Payment bonds provide a high level of security for contractors and suppliers. Generally you know (with some occasional exceptions) that if you do a good job and comply with the requirements of the bond, you are going to get paid no matter what else happens on the project. While that remains generally true, a recent decision from an Illinois bankruptcy court potentially curtails the remedies the surety may have to collect from the owner. This bankruptcy court decision may still be overturned on appeal or ultimately be an outlier that is rejected by other courts, but it raises some important practical issues to consider when signing on for bonded projects and measuring the risk that you are taking.
The question that you as a contractor or supplier probably have is: they still have to pay me, why should I care whether the surety is able to collect? While it is correct that a surety’s liability to you does not turn on their ability to collect, the practical impact of the surety’s ability to collect can have some significant impact on a number of things including: how quickly you are paid and how much you spend in legal fees to collect. Take, for example, a surety who has to pay $100,000 in claims but is able to collect $90,000 worth of remaining project funds. It is highly unlikely that a surety under those circumstances is going to want to pick a fight about your claim.
In contrast, consider a surety who faces $100,000 in claims but can collect nothing. In this situation—with the surety paying out of its own pocket—the odds are much higher that the surety is going to find something wrong with your claim. Strict adherence to all of the technicalities required by the law or the bond become much more important and even a minor mistake can be costly. The chances of spending legal fees goes up significantly. From a practical perspective, you want the surety to be able to collect as much money as possible not because you like them but because it makes your life easier. The next question is: how does that work? It has long been accepted that a surety is entitled to any remaining contract funds when its principal defaults and that the surety’s entitlement to those funds is superior to that of a bankruptcy trustee. This concept first came to the forefront in a decision by the Supreme Court of the United States in Pearlman v. Reliance Ins. Co. [1]. In Pearlman the general contractor on a federal project went out of business and into bankruptcy. Because of the general contractor’s failures, the government terminated its contract. As required by the Miller Act, the general contractor had provided payment and performance bonds for the partially completed project.
Along with its failure to perform its work properly, the general contractor had also failed to pay its subcontractors and suppliers. As a result, its surety was forced to pay approximately $350,000 in claims against the payment bond. After the government had completed the project with another contractor, it had approximately $88,000 in project funds remaining. Not knowing who to pay, the government turned the funds over to the bankruptcy trustee and litigation ensued to determine who—the surety or the trustee—was entitled to those funds.
The Supreme Court decided that the money was the property of the surety based on the doctrine of equitable subrogation. Equitable subrogation, to put it simply, is the idea that someone who pays the debts of another is entitled to step into the shoes of that person. The Pearlman court determined that because the general contractor, had the job been completed, would have been entitled to collect the funds and use them to pay the subcontractors and suppliers, the surety stepped into the general contractor’s shoes in front of the bankruptcy trustee. The approximately $88,000 that the surety was able to collect was only a small portion the claims it had to pay, but it was better than nothing.
A number of recent decisions have come to a similar result. In April of 2015, in Dwyer v Ins. Co. of the State of Pa. (In re Pihl, Inc.), [2] the United States Bankruptcy Court for the District of Massachusetts agreed with Pearlman and determined that the surety was entitled to the funds earned but not yet paid to the surety. In January of 2015, in Van Winkle v. 3From, Inc. (In re Trainor Glass Co.), [3] the United States Bankruptcy Court for the Northern District of Illinois reached the same conclusion. As did the United States District Court for the District of New Jersey in its 2013 decision in Bond Safeguard Ins., Co. v. Straffi (In re B & B Constr., LLC) [4]; the United States Bankruptcy Court for the Western District of New York in its 2010 decision in In re Union City Contrs., Inc. [5]; and the United States District Court for the Southern District of New York in its 2007 decision in Harley Worcester Mut. Ins. Co. v. Bank of Am, N.A. (In re Suprema Specialties, Inc.).[6] Given what seems to be a consensus on this issue, one would think we could close the book on this one. Not so fast! The only thing that we can be sure of when bankruptcy meets construction is that the book is basically never closed.
A very recent case out of the United States Bankruptcy Court for the Northern District of Illinois came to a different result on this issue. In the case of In re Glenbrook Group, Inc. [7] a contractor working for a municipal agency filed for bankruptcy. Before the bankruptcy, the debtor had supplied payment and performance bonds for the project. When the bankruptcy was filed there were a number of unpaid subcontractors and/or suppliers with claims against the bond. As usual, the surety was on the hook for these payments.
The project owner was still holding significant funds when the bankruptcy was filed and the surety asserted equitable subrogation rights to those funds. The bankruptcy trustee opposed the surety’s claim to the funds and, as a result, the owner paid the funds into the court and let the court decide who owned them.
Contrary to the many decisions applying Pearlman as meaning that a construction surety’s rights to any withheld funds was superior to that of a bankruptcy trustee, the Glenbrook Group court determined that Pearlman did not apply for two reasons: (1) that Pearlman was decided prior to the passing of the current bankruptcy code (in 1978!) and therefore no longer applied, and (2) that Pearlman involved a federal project and the Glenbrook Group case did not. As described above, numerous courts have applied Pearlman after 1978 to non-federal projects and found that the surety was entitled to funds held by the owner. These many other decisions were not really addressed in Glenbrook Group.
The end result in Glenbrook Group was that the funds held by the owner were turned over to the bankruptcy trustee. The bankruptcy court’s decision is being appealed and it remains to be seen whether it will hold up. The one thing that is certain is that if the right of a surety to remaining project funds is eliminated, the risks faced by a surety increase substantially. While the Glenbrook Group decision may get overturned on appeal, it raises some serious potential practical issues related to collecting on bond claims. The best strategy for dealing with this potential shift in the law is to make sure that you pay particularly detailed attention to your bond claims and to strictly complying with every technicality when asserting that claim. The intersection of construction law and bankruptcy law continues to be a place full of uncertainty where predictability is nearly impossible and where sometimes one plus two seems to equal five. Adding any uncertainty into whether your claim was properly made only can add to that risk and uncertainty.
[1] 371 U.S. 132, 83 S. Ct. 232, 9 L. Ed. 2d 190 (1962).
[2] 529 B.R. 414 (Bankr. D. Mass 2015).
[3] 2015 Bankr. LEXIS 148 (Bankr. N.D. Ill. 2015).
[4] 2013 U.S. Dist. LEXIS 80512 (D.N.J. 2013).
[5] 2010 Bankr. LEXIS 984 (Bankr. W.D.N.Y. 2010).
[6] 370 B.R. 517 (S.D.N.Y. 2007).
[7] 2016 Bankr. LEXIS 2112 (Bankr. N.D. Ill 2016).