Bankruptcy Court Upholds Doctrine Of Equitable Subrogation And Determines a Surety’s Interests Best a Bank’s Interests In A Chapter 11 Bankruptcy Case
By Jennifer Larkin Kneeland and Marguerite Lee DeVoll
On July 2, 2019, the Bankruptcy Court for the Southern District of Mississippi granted a Motion for Summary Judgment that delivered a big win for sureties (and a blow to banking institutions) when it determined that a surety’s right to retainage is superior to a creditor’s security interest even when the creditor’s security interest was perfected first.
In In re: Kappa Development and General Contracting, Inc. (Case No. 17-06046), Kappa, the general contractor (the “Debtor”), executed a Promissory Note in favor of third-party defendant, The First, a national banking association (the “Bank”). As collateral for the loan, the Debtor pledged to the Bank a lien on accounts receivable, general intangibles and proceeds. The Debtor then entered into 2 unrelated government contracts for construction projects and third-party plaintiff, Hanover Insurance Company (the “Surety”), issued performance bonds and payment bonds for both projects. The Debtor defaulted on the Promissory Note, payments to subcontractors and suppliers on both projects, and a workers’ compensation premium. The Bank perfected its lien and subsequently, the Surety paid the subcontractors and suppliers on both projects as well as the workers’ compensation premium, pursuant to the executed bonds.
In applying the doctrine of equitable subrogation – which applies when any person other than a volunteer pays the debt of another – the bankruptcy court first found that the right of subrogation “is not governed by the priority rules of the Uniform Commercial Code.” [citing Mississippi law]. The bankruptcy court further clarified that under the doctrine of equitable subrogation the surety’s entitlement to money and property takes precedence and precludes property to which the surety is equitably subrogated from becoming property of the debtor’s estate. Specifically, the bankruptcy court reasoned: “‘[A] debtor’s property rights are determined by state law, while federal bankruptcy law applies to establish the extent to which those rights are property of the estate.’ Here, under bankruptcy law, the retainage for the City of Waveland Project never became the property of the estate. And the retainage for the Camp Shelby Project became property of the estate subject to [the Surety’s] right of equitable subrogation, which was unaffected by perfection of [the Bank’s] security interest.” [internal citation omitted].
The bankruptcy court emphasized that the conclusion would be the same across jurisdictions, noting that the “overwhelming weight of case law favors the surety for retainage regardless of whether the bonds were executed before the financer’s security interest was perfected.” Additionally, because the Debtor had no rights in the retainage as a defaulting contractor, the Bank also had no rights in the retainage. The bankruptcy court did note, when distinguishing a Mississippi decision cited by the Bank, that an assignee bank may be entitled to funds over a surety when the funds were progress payments and not retainage.
Finally, the bankruptcy court affirmed that the United States Supreme Court’s 1962 decision in Pearlman v. Reliance Insurance Co., which was decided before the enactment of the Bankruptcy Code, still holds. Pearlman recognized a surety’s right of subrogation in retainage held by the project owner at the time of bankruptcy adjudication, as was the case with one of the projects in Kappa.