On April 10, 2018, I joined my colleagues Hanna L. Blake and Marguerite L. DeVoll in a presentation to bankruptcy attorneys at a meeting of the Northern Virginia Bankruptcy Bar Association. We were asked to address the following topic ̶ From a Surety’s Perspective: When a Contractor Hits the Zone of Insolvency or Files for Bankruptcy. Our objective was to educate bankruptcy attorneys about how sureties view the law of equitable subrogation and how most sureties have enhanced their rights with assignment clauses in their general agreements of indemnity. We were surprised to learn that over half of our audience was unfamiliar with the principle of equitable subrogation and harbored the initial belief that unpaid contract balances should be paid to the bankruptcy estate, rather than directly from the obligee to the surety.

 

It may come as no surprise that, at times, bankruptcy courts appear to be just as unfamiliar with the doctrine of equitable subrogation and are loath to enforce provisions in a general agreement of indemnity that potentially ruin a debtor-contractor’s chances of making a good-faith attempt to reorganize in the bankruptcy court. Consequently, bankruptcy decisions that address equitable subrogation do not come out consistently in favor of the surety. If a bankruptcy court applies the law of equitable subrogation, then the remaining contract balance held by the obligee should be paid directly to the surety. In this case, the surety takes the remaining contract balance held by the obligee and the debtor-contractor’s bankruptcy case is dead on arrival in the bankruptcy court without any cash to fund the reorganization or to pay creditors. The consequence of following the law of equitable subrogation or upholding an assignment clause in a general agreement of indemnity can be devastating to a bankruptcy case.

 

Guidance From The U.S. Supreme Court

 

The principle of equitable subrogation was first recognized by the U.S. Supreme Court in Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962). Decided under the Bankruptcy Act of 1978, the U.S. Supreme Court recognized the principle of equitable subrogation and its relationship to suretyship and bankruptcy law. The Supreme Court stated that “[t]he Bankruptcy Act simply does not authorize a trustee to distribute other people’s property among a bankrupt’s creditors.” Applying the doctrine of equitable subrogation, the Supreme Court decided that when a surety has performed under a surety bond, money held by the U.S. Government on a terminated contract with its principal was not property of the principal’s bankruptcy estate. Since the Supreme Court’s holding in Pearlman, bankruptcy courts have applied its reasoning to varying results.

 

Whether A Bankruptcy Court Will Follow Pearlman May Depend On Where The Case Is Filed

 

It is well-established that when a contractor defaults under the terms of a public contract, the remaining funds that could be paid under the contract are ordinarily no longer owing to the contractor. Indeed, several courts have found that ”[t]he law is clear that a surety under these circumstances has a right to the payments due the contractor to the extent of full reimbursement.” Kentucky Cent. Ins. Co. v. Brown (In re Larbar Corp.), 177 F.3d 439, 443 (6th Cir. 1999); First Indem. of Am. Ins. Co. v. Modular Structures, Inc. (In re Modular Structures, Inc.), 27 F.3d 72, 77 (3d Cir. 1994); In re Pac. Marine Dredging and Const., 79 B.R. 924, 929 (Bankr. D. Or. 1987). As a result, under the doctrine of equitable subrogation, the surety normally succeeds to the rights of the debtor-contractor to receive payment of any remaining funds held by the owner/obligee. See Pearlman, 371 U.S. at 138; In re Jones Constr. & Renovation, Inc., 337 B.R. 579, 584 (Bankr. E.D. Va. 2006).

 

Some bankruptcy courts have followed these principles and determined that contract balances held by obligees after breach by a debtor-contractor are not property of the bankruptcy estate. For example, in In re Pacific Marine Dredging, an Oregon bankruptcy court found that a debtor-contractor failed to pay labor and material obligations. Consequently, the bankruptcy court ruled in favor of the surety and held that when the contractor/debtor breached the contract with the project owner, it lost any “legal or equitable interest” in the remaining sums due under the contract held by the project owner.

