Case Law Note – The Surety GIA Trust Fund Provision vs. The Bank
In this Surety Today blog post, we provide a Case Law Note to explore the issue of the surety’s rights under the indemnity agreement trust fund provision versus the secured lender’s rights to bonded contract funds deposited into the bank.
GUARANTEE COMPANY OF NORTH AMERICA v. ASSOCIATED BANK, 2019 WL 489717 (D. Minn., August 8, 2019)
In this case, the surety claimed superior rights against a secured lender bank to earned and paid bonded contract funds that the principal deposited into the principal’s account at the bank. The basis for the surety’s position was its indemnity agreement trust fund provision rights. Factually, the progression went as follows:
- In 2013, the principal executed an indemnity agreement with the surety.
- The surety then issued numerous performance and payment bonds for the principal in favor of various obligees.
- In 2014, the bank loaned money to the principal and the principal opened an Account at the bank to receive contract funds, including bonded contract funds, paid to the principal.
- The bank obtained a perfected security interest in the principal’s assets, including all contract funds, and in the Account itself.
- When the principal received payments of contract funds, including bonded contract funds, from project owners, it deposited those payments into the Account.
- From November 1 through December 14, 2016, the principal deposited over $2,300,000 of contract funds from contracts bonded by the surety (the “Bonded Contract Funds”) into the Account, over $975,000 of which were swept by the bank to reduce the principal’s obligations to the bank under the secured loans.
- During 2017, the surety paid performance and payment bond claims with the net losses exceeding $2,300,000.
- In September of 2017, the surety sued the bank for conversion of the Bonded Contract Funds swept from the Account.
The surety has other rights to assert against a secured bank that receives a deposit from the principal of earned and paid bonded contract funds, including the surety’s own prior secured rights, if any, and the surety’s assertion of its subrogation rights. For a discussion of the surety’s assertion of its subrogation rights against the bank, see Steven H. Rittmaster, Ch. 10, The Surety v. The Assignee/Lender, in The Contract Bond Surety’s Subrogation Rights 363-432 (George J. Bachrach, James D. Ferrucci & Dennis J. Bartlett, eds. 2013). Many of the surety’s secured rights and subrogation rights to the bonded contract funds are discussed in prior Surety Today presentations and Surety Today blog posts.
This Surety Today blog post will only address a case involving the surety’s assertion of its indemnity agreement trust fund provision rights against the bank that receives a deposit of the bonded contract funds from the principal.
The surety’s theory was that it had superior rights as against the bank to the “converted” Bonded Contract Funds in the amount of $975,000 from the Account because the Bonded Contract Funds were trust funds under the indemnity agreement. The indemnity agreement provided that the Bonded Contract Funds were held in trust by the principal for the benefit of its subcontractors and suppliers and for the benefit of the surety to the extent that the surety paid those subcontractors and suppliers.
The court reviewed the elements of common law conversion, which required the surety to have an “enforceable interest” in the Bonded Contract Funds in the principal’s Account at the bank. The court then reviewed the elements for both the establishment of a statutory and a common law express trust under Minnesota law, and granted the bank’s motion for summary judgment dismissing the surety’s conversion claim based upon the following reasoning.
The establishment of a valid trust is dependent upon state law and whether the trust complies with the state’s elements for creating a trust. In Minnesota, there are both statutory and common law requirements to establish an express trust. The court found that no trust was established by the indemnity agreement trust fund provision in the Bonded Contract Funds deposited into the Account for two reasons.
- First, when the principal executed the indemnity agreement in 2013, the trust fund provision did not sufficiently identify as trust property the Bonded Contract Funds the principal expected to receive in the future from obligees, namely the Bonded Contract Funds deposited into the Account in 2016.
- Second, the surety did not provide any further “manifestation of intent” or evidence to the bank of the principal’s or the surety’s intention to impose a trust on the Bonded Contract Funds deposited into the Account in 2016. The bank first received a copy of the indemnity agreement trust fund provision in 2017 after the principal’s 2016 deposit to and the bank’s sweep from the Account of the “allegedly converted” Bonded Contract Funds.
Furthermore, the court found that the principal’s conduct after the execution of the indemnity agreement was inconsistent with the establishment of an express trust in the Bonded Contract Funds.
- First, the principal merely endorsed each check for payment of the Bonded Contract Funds as if they were the principal’s property and deposited them into the Account.
- Second, the principal commingled the alleged Bonded Contract Funds with non-trust contract funds in the Account. There was no segregation of Bonded Contract Funds from the other contract funds in the Account.
- Third, none of the principal’s financial records referred to the existence of the indemnity agreement creation of a trust fund in the Bonded Contract Funds.
Finally, the court stated that the surety’s conduct was inconsistent with the establishment or existence of a trust because the surety never took action or required the principal to set up a separate trust bank account for the Bonded Contract Funds only as provided in the indemnity agreement trust fund provision.
Based upon the above, the court found that the surety could not establish the existence of a trust in the Bonded Contract Funds deposited into the principal’s Account, and the bank prevailed.
