Sometimes First in Time Isn’t First in Right

“First in time, first in right,” is one of the first things taught in a law school’s secured transactions class. Yet a recent ruling from the U.S. Bankruptcy Court for the Southern District of Mississippi reminds us that sometimes the winner of the race to the courthouse does not get the gold medal in a lien-priority contest.[1]

In Kappa, a general contractor obtained a loan from a bank. To secure this loan, the general contractor granted the bank a security interest in its accounts receivables (among other collateral). The bank filed a UCC-1 financing statement perfecting this security interest just a few days after the security agreement was signed. Sometime later — but before the bank’s loan was repaid — the general contractor entered into public works contracts, one with the City of Waveland, Miss., and one with the Mississippi Military Department. A surety company issued performance bonds on behalf of the general contractor in connection with each project. As is the case with most construction contracts of this nature, the contracts called for the project owner to retain a portion of the contract price (the “retainage”) until the project was satisfactorily completed.

Disputes arose regarding the project, the bank’s loan went into default, and the general contractor filed chapter 11 bankruptcy. Subcontractors made claims on the surety bond for unpaid amounts related to the project, and the surety company paid these claims under the bond. Through different channels on each project, final payment was approved to be paid by the project owners, a portion of each of which was characterized as retainage. Both the bank and the surety company argued that they were entitled to the retainage payments. The surety argued that it was entitled to the retainage under the doctrine of equitable subrogation since it had paid the debts owed by the general contractor to the subcontractors. The bank on the other hand argued that it was entitled to the retainage since it constituted an accounts receivable of the general contractor on which the bank held a properly perfected security interest that pre-dated issuance of the surety bonds.

The court began its analysis by reviewing the law of equitable subrogation. Of particular note is the court’s reminder that “[t]he right of equitable subrogation is not governed by the priority rules of the Uniform Commercial Code.”[2] Based on this principle, the court rejected the bank’s argument. The court found the bank could only have a right in the retainage if the general contractor (i.e., the borrower) had a right in it. Because the general contractor defaulted under the project contracts, the contractor had no rights in the retainage.[3]

The court did not stop at awarding the surety company the amounts from the retainage necessary to reimburse it for the subcontractor claims it had paid; the court also awarded the surety its attorneys’ fees and expenses incurred as a result of the general contractor’s default.[4] However, the court limited the surety’s ability to reimburse its attorneys’ fees so that only the fees incurred for a particular project could be paid out of the retainage for that project. Stated differently, the retainage from one project cannot be used to pay the costs incurred in another project.

The court’s ruling in Kappa shatters no new glass. However, it is a good reminder for lenders in the construction sector that rely on accounts receivable as a primary source of collateral: When a surety steps in and pays the claims of the general contractor, equitable subrogation kicks in and kicks out the UCC’s priority rules, at least with respect to retainage payments. Keeping a close eye on your borrower is important across the board, but particularly in the construction arena.