PAVARINI MCGOVERN, LLC v. Waterscape Resort LLC et al

UNITED STATES BANKRUPTCY COURT
SOUTHERN DISTRICT OF NEW YORK
---------------------------------------------------------------X 	FOR PUBLICATION
In re: 	:
:
WATERSCAPE RESORT LLC, 	: 	Chapter 11
: 	Case No. 11-11593(SMB)
Debtor. 	:
---------------------------------------------------------------X
PAVARINI MCGOVERN, LLC, 	:
:
Plaintiff, 	: 	Adv. Proc. No. 11-02248
:
-- against -- 	:
:
WATERSCAPE RESORT LLC, et al., 	:
:
Defendants. 	:
---------------------------------------------------------------X
MEMORANDUM DECISION GRANTING IN PART
AND DENYING IN PART PLAINTIFF’S MOTION
FOR PARTIAL SUMMARY JUDGMENT
A P P E A R A N C E S:
HOLLAND & KNIGHT LLP
Special Litigation Counsel for the Debtor
and Debtor in Possession
31 West 52 nd Street
New York, NY 10019
Frederick R. Rohn, Esq.
Henry A.H. Rosenzweig, Esq.
BARTON LLP
Attorneys for Pavarini McGovern
420 Lexington Avenue
New York, NY 10170
Eric W. Sleeper, Esq.
STUART M. BERNSTEIN
United States Bankruptcy Judge:
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The plaintiff Pavarini McGovern, LLC (“Pavarini”) was retained as general contractor by
the debtor and defendant Waterscape Resort LLC (“Waterscape”) to construct a building (the
“Project”) in Manhattan. Allegedly owed approximately $11 million, Pavarini commenced this
class action adversary proceeding contending that Waterscape diverted certain trust fund monies
owed to Pavarini and, ultimately, the subcontractors that worked on the Project. (See Complaint,
dated June 10, 2011 (ECF Doc. # 1).) 1 Pavarini has moved for partial summary judgment on the
first two counts of the Complaint. For the reasons that follow, the motion is granted in part and
denied in part.
BACKGROUND
A. 	The Deal
1. 	The Loan Agreements
On or about June 11, 2007, U.S. Bank, National Association and USB Capital Resources,
Inc. f/k/a USB Capital Funding Corp. (collectively “US Bank”) made the following loan
facilities available to Waterscape to refinance pre-existing debt and fund the construction of the
Project, a 45-story hotel and condominium building located at 66-70 West 45th Street in
Manhattan:
Loan 	Amount
Construction Loan 	$100,112,566
Project Loan 	$9,180,486
1 	“ECF” refers to the docket in this adversary proceeding; “ECF/Main Case” refers to the docket in Case No.
11-11593.
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Acquisition Loan2 $31,321,306
USB Loan 	$8,653,589
(Affidavit of Gary D. Houston in Connection with Pavarini McGovern LLC’s Motion for
Summary Judgment, sworn to Aug. 3, 2012 (“Houston Affidavit”), at ¶ 4 (ECF Doc. #60).) The
Acquisition and USB Loans were fully funded at the closing; the Construction and Project Loans
were advanced as construction progressed. (Id.) The Construction Loan was to fund “a portion
of the actual hard costs” (see Amended and Restated Construction Loan Agreement, dated June
11, 2007 (“Construction Loan Agreement”), at 1, ¶ C), 3 and the Project Loan was to fund
“certain indirect construction costs . . . that do not qualify as cost of improvements under the
Lien Law.” (See Acquisition and Project Loan Agreement, dated June 11, 2007 (“Project Loan
Agreement”), at p. 1, second paragraph.) 4 The Construction Loan was secured by a mortgage,
and the Project Loan was secured by a Project Mortgage, Assignment of Rents and Security
Agreement. (Houston Affidavit at ¶ 6.)
2. 	Funding the Project
Pursuant to the Construction Loan and Project Loan Agreements, US Bank agreed to
make monthly advances to Waterscape to fund Project costs. (See Construction Loan Agreement
2 	As explained in the succeeding text, the Project and Acquisition Loans were contained in a single loan
agreement.
3 	A copy of the Construction Loan Agreement is annexed as Exhibit 1 to the Houston Affidavit. A copy of
the Construction Loan Agreement and a Lien Law § 22 affidavit were filed with the New York County Clerk on
June 14, 2007. (Affidavit of William Frederick in Support of Pavarini McGovern LLC’s Motion for Partial
Summary Judgment, sworn to June 25, 2012 (“Frederick Affidavit”), at ¶ 6 (see ECF Doc. # 35).) The version of the
Frederick Affidavit filed on the Court’s Electronic Case Filing system is incomplete, unsigned and unsworn, but the
copy delivered to chambers is verified and complete.
4 	A copy of the Project Loan Agreement is annexed as Exhibit 2 to the Houston Affidavit.
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at §§ 3.1 & 3.2; Project Loan Agreement at §§ 3.1 & 3.2.) Waterscape requested advances by
submitting monthly Draw Requests to US Bank containing copies of, among other things,
invoices of the Project contractors and vendors. (Houston Affidavit at ¶ 9.) The Draw Requests
had to be accompanied by a Draw Request Certification that contained affirmative
representations by Waterscape to US Bank that, among other things, the funds being drawn
would be applied to fund the Project as specified in the requisition. (Id. at ¶ 10.) Once
approved, US Bank transferred the funds to Waterscape.
3. 	The Construction Agreement
On June 28, 2007, Waterscape entered into a contract with Pavarini that designated
Pavarini as the Construction Manager for the Project. (See Construction Management
Agreement, dated June 28, 2007 (“CM Agreement”).)5 Pavarini entered into subcontracts with
various trade contractors and vendors to perform the necessary work. (Frederick Affidavit at ¶
7.) Pavarini was responsible for managing and hiring subcontractors, and was entitled to a fee of
2.75% of the entire cost of construction exclusive of the fee itself. 	(See CM Agreement at Art.
