Owners, Contractors and Subcontractors: Control Your Own Destiny – Know and Understand the Legal Rules as to how Payments are Allocated

A subcontractor friend of yours comes to you for advice.  A contractor partially paid him for work and materials supplied on a job but didn’t designate the portion of the labor, services or materials to which the payment applies.  What should he do?  I said he should consult with a construction attorney because this area can be fraught with perils.  He said that was what he was doing!  To answer my friend’s question, we must review Florida law, with a focus on Florida statutes relating to construction law.

Owners that hire contractors, and contractors that hire subcontractors, are mostly concerned with getting a good deal, making sure their contract(s) protect their interests and ensuring that the hired contractors and subcontractors perform competent work.  Although most contracts govern when and under what circumstances progress payments, final payments and retainages are paid, these contracts usually do not spell out how payments are allocated when they are paid.  How payments are allocated is often ignored or merely passed on to a bookkeeper or accountant.  

What does it mean to “allocate” a payment?  When one party owes money to another party for goods and/or services, a creditor/debtor relationship is created with the party owing the money is labeled the “debtor” and the party the money is owed to is labeled the “creditor.”  Under Florida law, the debtor has the right to “allocate” or designate to the creditor how its payments are to be applied to particular goods and/or services.  Such a designation or allocation is not necessary when the debtor owes only one debt.  

When a debtor owes the creditor on several debts, what happens when a debtor fails to allocate or designate a particular payment?  Under Florida law, when a debtor fails to allocate or designate a particular payment, the creditor has the right to allocate the payment to whichever debt the creditor chooses, but only if the designation is made contemporaneously with the payment.  If the creditor fails to promptly apply the payment when it is made, the creditor loses the right to designate which debt the payment gets applied to.  Under Florida construction law, these principals are included in a statute. To answer my friend’s question, generally when a contractor fails to designate a payment to a subcontractor for specific labor costs, services or materials, the subcontractor may apply the payment in any manner the subcontractor deems appropriate, except when the payment is for materials, in which case the subcontractor must demand the contractor to designate the account and the items of account to which the payment is to apply. 

What happens when both the debtor and the creditor fail to allocate a payment when it is made?  Who gets to allocate the payment to which debt?  In Florida, that responsibility falls upon the court.  When a debtor and creditor agree as to how a payment is allocated, there is no need for court intervention.  More often, there is a contractual dispute among the parties and litigation is initiated.  In these instances, when the parties failed to allocate payments when they were made and the parties cannot agree as to how the payments should be allocated, the court will determine how the payments are allocated.  The general rule for allocation of payments is that the court should apply payments to the oldest debts first and then to an unsecured debt in preference to one that is secured. Federal courts hold that “if a creditor fails to designate within a reasonable time how payment is to be applied, the court may allocate the payment in an equitable manner.” If the payment the subcontractor receives is for the services of a sub-subcontractor, the subcontractor must pay the sub-subcontractor for his services within 30 days of receipt of the payment, as long as there is no dispute as to the amount owed.  Intentionally paying other obligations other than paying undisputed monies owed to the sub-subcontractor may constitute a misappropriation of construction funds, a felony.

Practice Tip to owners, contractors and subcontractors:  Control your own destiny by timely and clearly designating all payments made under a contract.  No one enters into a contract with the anticipation that there will be a legal dispute that will result in litigation.  Disputes have been known to happen and the contract is supposed to define the legal rights and expectations of the parties.  However, contracts usually do not include a clause on how payments are to be allocated during the contract.

Owners are generally “debtors” since they are responsible for paying all contractors and materialmen; contractors are generally “creditors” with respect to owners and “debtors” with respect to subcontractors and materialmen; subcontractors are generally “creditors” with respect to contractors and “debtors” with respect to sub-subcontractors and materialmen.  “Debtors” should exercise their right to allocate all payments made to either contractors, subcontractors and/or materialmen.  “Debtors” get the proverbial first bite out of the apple when it comes to designating how payments get applied.  Don’t lose that right by failing to allocate payments and forfeit that right to “creditors.”  Those creditors are going to allocate the payments in their best interests, not in the debtors’ best interests and not necessarily to the oldest unsecured debts first.  

If “debtors” fail to allocate payments, “creditors” should immediately and timely allocate payments in their best interests.  In such instances, “creditors” control their own destiny by not forfeiting their right of allocation to the court if a legal dispute arises.   

If a settlement is reached in any litigated case, particular attention should be paid to allocating or apportioning settlement proceeds between the parties and between specific types of damages to avoid any potential claim of set-off.  If a settlement agreement does not apportion or allocate the settlement payment between (1) claims for which there is common liability among the defendants; and (2) claims which are only asserted against the settling defendant, then the entire amount of the undifferentiated settlement may be subject to set-off.

A “debtor” or “creditor,” an owner, contractor and/or subcontractor should exercise their legal right to allocate payments under a contract and avoid the uncertainty of letting a court decide this issue if a legal dispute arises.  When the law provides an opportunity to a party to control their own destiny on a disputed issue, such as the right to allocate payments under a contract or as part of a settlement agreement, grab it and avoid an additional issue that has to be litigated. 

If payment are being allocated in the construction law setting, owners, contractors and subcontractors should consult with an experienced construction attorney.