Surety Case Law Note: Surety Beats the Bank
In this Surety Today blog post we will provide a Case Law Note to consider the issue of the rights to certain contract funds that were deposited into the court between the surety and the principal’s bank. The case involves the nature of the bank’s security interest and the surety’s equitable rights.
IN RE KAPPA DEVELOPMENT AND GENERAL CONTRACTING, INC.,
2019 WL 2867110 (Bankr. S.D. Miss. July 2, 2019)
In this case, money was deposited into the court’s registry by two separate construction project owners. Thereafter, the debtor’s surety and lender engaged in a fight over who was entitled to the funds. The debtor took no position in the dispute because it knew that regardless of the outcome, the bank and surety had superior rights over the funds. The surety paid payment bond claims and the premium of a worker’s compensation insurer, which was a performance bond obligation. The bank contended that it had a security interest in the debtor’s accounts receivables, general intangibles and account proceeds that was perfected long before the bonds were even issued. In granting summary judgment in favor of the surety, the Court held:
The right of a surety to retainage is superior to a creditor’s security interest in accounts receivable, general intangibles, and account proceeds regardless of when the creditor’s security interest was perfected.
The Court made quick work of brushing aside the bank’s meritless arguments that the surety was a volunteer and that the funds were not retainage. Addressing the bank’s argument that its security interest was perfected before the bonds were issued, the court stated that “[t]he right of equitable subrogation is not governed by the priority rules of the Uniform Commercial Code.” Id., 2019 WL 2867110 at *6; citing Travelers Indem. Co. v. Clark, 254 So. 2d 741, 746 (Miss. 1971) (“[W]e hold that a surety’s right of subrogation is unaffected by the filing requirements of the Uniform Commercial Code.”). When the funds at issue are retainage, the surety’s right of equitable subrogation is superior to the right of an assignee bank.” Id.; citing Canton Exch. Bank v. Yazoo Cty., 109 So. l, 7-8 (Miss. 1926).
The Court observed that because “the surety’s right of equitable subrogation is based on equity, not the UCC, it is immaterial whether the bank filed its financing statement before or after the bond was issued. Either way, [the surety] wins.” The court cited to the authors of the treatise The Law of Secured Transactions Under the Uniform Commercial Code observing that the overwhelming weight of case law favors the surety for retainage regardless of whether the bonds were executed before the [bank’s] security interest was perfected. See 1 Barkley Clark & Barbara Clark, The Law of Secured Transactions Under the Uniform Commercial Code § 1.07[2]-[3] (3d ed.) (2018) (“Once the priority conflict is taken outside the confines of Article 9 [of the U.C.C.], the blue ribbon should be given to the surety, even when the bonds are executed after the bank’s security interest is perfected.”); e.g., In re J.B. Constr. Co., No. BK 10-80880-TJM, 2011 WL 830101, at *2 (Bankr. D. Neb. Mar. 4, 2011) (quoting US. Fid. & Guar. Co. v. APAC-Kansas, Inc., 151F.Supp.2d 1297, 1300 (D. Kan. 2001)) (“[The contractor] has not cited, nor has this court found, any authority requiring that the surety’s interest predate another creditor’s interest for the doctrine of equitable subrogation to control.”).
The Court further noted that whether the bank has any rights in the retainage depends on whether the debtor had any rights in the retainage. A security interest is enforceable only if the debtor has rights in the collateral. An assignee’s rights (like the bank) can rise no higher than the assignor’s (the debtor). A defaulting contractor has no rights in the retainage. United States v. TAC Constr. Co., 760 F. Supp. 590 (S.D. Miss. 1991). Upon default, the remaining funds are to be used to complete the project and satisfy subcontractors and suppliers to the project.
The bank also argued that the surety was subrogated to the rights of the subcontractors and suppliers whose claims the surety satisfied and that such subcontractors and suppliers were mere general unsecured creditors in the bankruptcy. Thus, the bank argued the surety’s rights are subordinate to the rights of the bank in bankruptcy because the bank was a secured creditor. However, the court noted that because the surety’s right of equitable subrogation relates back to the date of the issuance of the Bonds, under bankruptcy law, the retainage never became property of the estate. At most, the bankruptcy estate could succeed only to the debtor’s possessory interest in the retainage as mere legal title, not to the equitable interests of the subcontractors and suppliers. See In re Jones Const1: & Renovation, Inc., 337 B.R. 579, 583-84 (Bankr. E.D. Va. 2006) (quoting Pearlman, 371 U.S. at 135-36) (“The Bankruptcy Act simply does not authorize a trustee to distribute other people’s property among a bankrupt’s creditors.”).
It is always nice to see the court get it right and correctly note the distinctions between security interests and equitable subrogation. If you have questions regarding the issues discussed in this post, please do not hesitate to contact Michael A. Stover, Esq. (410-659-1321 or mstover@wcslaw.com) or any member of the Surety and Fidelity Practice Group.