9.5.1.)
Waterscape was not in privity with the subcontractors; it paid Pavarini and Pavarini was
responsible for paying the subcontractors. Pavarini agreed to provide Waterscape with the
necessary paperwork to submit Draw Requests to US Bank for funds with which Waterscape
could make periodic payments to Pavarini as work was completed. (See id. at Art. 12.) Among
other things, Pavarini was required to submit monthly requests for payment (requisitions) to
Waterscape. These monthly requests constituted an express representation by Pavarini, inter
5 	The CM Agreement is annexed as Exhibit 2 to the Frederick Affidavit.
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alia, that to the best of its knowledge, the payment requested was for work on the Project and
that the work performed thus far complied with the CM Agreement. (See id. at Art. 12.1.4.)
Within five business days after receipt of Pavarini’s request for payment, Waterscape had to
issue a Certificate for Payment or notify Pavarini in writing why it was withholding the
Certificate. (See id. at Art.12.2.) If Waterscape issued a Certificate of Payment, it was required
to pay Pavarini within five but no later than thirty days of receipt of the Application of Payment,
in full, irrespective of whether it disputed the amounts due Pavarini. (See id. at Arts. 12.3.1 &
19.5.) 6 Any disputes were committed to a dispute resolution board (“DRB”). (See id. at Art.
19.5.)
B. 	The Dispute Between the Parties
The dispute between the parties centers on two sets of events. First, US Bank funded
certain requisitions but Waterscape failed to remit all of the funded proceeds to Pavarini.
Second, Waterscape sold condominium units and paid the proceeds to US Bank rather than
Pavarini in satisfaction of its loan obligations. In a nutshell, Pavarini alleges that the funded
requisitions and sales proceeds were trust funds under New York’s Lien Law that Waterscape
illegally diverted.
6 	Article 19.5 of the CM Agreement provided that:
Costs for disputed Work shall be funded by [Waterscape] with the normal requisition
process. Within 10 business days of the submission of a requisition [Waterscape] shall
provide notice to [Pavarini] of any disputed portion of a requisition. [Waterscape] may
submit the matter to the DRB for resolution. However, the subject payment will not be
delayed and will be made 50% by the Owner as a Change Order and 50% from the
Contingency pending resolution by the DRB . . . .
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1. 	The Funded Requisitions
Pavarini submitted forty-two correspondingly numbered requisitions to Waterscape.
Waterscape submitted Draw Requests to US Bank for the first forty requisitions. US Bank
funded all or part of the forty Draw Requests, but Waterscape did not turn over the entire funded
portion to Pavarini. The shortfall, $4,458,616.97 (the “Shortfall”), represents what Pavarini has
characterized as diverted trust funds. (See Frederick Affidavit at ¶ 15.) 	Pavarini also submitted
a draft of Requisition no. 41 in the amount of $815,022, which US Bank did not fund and
Waterscape did not pay. (Id. at ¶ 16.) On December 22, 2010, after Waterscape terminated the
CM Agreement,7 Pavarini sent Requisition no. 42 in the amount of $5,145,809, and the total
amount owing under all of the unpaid requisitions aggregates $10,833,132.59.8 (Id. at ¶ 17.)
Although Waterscape has not specifically accounted for the Shortfall, it has offered
evidence that it used all monies received by US Bank per the Draw Requests to pay trust fund
expenses. According to Waterscape, it received $85,157,163.64 in advances from US Bank
pursuant to the Construction Loan. (See Verified Statement Pursuant to Lien Law sworn to Nov.
11, 2011 (“Verified Statement”), at 16 & Ex. E (p. 57 of 91).) 9 It paid out the aggregate sum of
$85,226,259.57 for trust fund purposes, (id. at 17 & Ex. G (pp. 59-89 of 91)), or $69,095.93
7 	On September 27, 2010, Waterscape sent Pavarini a letter terminating the CM Agreement. (See
Termination Letter, dated Sept. 27, 2010.) A copy of the Termination Letter is annexed as Exhibit A to the
Affirmation of Solly Assa in Opposition to Motion for Partial Summary Judgment, dated Aug. 3, 2012 (“Assa
Affirmation”) (ECF Doc. # 48).
8 	On September 22, 2010, Pavarini filed a Notice of Mechanic’s Lien in the sum of $12,179,601.59, an
amount that reflected what was due the subcontractors and Pavarini. (See Notice of Lien, filed Sept. 22, 2010.) A
copy of the Notice of Lien is annexed as Exhibit A to the Declaration of Jason B. Bailey, dated Aug. 2, 2012, which
is attached to the Cross Motion for Summary Judgment filed by Jason B. Bailey on behalf of Estate Hardwood
Floors Corp. d/b/a Kultar Flooring, dated Aug. 13, 2012 (ECF Doc. # 52). As noted below, Pavarini filed a proof
of secured claim in this case limited to the unpaid amount of the requisitions—$10,833,132.59.
9 	A copy of the Verified Statement is annexed to the Frederick Affidavit as Exhibit 20.
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more than it drew from US Bank. Pavarini concedes for the purpose of its motion that
Waterscape paid this amount and that the payments were for legitimate trust fund expenditures.
(See Memorandum of Law in Support of Pavarini McGovern, LLC’s Motion for Partial Summary
Judgment, dated June 25, 2012 (“Pavarini Memo”), at 7 (see ECF Doc. # 35).)
2. 	The Condominium Sales Proceeds
In addition to the funded Draw Requests, Waterscape received $14,510,340.00 from the
sale of certain condominium units. (See Verified Statement at 17 & Ex. F (p. 58 of 91).) As
noted earlier, it paid the net proceeds to US Bank at each closing to reduce US Bank’s loans. (Id.
at 16.) Although the Verified Statement does not indicate how the proceeds were applied,
Waterscape’s disclosure statement said that they were used to pay back the entire principal and
interest due on the Project Loan. (Debtor’s Second Amended Disclosure Statement Pursuant to
§1125 of the Bankruptcy Code, dated July 21, 2011 (“Disclosure Statement”), at 17 (ECF/Main
Case Doc. # 296).) It appears that there was little if any repayment of the Construction Loan.
