A recent bankruptcy court opinion out of the Fifth Circuit explains why the provider of a surety bond on a construction project beats out a secured lender’s prior lien on accounts receivable, general intangibles, and proceeds over the right to retainage payments.
The Uniform Commercial Code and the Debtor’s status as a hypothetical judgment lien creditor didn’t matter in the opinion of the Judge Katherine Samson, who granted summary judgment in favor of the surety bond provider.
In the case at issue, the Debtor, a general contractor, filed for chapter 11 protection.[1] Long before the bankruptcy, the Debtor gave its lender a lien on the Debtor’s accounts receivable, general intangibles, and proceeds, which the bank properly perfected. Later, a surety company issued payment and performance bonds on the Debtor’s behalf.
Facing financial difficulties, the Debtor failed to pay several subcontractors as well as a provider of workers’ compensation insurance. The surety company paid the subcontractors and the insurance carrier around $200,000 in total to cover what they were owed. At this time, the Debtor was also in default to its lender to the tune of approximately $800,000.
Both before and after bankruptcy, the Debtor received final payments from the owners of two projects, which payments included around $190,000 designated as retainage. Both the Debtor’s bank and the surety brought claims asserting that the $190,000 in retainage belonged to them.
The bank, understandably, argued that its prior, properly perfected lien came ahead of the surety’s rights to the funds. The surety argued that its right of equitable subrogation was superior to the bank’s lien. Both sides moved for summary judgment, and in an opinion that reads like a mini hornbook on the issue, Judge Samson granted judgment in favor of the surety.
In summary, equitable subrogation applies whenever someone other than a volunteer pays a debt that should have been paid by someone else. Dispositive to the Court’s finding was that equitable subrogation is not governed by the rules of priority in the Uniform Commercial Code.
Combining the principles of state and federal law, given the bankruptcy context, Judge Samson ruled: (1) the retainage received before bankruptcy never became property of the Debtor’s bankruptcy estate, and (2) the retainage received after bankruptcy became property of the estate subject to the surety’s right of equitable subrogation.
Most importantly, Judge Samson held that the right of subrogation was unaffected by the bank’s prior, perfected security interest. Judge Samson explained her holding on this point was not particular to Mississippi and noted the overwhelming weight of case law favors the surety for retainage regardless of whether the bonds were executed before the lender’s security interest was perfected. Additionally, Judge Samson noted that the U.S. Supreme Court “recognized the surety’s right of subrogation in retainage held by the project owner at the time of bankruptcy.”[2] Although Pearlman was decided in 1926 under the former Bankruptcy Act, Judge Samson note that “most courts” have found Pearlman survived the adoption of the modern Bankruptcy Code.
One take away for bankers? Don’t count on your properly perfected lien on a contractor’s accounts receivable having an absolute priority over another’s right to the accounts / funds—equity can and will trump the UCC.
[1] Kappa Development & General Contracting Inc. v. Hanover Insurance Co. (In re Kappa Development & General Contracting Inc.), 17-06046 (Bankr. S.D. Miss. July 2, 2019).
[2] Pearlman v. Reliance Insurance Co., 371 U.S. 132 (1962).