of wrong, or by any form of unconscionable conduct, artifice, concealment, or questionable means, or who in any way against equity and good conscience, either has obtained or holds the legal right to property which he ought not, in equity and good conscience, hold and enjoy. It is raised by equity to satisfy the demands of justice.[i]
Ferguson v. Owens, 459 N.E.2d 1293 (Ohio 1984); In re Team America, Inc., 2009 U.S. Dist. LEXIS 32562 (S.D. Ohio 2009), see also Superior Glass Co., Inc. v. First Bristol County Nat’l Bank, 394 N.E.2d 972 (Mass. App. 1979), aff’d, 406 N.E.2d 672 (Mass. 1980); Kelly v. Kelly, 260 N.E.2d 659 (Mass. 1970); In re H&A Constr. Co., Inc., 65 B.R. 213 (Bankr. D. Mass. 1986).
A constructive trust is not actually a trust, but rather a common-law remedy, developed in equity, for unjust enrichment. In re McCafferty, 96 F.3d 192, 196 (6th Cir. 1996); Am. Nat’l Bank & Trust Co. of Rockford v. U.S., 832 F.2d 1032, 1035 (7th Cir. 1987); Dunham v. Kisak, 1998 U.S. Dist. LEXIS 22660 (S.D. Ill. 1998) (“A constructive trust, under Illinois law, is an equitable remedy to prevent unjust enrichment, not a real trust.”); Yetter Well Serv., Inc. v. Cimarron Oil Co., 841 P.2d 1068, 1070 (Colo. App. 1992); Syfrett v. Pullen, 2008 Colo. App. LEXIS 2174 (Colo. App. 2008). Constructive trusts are raised or “imposed” by equity in respect of property which has been acquired by fraud, or where, though acquired originally without fraud, it is against equity that it should be retained by the one who holds it. “Equity declares the trust in order that it may lay its hand on the thing and wrest it from the possession of the wrongdoer.”
Such trusts arise purely by construction of equity, independently of any actual or presumed intention of the parties to create a trust, and are generally thrust on the trustees for the purpose of working out the remedy. A constructive trust arises only when “a court declares the party in possession of wrongfully acquired property as constructive trustee of that property.” Suttles v. Vogel, 533 N.E.2d 901, 904 (Ill. 1988); Dunham v. Kisak, 1998 U.S. Dist. LEXIS 22660 (S.D. Ill. 1998). Once a constructive trust is declared, the limited duties of the constructive trustee are to transfer property to the rightful owner, account for the handling of such property and pay over any damages associated with the wrongful retention of the property. Although the trust arises when ordered by the court, it is deemed to relate back to the date of the wrongful acquisition.
Because a constructive trust is an equitable remedy there are no firmly established elements for imposing such a trust. Such trusts arise out of consideration of all the relevant facts and circumstances. Even where a particular jurisdiction has established elements of a constructive trust they are typically general in nature and often not strictly adhered to. Nevertheless, the elements for a constructive trust are variously stated as including: (1) obtaining property or retaining property; (2) through actual or constructive fraud, a breach of a fiduciary duty, duress, coercion or mistake or other wrongful conduct; (3) causing unjust enrichment of the wrongdoer. Some courts also require that the party seeking the relief be able to trace to an identifiable res. Other courts require an existing confidential or fiduciary relationship between the parties. Although it has been stated that fraud is an essential element in the creation or existence of a constructive trust, fraud is not always required. Bailiff v. Woolman, 906 A.2d 409 (Md. App. 2006). A mere breach of contract alone is not sufficient and does not qualify as the type of wrongful act or fraud which would warrant the imposition of a constructive trust. Finally, the party seeking to establish the constructive trust bears the burden of proof by “clear and convincing evidence.” It should be noted that a constructive trust will generally not be imposed unless there is no relief at law or such relief is inadequate.
- Resulting Trusts
A resulting trust is “an implied trust which rests upon the presumed intention of the parties.” Levin v. Levin, 405 A.2d 770 (Md. App. 1979). It is an equitable remedy designed to prevent unjust enrichment and ensure that legal formalities do not frustrate the original intent of the transacting parties. Such trusts are implied by law from the acts and conduct of the parties and the facts and circumstances which surround the transaction out of which the trust arises. Resulting trusts have been defined as: “[a] reversionary, equitable interest implied by law in property that is held by a transferee, in whole or in part, as trustee for the transferor or the transferor’s successors in interest.” Restatement (Third) of Trusts § 7 (2003).
A resulting trust arises in three situations: (1) where an express trust fails in whole or in part; (2) where an express trust is fully performed without exhausting the trust estate; and (3) where a person furnished the money to purchase property in the name of another, with both parties intending at the time that the legal title be held by the named grantee for the benefit of the unnamed purchaser of the property. Some courts hold that to establish a resulting trust there must be evidence of intent to separate beneficial and legal ownership of the property by words or by the circumstances of the transaction. In contrast to a constructive trust, “a resulting trust, like an express trust, comes into being independent of any judicial action,” and it arises, if at all, at the time that legal title vests. First Nat’l Bank & Trust Co. of Rockford v. Illinois Nat’l Bank & Trust Co. of Rockford, 167 N.E.2d 223, 225 (Ill. 1960). “A resulting trust, unlike a constructive trust, seeks to carry out a donative intention rather than to thwart a wicked scheme.” Am. Nat’l Bank & Trust Co. of Rockford, Ill. v. U.S., 832 F.2d 1032, 1035 (7th Cir. 1987). The party seeking to establish a resulting trust bears the burden of proof by clear and convincing evidence.
If you have any questions regarding the issues addressed in this blog post please contact Michael A. Stover, Esq. (firstname.lastname@example.org) or any member of the Surety and Fidelity Practice Group.
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