According to the Disclosure Statement, the balance as of March 1, 2011, was $94,871,542. (Id.
at 18.)
C. 	This Bankruptcy
Waterscape commenced this chapter 11 case on April 5, 2011. On June 9, 2011, Pavarini
filed a proof of secured claim in the amount of $10,833,132.59, plus interest, and commenced
this adversary proceeding the next day. The Complaint includes seven counts, but the last four
were directed at US Bank and have been dismissed by stipulation. (See Stipulation and Order
Dismissing Claims Against U.S. Bank National Association and USB Capital Resources, Inc.
f/k/a USB Capital Funding Corp., dated Aug. 13, 2012 (ECF Doc. # 51).)
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Three counts remain against Waterscape as well as other defendants, and Pavarini has
moved for partial summary judgment on Counts I and II. In Count I, Pavarini seeks a declaration
that the estate holds only bare legal title to any and all trust funds, including the Trust Assets,10
and has no equitable interest in those funds until the claims of Pavarini and the subcontractors
are fully satisfied. (Complaint at ¶ 63.) Consequently, Waterscape should hold those funds in
trust until those claims are resolved. (Id. at ¶ 66.) In Count II, Pavarini alleges that Waterscape
diverted trust funds and “should be compelled to identify all trust funds that were diverted and/or
distributed by them, and all such trust funds should be recovered and returned to the benefit of
Pavarini and the Trade Contractors, as the trust beneficiaries.” (Id. at ¶ 80.)
Approximately one month after Pavarini commenced the adversary proceeding,
Waterscape confirmed its Second Amended Plan of Reorganization (“Plan”). (See Order
Approving Disclosure Statement and Confirming Plan of Reorganization, dated July 21, 2011
(“Confirmation Order”) (ECF/Main Case Doc. # 128).) 11 The Plan represented the product of
substantial negotiation and comment from Pavarini, US Bank and the Court, and resolved many
of the issues raised in this adversary proceeding. The Plan contemplated the sale of the hotel
portion of the Project free and clear of all liens, claims and interests. 	(See Confirmation Order
at ¶ 18.) The mechanics lien claims were placed in Class 3. (Plan at § 4.3.) All but $14 million
from the hotel sale proceeds would be paid to US Bank in partial satisfaction of its Class 1 claim.
(Id. at § 4.1(b).) The balance would fund an $11 million Trust Fund Account for the benefit of
10 	“Trust Assets” means “the proceeds generated from the Debtor’s proposed sale of condominium units of
the Project pursuant to this Court’s Order entered on May 31, 2011, and the Debtor’s proposed sale of the hotel
portion of the Project, i.e., the Hotel Assets, pursuant to the Debtor’s pending Plan of Reorganization filed on May
6, 2011.” (Complaint at ¶ 46.)
11 	A copy of the Plan is annexed to the Confirmation Order.
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the overlapping Class 3 Lien Law/trust fund claimants; the remaining $3 million would fund the
Class 5 Reserve Account for the benefit of the unsecured creditors in that class. (Id. at §§ 4.1(b)
& 5.3.)
The $11 million contribution to the Trust Fund Account was not an arbitrary amount, and
reflected a settlement. Waterscape’s original plan essentially provided that all of the hotel sales
proceeds would be paid to US Bank in partial satisfaction of its secured claims. (See Debtor’s
Plan of Reorganization, dated May 6, 2011, at § 4.1 (ECF/Main Case Doc. # 43).) Waterscape
also filed a plan modification that provided that the proceeds of any condominium sales would
be paid to US Bank until its claims were fully satisfied. (Modification to Debtor’s Plan of
Reorganization, dated May 20, 2011, at pp. 2-3 (ECF/Main Case Doc. # 68).) Pavarini objected,
arguing that the trust beneficiaries held claims exceeding $10 million, the funds generated by the
hotel and condominium units were trust assets, and the trust claims had to be fully satisfied from
these proceeds before any monies could be distributed to US Bank. (See Objections of Pavarini
McGovern LLC to the Adequacy of the Debtor’s Disclosure Statement and Confirmation of its
Plan of Reorganization, dated June 17, 2011, at ¶¶ 19, 21-24 (ECF/Main Case Doc. # 93).)
The dispute was eventually resolved by US Bank’s agreement to carve $11 million out of
the hotel sale proceeds to fund the Trust Fund Account. This sum was selected because it
rounded up and therefore exceeded Pavarini’s approximate $10.8 million claim. All Class 3
claims would be deemed to be disputed, (Plan at § 4.3), and the Class 3 claimants would
continue to litigate their rights primarily in non-bankruptcy fora. (Id. at § 5.6(c).) Once a Class
3 Claim was finally resolved, the claim would be allowed and receive payment from the Trust
Fund Account. (Id. at §4.3(c).)
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The sale of condominium units, other than those covered in the Verified Statement, was
first addressed shortly before confirmation. On May 31, 2011, the Court authorized Waterscape
to consummate the pending sales of units 38A, 38B, 38C and 39B free and clear of liens, claims,
interests and encumbrances, which would attach to the net proceeds thereof with the same force,
effect and validity. (Order Granting Authority to Debtor to (A) Assume and Consummate
Pending Sale Agreements for Condominium Units; and (B) Make and Consummate New Sales of
Condominium Units, dated May 31, 2011 (“Condo Sale Order”), at ¶ B (ECF/Main Case Doc. #
82).) In addition, Waterscape was authorized to make future sales free and clear of liens, claims,
interests and encumbrances at certain minimum prices without further order of the Court, with
any liens, claims, interests and encumbrances similarly attaching to the net proceeds. (Id. at ¶
C.) The net proceeds would be held in a separate escrow account pending further order of the
Court. (Id. at ¶ F.) Lastly, US Bank and the mechanics lienors were required to deliver releases
of any liens of record at the closing. (See id. at ¶ E.)
