Introduction

Throughout the United States, federal and state courts have consistently held that a lending bank’s security interest under Article 9 of the Uniform Commercial Code (“UCC”) does not and cannot attach to trust funds held in its contractor borrower’s account at the bank. Courts have reached that conclusion even when construction project trust funds are comingled with non-trust funds in the same account. On that basis, courts have held that a surety’s equitable subrogation rights to project trust funds on bonded construction projects are superior to a lending bank’s UCC security interests.

In a recent case in the United States District Court for the Northern District of Illinois, Travelers Casualty and Surety Co. of America v. John P. Paderta and Fifth Third Bank, No. 10 C 406, 2018 WL 1535117 (N.D. Ill. Mar. 29, 2018), the court addressed two related issues. First, the court addressed whether the “holder in due course” rule under Article 3 of the UCC applies to a lending institution acting as a collecting bank on a bonded construction project. Specifically, the court addressed whether defendant Fifth Third Bank (“Fifth Third”) was a “holder in due course” with regard to checks deposited into its borrower’s account (i.e., the bonded contractor’s account), after the lending bank collected the proceeds of the checks from the project owners’ banks and credited the proceeds to its borrower’s account. Second, the court addressed whether the collecting bank, assuming it was a “holder in due course,” could take the checks “without notice” of any superior claims by its borrower’s surety, plaintiff Travelers Casualty and Surety Company of America (“Travelers”).

As discussed in detail below, the court ruled in favor of Travelers (represented by Watt Tieder) as to both issues and granted Travelers’ Motion for Summary Judgment against Fifth Third.

Factual Background

Krahl Associates, Inc. d/b/a Krahl Construction (“Krahl”) entered into contracts with various public and private construction project owners located primarily in Illinois and Colorado, whereby such contracts required Krahl to obtain surety performance and payment bonds (which were ultimately issued by Travelers in exchange for Krahl entering into an Indemnity Agreement with Travelers). The Indemnity Agreement, consistent with universal surety industry custom and practice, required that Krahl treat all bonded construction project funds that it received from the project owners as trust funds for the benefit of Krahl’s subcontractors.

On January 5, 2010, the FBI executed a search warrant upon Krahl’s Chicago headquarters in connection with allegations of fraud on a data center project. Shortly after Fifth Third (which had previously loaned approximately $6 million to Krahl) learned of the FBI’s raid upon Krahl’s headquarters, it requested and conducted several meetings with Krahl’s representatives to discuss how Krahl planned to continue to generate positive cash flow and operate, notwithstanding the future impact of the government’s fraud allegations. After these meetings, Fifth Third did not believe that Krahl sufficiently addressed the concerns. Therefore, on January 8, 2010, Fifth Third set off the entire $3,086,931.05 balance contained in Krahl’s business demand deposit account in order to satisfy Krahl’s obligations to Fifth Third.

Shortly after the bank’s set off, Travelers received a number of payments and performance bond claims on Krahl’s bonded projects. Travelers notified Fifth Third that a substantial portion of the $3,086,931.05 in Krahl’s account as of January 8, 2010 was comprised of bonded project trust funds (by virtue of the Krahl-Travelers Indemnity Agreement, as well as Section 21.02 of the Illinois Mechanics Lien Act and Section 38-26-109 of the Colorado Bond Act) and demanded that Fifth Third turn over all such trust funds to Travelers, as equitable subrogee to Krahl (as trustee for said funds), and Krahl’s subcontractors (the beneficial owners of such trust funds, by virtue of supplying labor, materials and supplies to the bonded construction projects).

Fifth Third refused to turn over any portion of the trust funds to Travelers, based in part upon the following: 1) the bonded project funds in question were deposited into Krahl’s account by means of checks written by bonded project owners and payable to Krahl; 2) as a result of Krahl’s deposit of the checks into its account at Fifth Third, Fifth Third “took” and became a “holder” of the checks “for value” (i.e., given that Fifth Third previously loaned approximately $6MM to Krahl); and 3) Fifth Third had no “actual knowledge” of the trust fund nature of the checks from the bonded project owners, given that: a) the account in question was not specifically designated as a trust account; b) Fifth Third claimed that it lacked actual knowledge that the proceeds of such checks consisted of express/statutory trust funds; and c) the proceeds of such checks (trust funds), when deposited into the account in question, were comingled with non-trust funds.

Applicability Of “Holder In Due Course” Rule

The court first recognized the general rule that a “holder in due course” of an instrument (check) has a superior right against other competing claimants to that same instrument. The court also noted that neither of the parties challenged Fifth Third’s right to have received and taken title to the proceeds of the checks (from the project owners’ banks) in the first place.

The court noted, however, the following undisputed chain of events: 1) after Krahl deposited the checks into its account, Fifth Third, as collecting bank, presented and returned the checks to the bonded project owners’ banks for payment (through the normal check clearinghouse process); 2) the project owners’ banks then made payment for the checks to Fifth Third (as collecting bank for said checks); 3) upon Fifth Third’s receipt of payment from the project owners’ banks, Fifth Third then fully credited Krahl’s account in amounts corresponding to the face value of the checks; and 4) upon the completion of the foregoing events prior to January 8, 2010, Fifth Third could no longer be considered a “holder” of any such returned and paid checks, which in turn precluded “holder in due course” status as a matter of law. The court explained:

This is not an argument over the right to the account funds as proceeds of the checks (to which the holder in due course doctrine would be relevant), but the right to the account funds as between Krahl and Fifth Third each as creditor and debtor (Krahl as creditor of its account and debtor on its loan, and Fifth Third as debtor on the account and creditor on the loan). The holder in due course doctrine is not relevant to this issue.

What Constitutes “Notice” Under UCC Article 3?

The court then explained how even if the holder in due course doctrine was somehow relevant, Fifth Third still could not avail itself of “holder in due course” status given that it had “notice” of Travelers’ claims to the checks from the bonded project owners. The court rejected Fifth Third’s argument that only “actual knowledge” of the trust fund nature of the deposited funds could defeat its claimed holder in due course status. Instead, UCC Sections 3-302(a)(2)(v) and 1-202(a) (as enacted in Illinois) provide that a person has “notice” of a fact if the person: 1) has actual knowledge of it; 2) has received a notice or notification of it; or 3) from all the facts and circumstances known to the person at the time in question, has reason to know that it exists. The court explained:

And the Court holds that no reasonable jury could find that Fifth Third did not have constructive knowledge that there were equitable trust claims to the funds in Krahl’s account. There is no dispute that Fifth Third knew that much of Krahl’s business required surety bonds.…It is possible that when Fifth Third took the funds in Krahl’s account it did not know specifically how much of those funds were bonded. But Krahl knew that some of the funds were bonded because it received monthly reports with this information, and it used this information to adjust Krahl’s credit… Fifth Third could have identified the trust funds with reasonable diligence. The evidence is sufficient to grant summary judgment in Travelers’ favor.

Based in part upon the foregoing analysis, the court held that Travelers sufficiently established its claims for conversion of the trust funds (Count I of Travelers’ Second Amended Complaint) and constructive trust (Count II).

In conclusion, banks considering a claimed right of setoff against their bonded contractor borrowers’ accounts (even if not specifically designated as trust accounts) should take notice of the surety’s broad rights of equitable subrogation, regardless of whether the bank’s anticipated defenses to the surety’s claims are based upon Article 9 or Article 3 of the Uniform Commercial Code.