Suppliers frequently provide supplies on lines of credit to contractor customers who are involved in multiple construction projects. In an ideal world, both the customer and the supplier would maintain accounting records keeping each construction project and the payments attributable to those construction projects separate and accurate. Out of practical convenience, however, contractors and the suppliers sometimes lump projects and payments into a single account, making it difficult, if not impossible, for the supplier to determine which payments apply to each ongoing project, i.e., a task that is necessary for a supplier seeking to assert a mechanics’ lien claim against a particular project when its customer fails to timely pay.
Several weeks ago the Appellate Division of the New Jersey Superior Court, in L&W Supply Corporation v. Joe Desilva, described the affirmative duty suppliers have to determine the source of its customers’ payments for materials, by requiring suppliers to ask. According to the Court, a supplier who fails to do so “sacrifices its rights under the Construction Lien Law." A brief review of the evolving mechanics’ lien laws relating to suppliers helps explain the Court’s potentially severe ruling.
The New Jersey Construction Lien Law (“Lien Law") allows contractors and suppliers who are owed payment for work or materials on privately procured projects to file a lien against the property where the improvements (labor and supplies) were constructed. The lien encumbers the property, which prevents the owner from selling or transferring the property without first dealing with the contractor’s or supplier’s payment claim. The purpose of the Lien Law is twofold: first, to secure payment of money due to contractors and suppliers; and second, to protect owners from paying more than once for the same work or materials. In order to protect owners from being forced to pay twice for the same work or materials, the Lien Law provides that the value of a lien cannot exceed the value of the “lien fund," which, in the simplest terms, is the amount of money that remains unpaid on the job.
In 2004 the New Jersey Supreme Court held, inCraft v. Stevenson Lumber Yard Inc., that a material supplier who files a construction lien has a duty to allocate payments from the material purchaser to the appropriate construction project when the supplier has “reason to know" that the payment is associated with a particular project. In other words, if a general contractor pays a subcontractor for work on a specific job and the subcontractor then pays its supplier, the supplier must apply the subcontractor’s payment to the same project account. The supplier may not simply apply the payment to an older receivable from a different project. This requirement protects the owner from double payment because it helps to ensure that when a supplier files a construction lien relating to a particular project, the supplier is not seeking monies owed from the subcontractor on a different project.
InL&W Supply, the Appellate Division clarified the circumstances that would give a supplier “reason to know" the source of the payment. The Court held that in order to ascertain the source of a subcontractor’s funds, “a supplier must take some action, and an inquiry about the source of the funds is the most obvious action to take." In other words, suppliers providing material to New Jersey projects must now affirmatively inquire as to how payments should be allocated when the purchaser has not otherwise provided reliable instructions as to how the payment should be allocated. As the Appellate Division held, “when the purchaser of materials has not provided specific, reliable instruction as to the allocation of its payment, or when the circumstances are such that a reasonable supplier should suspect the purchaser has not used an owner’s funds to pay for materials supplied for that owner, then the supplier must make further inquiry and attempt to ascertain the source of the payment funds so that it can allocate them to the correct accounts."
The Court’s decision in L&W Supplymeans that suppliers must be diligent in ascertaining the source of the funds that it receives from its customers, and I recommend that the supplier memorialize its efforts in writing. This should be done in writing because a supplier who files a lien claim after this L&W Supplydecision must anticipate that the owner or general contractor will defend against the lien claim by (i) challenging the accuracy of the supplier’s accounting and (ii) questioning the sufficiency of the supplier’s inquiry into the subcontractor’s accounting. Documented efforts by the supplier to ascertain the source of payments are the best way to overcome those challenges because they demonstrate the supplier’s good faith efforts to inquire and accurately account for customer payments.