Potential Defense – Misapplication of Payments
August 6, 2024
In this Surety Today: The Blog post we discuss the potential defense of misapplication of payments. The scenario would be as follows: The principal on a bonded job owes money to a supplier on the bonded job and also on a non-bonded job. The principal makes a payment to the supplier from the bonded contract funds, but the supplier applies the payment to the non-bonded receivable. When the principal subsequently defaults the supplier makes a claim against the payment bond. Because the surety is secured by its equitable and other rights in the bonded contract funds, such funds must be utilized to first satisfy the bonded obligations of the surety. The failure of the supplier to properly credit the bonded contract funds to the bonded contract obligations unjustly enriches the supplier at the expense of the surety, i.e. the supplier has its non-bonded obligation satisfied with bonded funds and the surety remains liable under its bond for the full amount of the debt. In most jurisdictions, this scenario gives rise to the misapplication of payments defense.
In U.S. For & On Behalf Of W. Chester Elec. & Elecs. Co. v. Sentry Ins., 774 F.2d 80 (4th Cir. 1985) the Fourth Circuit observed that “when a debtor makes a payment to a creditor on a secured debt and the creditor applies the payment to a different obligation, the surety is no longer bound to cover the debt for which payment was made. Under the misapplication of funds doctrine, [t]he surety in such a case is entitled to have the payment applied to the debt for which [it] is bound.” See also United States for the Use and Benefit of Crane Co. v. Johnson, Smathers and Rollins, 67 F.2d 121, 123 (4th Cir. 1933); United States Casualty Co. v. Noland Co., 286 F. Supp. 333, 337–39 (M.D.N.C.1968); St. Paul Fire and Marine Ins. Co. v. U.S. for the Use of Dakota Elect. Supply Co., 309 F.2d 22, 25 (8th Cir. 1962); U.S. for the Use of Clark-Fontana Paint Co., Inc. v. WIBCO, Inc., 396 F. Supp. 1253, 1255 (D.D.C. 1975), aff’d, 539 F.2d 243 (D.C. Cir. 1976); U.S. for the Use of Hyland Elect. Supply Co. v. Franchi Bros. Const. Co., 378 F.2d 134 (2d Cir. 1967); U.S. for the Use of C.H. Benton, Inc. v. Roelof Const. Co., 418 F.2d 1328 (9th Cir. 1969).
There are a number of rules and doctrines at play in the simple process of allocating payments. There is the “identical source rule,” the “doctrine of marshalling of assets,” the “doctrine of application of payments” or “equitable application of payments,” and the common law rule of payments, sometimes referred to as the “rule of freedom of application.” The common law rule of payment provides that “[w]here a debtor owes a creditor multiple debts, a payment by the debtor should be applied to one or another of the debts as the debtor directs. Where the debtor fails to direct the application of the payment to a particular debt, the creditor may apply the payment as he chooses. If neither the creditor nor the debtor applies the payment, then the court makes the application in accordance with equitable principles.” Moser Paper Co. v. North Shore Pub. Co., 83 Wis.2d 852, 857–58, 266 N.W.2d 411, 414–15 (1978); Lyman Lumber of Wisconsin, Inc. v. Thompson, 138 Wis.2d 124, 127, 405 N.W.2d 708, 710 (Wis. Ct. App. 1987); Bolgen v. Progressive Composition Co., 430 Pa. 140, 242 A.2d 269 (1968). The common law rule “rests upon the concept that the money which the debtor is utilizing to make the payment is his own and is free for use as he pleases.” St. Paul Fire & Marine Ins. Co. v. U. S. for Use of Dakota Elec. Supply Co., 309 F.2d at 25. Some courts have referred to the creditor’s right to allocate payments as it chooses, if the debtor fails to do so, as the doctrine of equitable application of payments. See Airtite, a Div. of Airtex Corp. v. DPR Ltd. P’ship, 265 Ill. App. 3d 214, 220–21, 638 N.E.2d 241, 245 (1994); Illinois Refining Co. v. Welch, 341 Ill. 292, 300, 173 N.E. 345, 348 (1930).