Under the Plan, the Condo Sale Order continued to govern sales under contracts entered
into prior to the Effective Date. The proceeds of post-Effective Date sale contracts, as well as
any remaining sale proceeds from pre-Effective Date transactions, were to be distributed
pursuant to a “waterfall.” (See Plan at § 5.2(a).) Waterscape was required to deposit the first $2
million in the Class 5 Condominium Reserve Account, which would ultimately be transferred to
the Class 5 Reserve Account for the benefit of the unsecured creditors. (Id. at § 5.2(a)(iv) & (v).)
Once the Class 5 Condominium Reserve Account was fully funded, additional sale proceeds
would be deposited into the Secured Claim Reserve Account for payment in order of priority,
first to satisfy the balance of the US Bank claims that comprised Class 1 and Class 2, (id. at §
5.2(a)(vii)), and then to satisfy the Allowed Class 3 Claims. (Id. at §§ 5.2(a)(viii) & 5.3.) After
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any disputed Class 3 Claims were resolved and Allowed Class 3 Claims were paid in full or all
mechanics liens were discharged, the Secured Claim Reserve Account would remain subject
only to the Chartis Lien as defined in the Plan. (Id. at § 5.2(a)(ix).)
The sale of the hotel closed on January 20, 2012—the Effective Date of the Plan. (See
Debtor’s Second Post-Confirmation Report and Notice of Effective Date of the Debtor’s
Confirmed Second Amended Plan of Reorganization, dated Jan. 20, 2012, at ¶ 3 (ECF/Main Case
Doc. # 306).) Waterscape used the proceeds from the hotel sale and pre-Effective Date
condominium sales to pay US Bank $109 million in partial satisfaction of its claims, fund the
$11 million Trust Fund Reserve Account and fund the $3 million Class 5 Reserve Account. (Id.
at ¶ 4.)
D. 	Pavarini’s Motion
On June 25, 2012, Pavarini moved for partial summary judgment on Counts I and II of
the Complaint. As noted, the substance of Pavarini’s claims is that Waterscape diverted trust
assets, including the Shortfall and the proceeds of the condominium sales that Waterscape
admittedly paid to US Bank outside of the Plan. Waterscape concedes that the money it
requisitioned from US Bank and the net proceeds from the sale of the condominium units
constituted trust funds. (See Verified Statement at 16-17 (scheduling the payments received from
US Bank and the condominium sales proceeds as trust funds).) It argues, however, that it did not
divert these funds because it used them to pay other trust fund obligations. Furthermore, even if
it diverted trust funds, it restored the diverted funds through the establishment of the $11 million
Trust Fund Account under the Plan.
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Each side cites to provisions of the CM Agreement in support of their respective positions
regarding, among other things, the timing of payments, the obligation to make payment
notwithstanding a dispute and the right to set off. However, the parties’ contract claims have
been committed for resolution to the DRB or other non-bankruptcy courts, and the Court offers
no view on those issues. The Complaint raises only Lien Law questions, and the parties have not
contended that the Lien Law presents a set of default rules that can be modified by contract
between an owner and general contractor. Accordingly, the Court will limit the discussion to the
Lien Law.
DISCUSSION
A. 	Standards Governing Motion
Rule 56 of the Federal Rules of Civil Procedure, made applicable to this adversary
proceeding by FED. R. BANKR. P. 7056, governs summary judgment motions. “The court shall
grant summary judgment if the movant shows that there is no genuine dispute as to any material
fact and the movant is entitled to a judgment as a matter of law.” FED. R. CIV. P. 56(a).12 The
moving party bears the initial burden of showing that the undisputed facts entitle it to judgment
as a matter of law. Rodriguez v. City of New York, 72 F.3d 1051, 1060-61 (2d Cir. 1995).
Where the non-moving party would have the burden of proof at trial, the movant may obtain
summary judgment by showing that “little or no evidence may be found in support of the
nonmoving party’s case.” Gallo v. Prudential Residential Servs., L.P., 22 F.3d 1219, 1223-24
(2d Cir. 1994); accord Celotex Corp. v. Catrett, 477 U.S. 317, 322-23 (1986). If the movant
12 	Pavarini’s motion is governed by the amendments to Rule 56 that became effective on December 1, 2010.
Although some language has changed, the standard for granting summary judgment remains unchanged and the
amendments will not “affect continuing development of the decisional law construing and applying these phrases.”
F ED. R. Civ. P. 56 advisory committee’s note (2010).
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carries this initial burden, the nonmoving party must set forth specific facts that show triable
issues, and cannot rely on pleadings containing mere allegations or denials. Matsushita Elec.
Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 586-87 (1986); see Celotex Corp., 477 U.S. at
324. In deciding whether material factual issues exist, all ambiguities must be resolved and all
inferences must be drawn in favor of the nonmoving party. Matsushita Elec., 475 U.S. at 587.
The parties must cite to the parts of the record that support or undercut the assertion that a
fact is not disputed. FED. R. CIV. P. 56(c). Under our local rules, the movant must submit a
“short and concise statement in numbered paragraphs” of the undisputed material facts, Bankr.
S.D.N.Y. R. (“LBR”) 7056-1(b), and the opposing party must submit a statement controverting
those material facts that it contends are disputed. LBR 7056-1(c). In each instance, the movant
and opposing party must include a citation to admissible evidence that supports or controverts
the undisputed nature of material fact. LBR 7056-1(e). The latter requirement allows the Court
and the parties to focus on what is and is not in dispute, and provides a roadmap that permits the
Court to go directly to the cited evidence to determine whether it supports the statement.
