Surety Case Law Note: Preferences, Payment Bonds and Releases – Oh My!
April 5, 2022
In this Surety Today blog post we will provide a Case Law Note to consider the issue of Preferences and Payment Bond Claims and the impact of a release. Read on to learn more about the potential impact of bankruptcy on payment bond claims.
KIMBALL CONSTRUCTION CO. V. XL SPECIALTY INSURANCE COMPANY, 2016 U.S. Dist. LEXIS 143793 (D. Md. October 18, 2016)
This case involves a preference action in the principal’s bankruptcy case. The facts were that less than 90 days before the principal filed its bankruptcy, the principal paid a subcontractor $100,000. After the principal filed the bankruptcy case, the Surety paid the subcontractor an additional $200,000 under the payment bond, and obtained a full, executed release – and that’s the important fact here. Twelve months later, the principal’s trustee filed a preference complaint against the subcontractor for the $100,000 that was paid pre-petition by the principal. There was no defense to the preference payment action (it is not in the ordinary course of business, not for new value, no trust fund provision – there were no defenses). The subcontractor, having been forced to disgorge the $100,000 to the trustee, sued the Surety for the $100,000 it turned over to the Trustee as a preference.
The question is: who wins – the Surety because of the full release, or the subcontractor because it has not been paid in full for its work despite the release?
Initial Comments – These are tough cases. They usually come up under one of two situations: (a) first, like this one, as a result of the subcontractor signing a full release of its claims against the Surety and the payment bond; or (b) second, when the applicable statute of limitations for a claim against the payment bond has expired at the time of the filing of the preference complaint. Sometimes sureties make a policy decision to pay these claims regardless of the limitations or release defenses, and I’ve been on that side of the fence. Sometimes the payment may have to be made in order for the surety to successfully assert its subrogation rights to the bonded contract funds; namely, if a subcontractor hasn’t been paid, the surety may not have subrogation rights. Sometimes, the release: (a) Does not include a release of possible preference actions and the subcontractor maintains the right to seek additional claims if it subsequently faces preferential payment exposure; or (b) Refers to specific invoices to be paid and the preference action is for prior invoices that are not listed in or part of the release.
Furthermore, even if there is no post-petition payment by the surety or release by the payment bond claimant, Section 70 of the Restatement of Suretyship provides that the surety’s payment bond obligation revives when the claimant paid by the principal within 90 days before the bankruptcy case is then sued for receiving a preferential payment. In the Kimball case: The subcontractor lost Big Time because when it attempted to assert its claims against the Surety while facing almost $600,000 in preferential payments, the court found that the executed release of all claims against the Surety was clear, straightforward, “plain and unambiguous.” The Court stated that even though the Trustee filed the preference action after the release was executed, the subcontractor signed the release over four months after the principal’s bankruptcy case was filed. Therefore, the subcontractor was on “clear notice” of the principal’s bankruptcy filing and the possible filing of a preference complaint for the $100,000 payment. The release was found to be valid and applicable with respect to the bond claims the subcontractor asserted after the release was executed arising from the pre-petition preferential payments.
The takeaway here when a preference action resurrects a payment bond claim be sure to check the release and see if the claim was released. When drafting a payment bond claim release make sure to include a release of any rights arising under bankruptcy law.
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