 

The Third Circuit reached a similar conclusion in In re Modular Structures, Inc., 27 F.3d 72, 77-78 (3d Cir. 1993). The Third Circuit found that because the principal failed to fulfill its contractual obligations, either the funds held by the project owner should be paid to the surety (which is secondarily liable to subcontractors and suppliers under its payment bond) or made as “direct payments to the subcontractors” that remained unpaid by the principal contractor/debtor. Consequently, due to the contractor’s breaches, the Third Circuit found that the principal contractor/debtor did not hold a property interest in the remaining funds and the funds “did not become a part of the estate in bankruptcy.”

 

In addition to applying the doctrine of equitable subrogation, some bankruptcy courts have also enforced the surety’s assignment clause in a general agreement of indemnity. These courts recognize that a pre-petition assignment clause in a general agreement of indemnity enhances a surety’s rights to unpaid contract funds in the hands of the obligee. For example, in In re Jones Constr. & Renovation, Inc., the bankruptcy court for the Eastern District of Virginia found that “although [the surety] enjoys the rights of equitable subrogation, it is also entitled to enhance and supplement those rights through the assignment provisions of the indemnity agreement.” The bankruptcy court reasoned that the mere fact that the debtor filed for bankruptcy does not alter the parties’ bargained for rights under state law. Rather, as the court noted, if pre-petition assignment clauses are valid under state law, then the proceeds of any assignment that vests rights in the assignee, e.g., the surety, pre-petition are not property of the estate. As a result, the bankruptcy court held that the surety had an ownership interest in remaining contract funds under the pre-petition assignment clause, in addition to its equitable subrogation rights, which permitted the surety to recover contract balances on one project in excess of the losses for that specific project.

 

Unquestionably the Virginia bankruptcy court’s decision in Jones Construction is music to a surety’s ears. However, there are other bankruptcy court decisions that do not resonate quite as well. Recently, in 2016, the bankruptcy court for the Northern District of Illinois decided in In re Glenbrook Group, Inc., 552 B.R. 735 (Bankr. N.D. Ill. 2016) that Pearlman had been superseded by the passage of the Bankruptcy Abuse and Prevention Act of 2005 (“BAPCPA”) and that the principle of equitable subrogation no longer applies in bankruptcy cases. The court examined section 541 of the Bankruptcy Code, which defines what is property of a debtor’s bankruptcy estate, and noted that the plain language of section 541(a)(1) and (d) instructs that any property in which the debtor has the slightest interest comes into the estate. The Glenbrook Group court concluded that BAPCA had expanded the definition of property of the estate. Consequently, the court reasoned that “the very things the [Supreme] Court states are not property of the estate in Pearlman, property subject to equitable interests, mortgages, liens, etc., are now included as property of the estate under § 541(d), albeit subject to any equitable interest.” Id. Therefore, Pearlman was no longer binding precedent on the court. The bankruptcy court found that the debtor-contractor retained an equitable interest in the remaining contract funds held by the owner/oblige. As a result, the bankruptcy concluded that the remaining contract funds became property of the estate.

 

In reading the Glenbrook Group decision it occurs to me that the bankruptcy court simply did not appreciate that upon a contractor’s default, well-established law clearly holds that the contractor loses all rights to unpaid contract balances because those rights vest fully with the surety. Therefore, the contractor simply has no rights (equitable or otherwise) to the remaining contract balance held by the owner/obligee. As a consequence, an examination of whether or not remaining contract funds are property of the debtor’s estate is not the analysis that the court should have made.

 

Hanna Blake, Marguerite DeVoll and I were honored and delighted to provide the surety’s perspective on this important area of bankruptcy law to the Northern Virginia Bankruptcy Bar Association. Given the troubling ruling by the Glenbrook Group court, we believe that it is important to continue to educate bankruptcy practitioners and judges regarding the intersection between surety law and bankruptcy law. We plan to take our show on the road in the upcoming months and are actively looking for places to make our presentation. If you would like us to present our discussion to your group, please let us know. We would be delighted to accept your request.