Neither side complied with LBR 7056-1. Pavarini submitted a twenty page, seventy two
paragraph statement that contained no more than a handful of citations to any evidence submitted
with the motion. (See Pavarini McGovern, LLC’s Statement of Undisputed Facts in Support of
Its Motion for Partial Summary Judgment, dated June 25, 2012 (“Pavarini 7056 Statement”) (see
ECF Doc. # 35).) Waterscape’s statement failed to cite any controverting evidence although it
contended that many of Pavarini’s factual statements were disputed. (See Waterscape Resort
LLC’s Responses to Pavarini McGovern LLC’s Statement of Undisputed Facts, dated Aug. 3,
2012 (ECF Doc. # 50).) The failure to comply with LBR 7056-1(e) increased the burden on the
Court by requiring it to hunt through the substantial record created by the parties to determine
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what was and was not in dispute. In the end, the Court has disregarded the parties’ statements,
and the only undisputed facts are those identified in this opinion.
B. 	Disposition of the Motion
1. 	Introduction
Under Article 3-A of the New York Lien Law, an owner holds in trust the funds received
in connection with a contract for the improvement of real property, as well as any rights of action
with respect to those funds. N.Y. LIEN LAW § 70(1) (McKinney 2009). The assets of the trust
include, among other things, the funds received and the rights of action for payment under a
building loan contract, N.Y. LIEN LAW § 70(5)(a), and “consideration for a conveyance recorded
subsequent to the commencement of the improvement and before the expiration of four months
after the completion thereof.” N.Y. LIEN LAW § 70(5)(d). The trust comes into “existence from
the time of the making of the contract . . . out of which the claim arises.” N.Y. LIEN LAW §
71(5). It continues “with respect to every asset of the trust until every trust claim . . . has been
paid or discharged, or until such assets have been applied for the purposes of the trust.” N.Y.
LIEN LAW § 70(3).
Trust funds must be “held and applied for the payment of the cost of improvement.”
N.Y. LIEN LAW § 71(1). If the trustee is the owner, trust claims include “claims of contractors,
subcontractors, architects, engineers, surveyors, laborers and materialmen arising out of the
improvement, for which the owner is obligated, and also means any obligation of the owner
incurred in connection with the improvement for a payment or expenditure defined as cost of
improvement.” N.Y. LIEN LAW § 71(3)(a); accord N.Y. LIEN LAW § 2(5) (defining “cost of
improvement”). The trustee holds bare legal title to the trust funds, and an equitable interest
vests in the balance of the trust funds only after all trust claims have been satisfied. RLI Ins. Co.
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v. New York State Dep’t of Labor, 766 N.E.2d 934, 938 (N.Y. 2002); City of New York v. Cross
Bay Contracting Corp., 709 N.E.2d 459, 462 (N.Y. 1999); Canron Corp. v. City of New York,
674 N.E.2d 1117, 1122-23 (N.Y. 1996).
The use of trust funds for non-trust purposes constitutes a diversion, and if done
voluntarily by the trustee, is also a breach of trust. N.Y. LIEN LAW § 72(1); see In re Elm Ridge
Assocs., 234 F.3d 114, 125 (2d Cir. 2000); Aspro Mech. Contracting, Inc. v. Fleet Bank, N.A.,
805 N.E.2d 1037, 1039 (N.Y. 2004). The failure to maintain the books and records required by
the Lien Law regarding the trust creates a presumption that trust funds have been diverted, see
N.Y. LIEN LAW § 75(4), but the presumption is only a “permissible inference” and does not shift
the burden of proof. See Truax & Hovey, Ltd. v. Grosso (In re Grosso), 9 B.R. 815, 826 (Bankr.
N.D.N.Y. 1981) (quoting People v. Rosano, 409 N.E.2d 1357, 1358 (N.Y. 1980)). Furthermore,
the trustee is not required to segregate the trust assets, and “may treat the trust funds as running
bookkeeping balances rather than as segregated accounts.” Fentron Architectural Metals Corp.
v. Solow, 420 N.Y.S.2d 950, 952 (N.Y. Sup. Ct. 1979); accord Caristo Constr. Corp. v. Diners
Fin. Corp., 236 N.E.2d 461, 463 (N.Y. 1968); N.Y. LIEN LAW § 75(1) & (2).
2. 	Count I
According to Pavarini’s moving memorandum of law, Count I seeks a declaration that
neither Waterscape nor its estate has a vested interest in the Missing Trust Funds aggregating
$14,441,244.07. (Pavarini Memo at 10.) The Missing Trust Funds roughly correspond to the
proceeds of the pre-petition condominium sales13 identified in the Verified Statement,14 (see id. at
13 	One of the condominium sales generating proceeds of $1.8 million identified in the Verified Statement
actually closed on October 27, 2011, after the entry of the Condo Sale Order and confirmation of the Plan but prior
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7-8, 16), and that phrase will be used throughout the balance of this opinion to refer to those
proceeds.
Initially, Waterscape argues that Count I has nothing to do with the Missing Trust Funds
and instead, concerns only the Trust Assets, i.e., the net proceeds from the condominium unit
sales made pursuant to the Condo Sale Order and the net proceeds of the hotel sale contemplated
under the proposed plan. The disposition of the Trust Assets is addressed by the Condo Sale
Order and the Plan. The Condo Sale Order and the Confirmation Order are final and no longer
subject to review. To the extent they declare rights different from the Lien Law, they govern.15
Although Waterscape is correct that Count I does not expressly refer to the earlier
condominium unit sales identified in the Verified Statement, other allegations in the Complaint
refer generally to the use of condominium sale proceeds to repay US Bank, (Complaint at ¶¶ 48
& 49), and these allegations are incorporated by reference into Count I. (Id. at ¶ 62). These
allegations are sufficient to bring the question of the Missing Trust Funds within the relief sought
through Count I. Furthermore, Waterscape concedes that these condominium sale proceeds as
well as the proceeds received in connection with the Construction Loan Draws constituted trust
funds under the Lien Law. As such, Waterscape held bare legal title, and Pavarini is entitled to
partial summary judgment on Count I to that extent.
to the January 20, 2012 Effective Date. (See Verified Statement, Ex. F.) Neither side commented on this
“discrepancy,” and I assume the closing related to a contract that was entered into the before the Condo Sale Order.