Other Thoughts and Situations
It appears from the opinion that the surety made all of the possible arguments to support its position with respect to the indemnity agreement trust fund provision, but I am not surprised by the court’s decision. I have written or edited two books – The Surety’s Indemnity Agreement – Law & Practice, 2d Ed. (Marilyn Klinger, George J. Bachrach & Tracey L. Haley, eds. 2008) and The Contract Bond Surety’s Subrogation Rights (see footnote 1) – and have anticipated such a surety argument based upon the surety’s indemnity agreement trust fund provision might be made. But this is the first case that I remember when a surety raised the argument so clearly and as its only argument.
The Indemnity Agreement Book has a section on the indemnity agreement’s trust fund provision, and cites many cases in various jurisdictions about whether that provision creates a valid trust under state law. However, there are no citations to cases that are factually like the present case.
The Subrogation Book does discuss the performance and payment bond surety’s claims against a bank receiving bonded contract funds deposited by the principal, or directly by the obligee, into the principal’s bank account. Furthermore, on March 13, 2017, Mike Stover and I gave a Surety Today presentation entitled “The Limitations on the Surety’s Subrogation Rights.” One of the limitations concerned the surety competing with a secured lender bank for earned and paid bonded contract funds that end up in the principal’s bank account and are then swept by the bank. The surety’s subrogation rights law is essentially:
- When the earned and paid bonded contract funds are deposited into the principal’s bank account prior to the principal’s default, or if the bank receives payments from the principal without notice or knowledge that the principal has failed to pay its subcontractors and suppliers on the bonded project from the bonded contract funds, the surety has been unable to recover from the bank pursuant to its subrogation rights the payments received by the bank despite the fact that the surety may have subsequent losses under its bonds. In general, in the absence of knowledge or fraud on the part of the bank, the surety may not use its subrogation rights to obtain bonded contract funds that have already been paid to the bank and/or swept by the bank from the principal’s bank account.
- However, banks have been held to be on notice of the surety’s subrogation rights as banks are charged with knowledge that many principals are required to provide bonds. When the principal is in default under the bonded contracts prior to the payment of the bonded contract funds, and the bank is aware of the principal’s defaults, the surety may be entitled to obtain from the bank the bonded contract funds that were received by the bank in the principal’s account and swept by the bank to pay down any principal loans.
This issue is fundamentally determined by the circumstances and facts of the case. The Subrogation Book addresses the issues and the factors, and especially what the bank knew about:
- The principal’s financial issues and possible financial distress;
- The existence of the surety’s subrogation rights to the bonded contract funds; and
- The bank’s actual or constructive knowledge or notice of the principal’s bonded contract defaults.
Furthermore, the surety’s subrogation rights do remain and are enforceable with respect to the surety’s assertion of a state’s trust fund statute rights that require a principal to pay its subcontractors and suppliers from any payments of bonded contract funds.
Finally, the following question arises: Why do the surety’s indemnity agreement trust fund provision rights to have the bonded contract funds held in trust for the surety’s benefit lose out to a secured lender bank as in the Guarantee v. Associated case, but prevail over the powers and lien rights of a trustee in bankruptcy? After all, the bankruptcy trustee has all of the rights of a “hypothetical lien creditor without knowledge” of the rights of any other creditor such as the indemnity agreement trust fund provision rights of a surety. The reason lies in the definitions of the powers of the trustee under the Bankruptcy Code.
The trustee’s “hypothetical lien creditor without knowledge” rights are limited by Section 544 of the Bankruptcy Code. The trustee is provided with “judicial lien” rights as of the commencement of the bankruptcy case. A “lien” is defined as a charge against or an interest in property to secure payment of a debt or performance of an obligation. A “judicial lien” is defined as a lien obtained by judgment, levy, sequestration, or other legal or equitable process or proceeding. The trustee is not provided with the rights of a secured creditor or a “security interest,” which is a lien created by a security agreement such as a bank’s security interest in the bonded contract funds and the principal’s bank account. The trustee is not “without knowledge” – it is the “principal/debtor” for which the trustee is acting that executed the indemnity agreement containing the trust fund provision, and the trustee is bound by that provision under Section 541(d) of the Bankruptcy Code.
What are the takeaways from the Guarantee v. Associated case?
- The wording of the indemnity agreement trust fund provision is critical, and there may not be applicable language that will get around cases like the Guarantee v. Associated case.
- If, as it should, the indemnity agreement trust fund provision does require, upon the surety’s demand, that the principal establish a separate trust account for the bonded contract funds, and this is not done, the court will likely find that no trust has been established in the bonded contract funds deposited prior to such a demand.
- Even if the surety makes such a demand, it may not assist the surety in recovering bonded contract funds that were previously swept by the bank from the principal’s bank account.
- BUT REMEMBER, if the surety does make a timely demand, and the principal actually opens a separate trust account, preferably at another bank, the principal’s bank will stop lending (unless the secured lender bank agrees to such a separate account and continues to lend money to the principal). The bank’s unwillingness to lend money to the principal once the bonded contract funds are deposited to another bank account not subject to the secured lender bank’s rights will definitely affect the surety’s claims handling of the principal’s defaults, and especially any ongoing performance bond defaults.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact George J. Bachrach, Esq. (firstname.lastname@example.org) or any member of the Surety and Fidelity Practice Group.
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