Tuesday, July 24, 2007

Business Law - Important Clauses for Small Business Contracts - Funds Held in Trust for Contracting Partner

In some instances your company may have a business opportunity that it cannot contract for on its own and it needs the assistance of another company to help it pursue that opportunity. Oftentimes your company may be willing to agree to pay a percentage of the revenue received on the deal to the company that is providing its assistance. You may consider having the revenue flow through the company assisting your company. That company can receive 100% of the funds from the customer and agree to send you 98% of those funds, keeping a 2% fee for its services. If the revenue flows through the company assisting your company you can run into a serious problem: What happens where the company assisting you receives payment from the customer, and then promptly files for bankruptcy before paying you your 98% of the revenue on the deal?

There is no easy answer to this question. If you do nothing, then the revenues received by your business partner will be a fund for the creditors of your bankrupt business partner, and you will be an unsecured creditor and unhappily receive pennies on the dollar, if anything.

One way to protect against such a catastrophe is to include “trust fund” language in your agreement with your business partner. If the funds in question are “trust funds,” then that can be excluded from the bankruptcy and paid over to your company. Specifically, if your company is XYZ Company and your partner is Partner Company, and you have agreed to pay Partner Company 2% of the revenue received by it, an example of such language could be:

Partner Company agrees that all funds received by it from the customer are to be received as trust funds, and are to be held in trust for the benefit of XYZ Company. Partner Company shall not have any beneficial interest in the funds received from the customer except to the extent of 2% of the funds received.

While such a clause is no guarantee that you will be safe in the bankruptcy situation, it will certainly be helpful in your effort to protect your business. A case illustrating the "trust fund" situation is Holmes Environmental, Inc., 287 B.R. 363 (Bankr.E.D.Va. 2002). In that case, the Court reviewed the state of the law in Virginia in regard to the exclusion of property from the bankruptcy estate under trust theory. Specifically, in Holmes, the Court held that funds that were held in a trust created by the debtor were not property of the debtor’s estate. In so holding, the court quoted Old Republic Nat. Title Ins. Co. v. Tyler (In re Dameron), 155 F.3d 718 (4th Cir. 1998), as follows:

Virginia law recognizes three basic forms of trust. Of these, the two that are potentially relevant to the instant case are the express (or actual) trust and the constructive trust. An express trust is created when the parties affirmatively manifest an intention that certain property be held in trust for the benefit of a third party. An express trust may be created "without the use of technical words." All that is necessary are words, or circumstances, "which unequivocally show an intention that the legal estate was vested in one person, to be held in some manner or for some purpose on behalf of another ...,". In contrast to an express trust, a constructive trust "arise[s] by operation of law, independently of the intention of the parties...." Such trusts "occur not only where the property has been acquired by a fraud or improper means, but also where it has been fairly and properly acquired, but it is contrary to the principles of equity that it should be retained...." With either form of trust, Virginia law recognizes the beneficiary as "equitable owner of the trust property." Holmes, 287 B.R. at 375 (citations omitted) (emphasis added).

While we have not litigated this issue through to a court decision, because of language in our client's contracts, we have been able to argue the issue and reach a favorable settlement in a bankruptcy case where our client would otherwise have lost more than $300,000.00. Before contracting to pay another company to be involved in an important business deal, you should always have counsel assist you in the process of developing agreements that protect your interests.

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