14 	The Missing Trust Funds reflect the difference between the proceeds of the condominium unit sales
reported in the Verified Statement ($14,510,340.00) and the trust fund expenditures made by Waterscape in excess
of the US Bank Draws ($69,095.93).
15 	Pavarini concedes that it is not relevant at this stage to determine whether the proceeds of the sale of the
hotel qualify as trust funds because of the $11 million escrow carved out of those proceeds under the Plan.
(Pavarini Memo at 11.)
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3. 	Count II
Pavarini also seeks partial summary judgment on Count II directing Waterscape to turn
over all diverted trust funds to Pavarini for the benefit of itself and the subcontractors. As noted,
the so-called diverted funds fall into two categories: the Shortfall and the Missing Trust Funds.
In each case, the motion presents two questions. First, has Pavarini demonstrated as a matter of
law that Waterscape diverted trust funds? Second, if a diversion occurred, is Pavarini entitled to
a turnover order or other relief?
a. 	The Shortfall
Pavarini has failed to demonstrate as a matter of law that Waterscape diverted the
Shortfall. Waterscape drew $85,157,163.64 in Construction Loan proceeds from US Bank, and
Pavarini concedes for the purpose of its motion that Waterscape paid $85,226,259.57 in trust
fund expenses, or $69,095.93 more than Waterscape received from US Bank. The Lien Law
“expressly vests discretion in the trustee ‘to determine the order and manner of payment of any
trust claims and to apply any trust asset to any purpose of the trust.’” Aspro Mech. Contracting,
805 N.E.2d at 1040 (quoting N.Y. LIEN LAW § 74(1)), and Waterscape had the discretion to use
the US Bank Draws to pay other trust fund expenses. Thus, even if I credited Pavarini’s
contention that it is entitled to a presumption of diversion, Waterscape rebutted the presumption
by offering evidence—which Pavarini does not dispute—that an amount greater than all of the
US Bank Draws was used to pay trust expenses. See Mike Bldg. & Contracting, Inc. v. Just
Homes, LLC, 901 N.Y.S.2d 458, 478-79 (N.Y. Sup. Ct. 2010).
Pavarini primarily relies on the provisions of the CM Agreement to argue that Waterscape
was required to pay the Shortfall to Pavarini without offset and regardless of any disputes.
While the failure to pay the Shortfall to Pavarini arguably breached the CM Agreement, it did not
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constitute a diversion or breach of trust. Furthermore, any breach claims must be pursued before
the DRB.
Accordingly, a material factual dispute exists regarding whether Waterscape diverted the
Shortfall.
b. 	The Missing Trust Funds
i. 	Diversion
According to the Verified Statement, “the net sale proceeds for each [condominium] unit
after adjustments and closing costs were paid directly to [US Bank] at the closings to reduce the
loan amounts.” (Verified Statement at 17.) Initially, it is no excuse that Waterscape never had
possession of the Missing Trust Funds, or that they were paid directly to US Bank at each closing
in accordance with the parties’ loan documentation. (See Assa Affirmation at ¶ 34.) A trustee
cannot avoid a diversion claim by pledging trust funds to a transferee who is not a beneficiary of
the trust under the Lien Law. See Caristo Constr. Corp., 236 N.E.2d at 463 (factor
impermissibly received trust funds from its debtor-trustee in payment of outstanding credits);
Palm Beach Realty Co. v. Kangeiser, Inc., 233 N.Y.S.2d 641, 643 (N.Y. Sup. Ct. 1962) (use of
trust funds to satisfy bank loan constituted diversion), aff’d without op., 243 N.Y.S.2d 413 (N.Y.
App. Div. 1963); cf. In re Dunwell Heating & Air Conditioning Contractors Corp., 78 B.R. 667,
671 (Bankr. E.D.N.Y. 1987) (“[A] prior perfected secured creditor in accounts receivable is not
entitled to its interest in that collateral until trust beneficiaries under Article 3–A of the N.Y. Lien
Law have been satisfied in full from those assets traceable to the improvements to which they
contributed as subcontractors.”).
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Although the Verified Statement did not disclose how the proceeds were allocated (which
US Bank obligations were paid), the Disclosure Statement revealed that they were used primarily
if not entirely to satisfy the Project Loan. (Disclosure Statement at 17.) The use of trust funds to
pay the Project Loan was improper, and constituted a diversion for two reasons. First, the
payment of the Project Loan was not a “cost of improvement.” A “cost of improvement”
includes:
sums paid to take by assignment prior existing mortgages, which are
consolidated with building loan mortgages and also the interest charges on
such mortgages, sums paid to discharge or reduce the indebtedness under
mortgages and accrued interest thereon and other encumbrances upon real
estate existing prior to the time when the lien provided for in this chapter
may attach . . . .
N.Y. LIEN LAW § 2(5) (emphasis added).
According to Pavarini, the US Bank mortgages did not exist prior to the time Pavarini’s
rights attached. Pavarini contends that its trust claim arose when the parties signed the CM
Agreement on June 28, 2007 because that is the contract out of which its claim arises. See N.Y.
LIEN LAW § 71(5). The Project Loan was not recorded until July 3, 2007. Pavarini reasons that
as a result, the payment of the Project Loan was not a “cost of improvement” within the meaning
of the Lien Law. (See Pavarini Memo at 17; Reply Memorandum of Law in Further Support of
Pavarini McGovern, LLC’s Motion for Partial Summary Judgment, dated Aug. 17, 2012, at 6-7
(ECF Doc. # 59).)
