Chief Bankruptcy Judge Katharine M. Samson of Gulfport, Miss., wrote an opinion that reads like a treatise on surety bonds. 

What’s the bottom line? 

Answer: The provider of a surety bond on a construction project beats out the contractor’s secured lender in a tussle over the right to retainage. The Uniform Commercial Code and the debtor’s status as a hypothetical judgment lien creditor don’t matter.

Richard Carmody from Adams & Reese LLP in Birmingham, Ala., said that the opinion is a “good lesson for bankers. Don’t lend on a contractor’s accounts receivable unless the project is complete.”

The Facts

A general contractor ended up in chapter 11, having lost money on two government construction projects. Long before bankruptcy, the contractor gave its bank a lien on accounts receivable, general intangibles, and proceeds. After the bank perfected its lien, a surety company issued payment and performance bonds on the contractor’s behalf.

The general contractor did not pay several subcontractors and a provider of workers’ compensation insurance. The surety paid the “subs” and the workers’ comp carrier about $200,000 to cover what they were owed.

Meanwhile, the general contractor was in default to the bank for about $800,000. 

Before and after bankruptcy, the contractor received final payments from the owners of the two projects. The final payments included about $190,000 that was designated as retainage.

The bank and the surety both laid claim to the $190,000 retainage. The bank argued that its lien came ahead of the surety’s rights. The surety contended that its right of equitable subrogation was superior to the bank’s lien.

Both sides filed motions for summary judgment. The surety came out on top in Judge Samson’s July 2 opinion.

Judge Samson’s Ratio Decidendi

Judge Samson’s opinion is chock full of black letter law. Some of it may be peculiar to Mississippi, but most is not.

The first principle is that equitable subrogation applies whenever someone other than a volunteer pays a debt that should have been paid by someone else. Second, and dispositive for the case at bar, equitable subrogation is not governed by the rules of priority in the UCC. 

Third, the Mississippi Supreme Court ruled in 1926 that a surety’s right of equitable subrogation is superior to the rights of a secured lender.

Next, Judge Samson laid out the applicable principles of bankruptcy law. 

Although state law determines a debtor’s property rights, the Fifth Circuit held that federal law governs the extent to which those property rights are estate property. 

Combining the principles of state and federal law, Judge Samson ruled that the retainage received before bankruptcy never became property of the estate and that the retainage received after bankruptcy became property of the estate subject to the surety’s right of equitable subrogation.

In addition, Judge Samson held that the right of subrogation was unaffected by the bank’s perfected security interest.

The result was not peculiar to Mississippi, Judge Samson said. She cited a treatise on secured transactions to say 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.”

Buttressing her conclusion, Judge Samson said that a defaulting contractor has no right in retainage under Mississippi law. Having only the rights of the contractor, the bank had no rights in the retainage either, she said.

Finally, Judge Samson said 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 . . . .” Pearlman v. Reliance Insurance Co., 371 U.S. 132 (1962). Although decided under the former Bankruptcy Act, she said “most courts” hold that Pearlman survived the adoption of the Bankruptcy Code.