The “identical source” rule is an exception to the common law payment rule and it gives rise to the misapplication of payment doctrine. Under this exception, where payment is made to a creditor who knows that the payment is derived from a particular source or fund, the creditor must apply it to the exoneration of the debt related to that source or fund, where the rights of third parties, such as sureties are concerned. In re Zersen, 189 B.R. at 742, citing Moser Paper, 83 Wis.2d at 858; St. Paul Fire and Marine Insurance Co. v. United States, 309 F.2d 22 (8th Cir. 1962); United States ex rel. Carroll v. Beck, 151 F.2d 964 (6th Cir. 1945)(when a supplier knows, or has reason to know, the source of a payment, the supplier must apply payments to the debt created by that source.); School District of Springfield v. Transamerica Insurance Co., 633 S.W.2d 238 (Mo. App. 1982); Bain-Nicodemus Inc. v. Bethay, 40 Tenn. App. 487, 292 S.W.2d 234 (1954). The “identical source” rule has been adopted by the majority of jurisdictions. 3 Bruner & O’Connor Construction Law, § 8:45 Payment Misapplication (2023), citing Restatement Second, Contracts §§ 258 to 260; §§ 387, 388 and 394; Lybeck & Shreves, eds., The Law of Payment Bonds at 258-59 (ABA 1998). The key to this rule is the knowledge of the creditor. A supplier’s/creditor’s right to make an application of payments is limited where the supplier/creditor “receives payment from the contractor with knowledge of the fact that the money comes from the particular construction job with respect to which the surety is liable …” Couch on Insurance 2d (Rev ed) § 47:74. Thus, it has been held that if a supplier knows that money paid to him is from a particular bonded job, the supplier is under a legal duty to apply that money to the debt stemming from the bonded job, thus providing a protection for the surety. This limitation on a supplier’s right to determine the application of his debtor’s payments on a running account is “sometimes grounded upon abstract considerations of equity and justice, and sometimes upon an implied contractual obligation to the surety and his principal.” American Oil Company v. Brown Paving Company, 298 F. Supp. 528, 535 (D.C.S.C. 1969). “[S]ome jurisdictions impose an affirmative duty upon material suppliers to inquire into the source of payments to assure allocation of payments properly among debtors’ different accounts for the benefit of the creditors making payments.” Bruner & O’Connor, supra., citing L & W Supply Corp. v. DeSilva, 429 N.J. Super. 179, 57 A.3d 558 (App. Div. 2012); Craft v. Stevenson Lumber Yard, Inc., 179 N.J. 56, 843 A.2d 1076 (2004) (holding that a material supplier has an affirmative duty to inquire into the source of payments received as a condition to recovering under a construction lien).
The “knowledge” of the creditor under the identical source rule can be inferred from a variety of circumstances including the timing of payment, knowledge that the debtor is working on a particular bonded project, payment by joint check, notations, attached paperwork and other such documents can also establish knowledge. Bruner & O’Connor, supra. An inference of knowledge may also arise where a supplier, without explanation, deviates from its customary application process which, if followed, would have reduced a third party’s obligation. Id.
The doctrine of marshalling of the assets is a similar equitable doctrine to the identical source rule, and has been described as “where a creditor has a lien on or interest in two funds or properties in the hands of the same debtor, and another creditor has a lien on one of these funds or properties, equity at the request of the latter creditor will compel the creditor with two funds to satisfy his debt out of that fund to which the other creditor cannot resort.” In re Zersen, 189 B.R. 732, 742 (Bankr. W.D. Wis. 1995).
Surety Knowledge
Notice to the surety of the redirection of funds can, in certain circumstances, render the misapplication of funds doctrine inapplicable. If the surety has knowledge of the redirection of funds and, through its actions, leads the creditor to believe that it intends to continue to secure the entire remaining debt, the surety may be estopped from asserting a misapplication of funds defense to avoid liability on the secured debt. Bruner & O’Connor, supra.; United States for the Use and Benefit of Hyland Electric Supply Co. v. Franchi Brothers Construction Corp., 378 F.2d 134, 138 (2d Cir. 1967).
Minority Position
A minority of courts have refused to apply the misapplication of payments doctrine. See Warren Brothers Co. v. Sentry Insurance, 13 Mass. App. 431, 433 N.E.2d 1253 (1982). In Warren, a supplier received payments from a contractor and applied the payments to earlier, unsecured debts of the contractor even though the supplier knew that the payments were derived from the proceeds of a bonded contract. The Massachusetts court stated that “an absolute right in the surety to receive the benefit of a payment which the creditor knows to have issued from the proceeds of the bonded contract, we do not think … fair or sound.” Id. at 437, 433 N.E.2d at 1257, citing Standard Oil Co. v. Day, 161 Minn. 281, 201 N.W. 410 (1924)(“The identical source rule leads to an instability in commercial business that does not have our approval. The creditor should not, in the collection of his money, be burdened with the responsibility of having to know the status of his debtor’s accounts nor the status of the obligation of the surety of the debtor.).
In addition to the rules and doctrines that have been developed by the courts and common law, statutes, bond forms, and contract forms may also specify that funds from a bonded job must be applied to debts arising on that job.
Accordingly, sureties, consultants and outside counsel should keep in mind that the manner in which payments of bonded contract funds are allocated could give rise to a defense.
If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321/mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.