Pavarini’s argument equates the term “lien” used in section 2(5)’s definition of “cost of
improvement” with the “trust claim” referred to in section 71(5). However, the two are not
synonymous, and “an Article 3-A trust beneficiary does not have to have a lien or be a lienor.”
Harman v. Fairview Assocs., 250 N.E.2d 209, 210 (N.Y. 1969); accord Ingalls Iron Works Co.
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v. Fehlhaber Corp., 337 F. Supp. 1085, 1091 (S.D.N.Y. 1972) (“Under New York law, a trust
beneficiary does not acquire the additional status of a mechanic's lienor.”) Nevertheless,
Waterscape has not contested Pavarini’s position, and its failure suggests that it does not dispute
it. Rosenblatt v. City of New York, No. 05 Civ. 5521(GEL), 2007 WL 2197835, at *7 (S.D.N.Y.
July 31, 2007) (“[p]laintiff effectively concedes defendants’ other arguments . . . by her failure to
respond to them”); Broad v. DKP Corp., No. 97 Civ. 2029(LAP), 1998 WL 516113, at *3
(S.D.N.Y. Aug. 19, 1998) (explaining that plaintiff’s “silence” or failure to respond to
defendant’s argument is a “tacit admission” thereof), aff’d 182 F.3d 898 (2d Cir. 1999).
Second, even if the repayment of the Project Loan was a “cost of improvement,” the use
of trust funds was still a diversion because US Bank never filed a Notice of Lending. Section
73(2) of the Lien Law states:
In any action in which it is sought to charge a trustee personally
with liability by reason of a diversion of trust assets, the trustee shall be
entitled to show by way of defense that the transfer constituting the
diversion was made to a transferee named in a “Notice of Lending” filed
as provided in subdivision three and that the transfer was made as security
for or in consideration of or in repayment of advances made to him as
trustee or on his behalf as trustee in accordance with such notice of
lending, and that such advances were actually applied for a purpose of the
trust as stated in subdivision one or subdivision two of section seventy-one
of this chapter.
N.Y. LIEN LAW § 73(2). The purpose of the Notice of Lending is to inform trust fund
beneficiaries that trust funds may be used to repay a lender, and to that extent, will not be
available to pay other trust fund beneficiaries. See Aspro Mech. Contracting, 805 N.E.2d at 1040
(filing a notice of lending promotes “the legislative intent to assure ‘public notice of any
transaction of the owner, contractor or subcontractor that may lead to depletion of funds
available for future trust claims, even where the depletion merely repays advances that were in
fact used to pay trust claims accruing at an earlier [d]ate [citation omitted].’”); Caristo Constr.
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Corp., 236 N.E.2d at 466 (“The function of a notice of lending, according to the Law Revision
Commission, which drafted the legislation, is to inform prospective suppliers and subcontractors
that ‘trust assets receivable by the trustee at a later stage of the improvement have been
anticipated for current expense [citation omitted].”). The repayment of such a “cost of
improvement” in the absence of a Notice of Lending or other notice to trust beneficiaries
precludes the trustee from asserting this defense to a claim of diversion. Spectrum Painting
Contractors, Inc. v. Kreisler Borg Florman Gen. Constr. Co., 864 N.Y.S.2d 61, 62-63 (N.Y.
App. Div. 2008). Here, Pavarini contends that Waterscape never filed a Notice of Lending, and
Waterscape has not disputed this either. Accordingly, this defense is not available to
Waterscape.
ii. 	Restoration
While Pavarini has demonstrated as a matter of law that Waterscape diverted the Missing
Trust Funds, Waterscape has established a defense of partial restoration. A trustee or its assignee
may defend against a diversion claim by showing that the diverted funds have been restored, and
that the funds are available to pay trust claims. See Caristo Constr., 236 N.E.2d at 464 (if the
transferee of diverted funds had used its own funds “to pay trust claims and there had been no
loss to anyone, there would have been no ultimate diversion or loss for which the factor would be
liable”) (dicta); Fenton Architectural Metals, 420 N.Y.S.2d at 953 (“If, in fact, there had been
any diversion by the payment of ground rents to the owner, he more than made up for it by
replacing those sums with other sums which more than restored the partially depleted trust.”);
Raisler Corp. v. Uris 55 Water St. Co., 397 N.Y.S.2d 668, 674 (N.Y. Sup. Ct. 1977) (“The court
holds that the defendants may prove the amounts diverted were restored in such manner that the
expectations of those who might look to the construction loan extended by the First National
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City Bank as a source of credit information were in all respects met.”); Travelers Indem. Co. v.
Cent. Trust Co., 263 N.Y.S.2d 261, 265-66 (N.Y. Sup. Ct. 1965) (“[I]t is proper to prove that
diverted funds have been replaced and the trust purposes fulfilled [citation omitted] which
amounts to a showing that a temporary diversion has been corrected.”) (decided under the prior
version of the Lien Law), aff’d without op., 1967 WL 21985 (N.Y. App. Div. Feb. 16, 1967).
The restoration defense is based on the principle that the “law is not designed to impose a
penalty upon a violator so as to create a windfall of double repayment for creditors.” Travelers
Indem., 263 N.Y.S.2d at 266; accord Raisler Corp., 397 N.Y.S.2d at 673. Moreover, voluntary
restoration serves the same purpose as an order directing one liable for diversion to post security
to assure the proper distribution of trust assets, or furnish assurance in any other manner that
trust funds will be available to pay trust claims. N.Y. LIEN LAW § 77(3)(a)(v); see Palm Beach
Realty Co., 233 N.Y.S.2d at 641 (directing owner who diverted trust funds to post security to
protect beneficiaries’ interests pursuant to N.Y. LIEN LAW § 77(3)(a)(v)). In either case, the
spirit of the Lien Law is fulfilled and trust beneficiaries can rely on the restored fund for the
payment of their claims.
