Third Circuit Makes Strict Rules Before Subrogation Rights Kick In

Affirming Bankruptcy Judge Christopher S. Sontchi of Delaware, the Third Circuit explained the meaning of Section 509(c), the most incomprehensible provision in the Bankruptcy Code.

In essence, the Third Circuit rigorously interpreted “paid in full” in Section 509(c) to benefit the beneficiary of a payment and performance bond. There can be no question about whether the beneficiary of the bond has been paid in full before the bonding company is subrogated to the claim and rights of the beneficiary.

The Contracts and the Bond

A contractor had multiple contracts with the U.S. government. The contractor was required to post a payment and performance bond.

The contractor defaulted on one of the construction contracts. The government tapped on the shoulder of the bonding company, which hired another contractor to complete the job.

According to the August 18 opinion by Chief Circuit Judge D. Brooks Smith, the bonding company was out of pocket by some $12 million more than the government paid to complete the project.

The defaulting contractor ended up in chapter 7. Just before bankruptcy, the contractor filed an income tax return and claimed a $5.5 million carryback refund from the IRS.

The bonding company was still paying to complete the project while the bankruptcy was in progress. The government notified the bonding company in February 2016 that the project was “sufficiently complete” to allow occupancy. However, the bonding company did not make the final payment to the replacement contractor until September 2016.

The government filed a claim against the contractor for some $170 million, including more than $80 million on the bonded project.

On the other side of the fence, the trustee was contending that the government owed more than $50 million on other projects.

The disputes led to a compromise with the bankruptcy trustee where the government agreed to release the $5.5 million refund to the trustee and waive its setoff rights. In return, the government was given an allowed unsecured, nonpriority claim for $170 million.

The bonding company objected to the settlement, claiming it was subrogated to the government’s rights to the $5.5 million tax refund. The objection resulted in a companion settlement where the $5.5 million was held in escrow, and the bonding company was assured that the primary settlement would not waive the bonding company’s claims, “if any,” to the tax refund.

The bankruptcy court approved the primary settlement in June 2016, waiving the government’s setoff rights. Note that the bonding company would not make the final payment to the replacement contractor until September 2016.

In approving the settlement and overruling the bonding company’s objections, Bankruptcy Judge Sontchi granted summary judgment in favor of the secured lender that had a lien on the contractor’s assets, including the tax refund. Judge Sontchi concluded that the government had not been “paid in full” when the waiver became effective. He therefore ruled that the government was entitled to waive its right of setoff and thus defeat the bonding company’s subrogation rights.

The district court affirmed, and so did Judge Smith.

‘Paid in Full’ in Section 509(c)

Judge Smith began by laying out the common law elements of subrogation and explained how they were modified by Section 509.

Departing from common law, Judge Smith said that “Section 509(a) provides that a surety is partially subrogated to the rights of a creditor to the extent that the surety has made any payments (i.e., short of payment in full).” [Emphasis in original.]

Fortunately for us, Judge Smith translated Section 509(c) into plain English. The subsection, he said, “provides that those subrogation rights are subordinated to the remainder of the creditor’s claim until the creditor has been paid in full.” He cited legislative history as reflecting the concern of Congress that the statute should not permit a bonding company to compete with the insured until the insured’s claim has been paid in full.

Judge Smith said that the statute does not define “paid in full.” There are broad and narrow interpretations of the words. Under either, the bonding company loses, he said.

The broad interpretation requires full payment of all claims that the beneficiary of the bond has against the contractor, not just the contract to which the bond applied. Under that definition, the bonding company would lose because the government had many other unpaid claims against the bankrupt contractor.

The narrow construction requires full payment of the claims covered just by the bond. Thus, Judge Smith launched into an analysis of whether the government had been paid in full by June 2016, when the government waived its right to set off the tax refund.

Judge Smith said there was “no evidence in the record” to show that the government had been paid in full when the waiver was made. To the contrary, he said, the government was not paid in full until the bonding company made the last payment to the replacement contractor months after the waiver.

Judge Smith also said that the bonding company’s agreement years before to complete the project did not in itself “satisfy” the bonding company’s suretyship obligations.

Affirming Judge Sontchi, Judge Smith held that the government had not been “paid in full” under Section 509(c) before the bankruptcy court approved the settlement waiving the government’s right of setoff. The bonding company was not yet subrogated and had no right to object to the government’s waiver of setoff rights.