The settlement that led to the funding of the $11 million Trust Fund Account was
intended to restore the trust up to that amount. That $11 million was carved out of the hotel sale
proceeds to resolve Pavarini’s objections to the use of hotel and condominium sale proceeds to
satisfy the US Bank claims under the Plan. The amount of the Trust Fund Account was based on
the amount of Pavarini’s claim, and reestablished the trust in a segregated account that cannot be
disbursed without further Court order. The terms of the Plan also allowed Waterscape to pay the
proceeds from the condominium sales governed by the Condo Sale Order and future sales to US
Bank.
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Pavarini nevertheless contends that the restoration defense is not available unless “the
[restored] funds thereby brought to the improvement are shown to have been used for the
purposes of the trust.” (Pavarini Reply at 11 (quoting Raisler Corp., 397 N.Y.S.2d at 673).)
Pavarini reasons that Waterscape cannot invoke the restoration defense because no part of the
Trust Fund Account has yet been paid to any trust beneficiaries, but the language it quotes it
misreads. As the Raisler court explained in the next sentence:
Relief in the nature of setting aside an unauthorized payment or other
transfer should not be available to unpaid beneficiaries of a Lien Law trust
when the assets contemplated when the work was undertaken have been
fully realized, and are available in the form of present cash to meet future
trust claims as they mature. 	To hold otherwise would be to impose a
double penalty without any explicit statutory authority therefor, such as
that found in Section 73 pertaining to the retention of trust funds by a
lender in repayment of funds previously advanced.
Raisler Corp., 397 N.Y.S.2d at 673 (emphasis added).
Here, $11million in Missing Trust Funds has been restored and is “available in the form
of present cash to meet future trust claims as they mature.” 	If Waterscape must pay Pavarini
another $11 million after escrowing $11 million from its sale proceeds for the same purpose, it
will suffer a double penalty. While the Court does not condone Waterscape’s diversion, its
punishment will be the costs of this litigation which, post-confirmation, will ultimately be borne
by its members. See Travelers Indem., 263 N.Y.S.2d at 266 (If the defendant proves the
restoration defense, “its punishment for the infraction will be the expense of this lawsuit and not
liability to the plaintiff, which will have lost nothing by reason of the alleged improper financial
dealings”).
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iii. 	The Balance of the Missing Funds
The Trust Fund Account did not fully restore the Missing Trust Funds. The
condominium sales reported in the Verified Statement exceeded $11 million, and Waterscape has
failed to offer any evidence that the net difference—$3,441,244.0716 —has been restored or
otherwise secured. The issue concerns the appropriate remedy.
Pavarini’s demand that Waterscape turn over any Missing Trust Funds to Pavarini is
premature. The Lien Law provides security for the payment of contractor and subcontractor
claims, but the right to payment depends on the law of contracts as well as the Plan. Pavarini’s
Class 3 claim was deemed to be disputed, and the Plan left the resolution of those disputes to the
DRB. While the Missing Trust Funds are not implicated by the express provisions of the Plan,
the intent was to require the trust beneficiaries to fix their claims in non-bankruptcy fora and
then to seek payment pursuant to the terms of the Plan.
Furthermore, there are other remedies that may be more appropriate to the extent that
any further remedy is necessary. First, the Class 3 claimants can also look to the proceeds of
future condominium sales to satisfy their claims. Waterscape stated at oral argument that the US
Bank debt had been refinanced, and the Class 3 mechanics lien claims now have the first right to
payment from future sales of the condominium units. (Transcript of Hearing, held Aug. 21,
2012, at 6 (ECF/Main Case Doc. # 390).) Thus, there may be sufficient security or other
assurances of payment that no further relief is necessary or warranted.17
16 	This amount reflects a credit to Waterscape to the extent that its payment of trust fund expenses exceeded
the US Bank Draws.
17 	I agree that Waterscape cannot offset any amounts Pavarini allegedly owes Waterscape under the CM
Agreement against claims by Pavarini that Waterscape diverted trust funds because mutuality is lacking.
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Second, the Lien Law prescribes remedies for a diversion other than the immediate
payment of diverted funds to trust beneficiaries. As noted, the Court could order Waterscape to
post additional security or furnish assurances to the extent “it appears that there is danger that
such assets or asset will be dissipated before judgment or diverted from trust purposes.” N.Y.
LIEN LAW § 77(3). The Trust Fund Account cannot be disbursed absent further order of the
Court and there is no danger of its dissipation. Moreover, it appears that the subcontractor
claims may be subsumed within the Pavarini claim, raising a substantial question whether any
further assurances are necessary.
Accordingly, while Waterscape has established only a partial restoration defense, the
appropriate remedy with respect to the balance of the Missing Trust Funds cannot be determined
on the state of this record. Pavarini has failed to establish as a matter of law that it is entitled to
the turnover of any portion of the Missing Trust Funds at this time, and its motion for partial
summary judgment is also denied to that extent.
The Court has considered the other issues raised by the parties, and to the extent not
specifically addressed are found to lack merit. The parties are directed to settle a proposed order
Waterscape would owe a debt in its capacity as trustee but would have a claim under a breached construction
contract. See Ross-Viking Merch. Corp. v. A. Cyanamid Co. (In re Ross-Viking Merch. Corp.), 151 B.R. 71, 74
(Bankr. S.D.N.Y. 1993) (“The existence of a fiduciary duty or a trust relationship in one of the capacities of a party
involved in an attempted setoff will not satisfy the concept of mutuality.”). It does not follow, however, and I do not
decide whether either party can assert an offset against the other in the proceedings before the DRB.
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consistent with this decision and contact chambers to schedule a conference at which to discuss
further proceedings in this matter.
Dated: New York, New York
December 10, 2012
/s/ Stuart M. Bernstein
STUART M. BERNSTEIN
United States Bankruptcy Judge
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