COMMERCIAL LENDERS AND TRADE CREDITORS OF THE COMMERCIAL CONSTRUCTION INDUSTRY – A NEW COURT RULING THAT ALTERS THE RIGHTS TO RETAINAGES.
When a construction contractor defaults on a loan with its lender, and, at the same time, a surety bond issuer is required to pay on a claim for the construction project, there has been some legal uncertainty as to the entitlement to any retainages at the conclusion of the construction project when the general contractor has entered a bankruptcy proceeding. A bankruptcy judge has issued a very detailed legal opinion on the topic of priorities as to retainage which will likely be widely followed by bankruptcy courts throughout the country which is important and significant for all lenders, trade creditors and suppliers of those in the commercial construction industry and issuers of surety bonds.
The following are the facts of the case:
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 as to the retainage was superior to the bank’s lien on the retainage.
The Court held as follows:
Although state law determines a debtor’s property rights, the Federal appellate courts have held that in bankruptcy cases, federal law governs the extent to which those property rights are estate property.
Combining the principles of state and federal law, the bankruptcy judge ruled that the retainage received before bankruptcy case was filed never became property of the contractor, and that the retainage received after bankruptcy became property of the estate subject to the surety’s right of equitable subrogation. In addition, the bankruptcy judge held that the right of subrogation was unaffected by the bank’s perfected security interest.
The bankruptcy judge 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.”
Why this is important:
Many times, lenders looked to a contractor's accounts receivable for collateralization of an outstanding loan. Also, trade creditors of contractors experiencing financial difficulty may believe that the project retainage will be available to them at the close of a project, not realizing that the surety on the project could have superior rights to those funds should a bankruptcy case be filed. This court ruling makes it clear that in bankruptcy cases, and possibly in non-bankruptcy cases, that neither the lender nor the creditors of the contractor in bankruptcy can prevail over the rights of a surety has to retainage. Thus, in assessing the collectibility of obligations of contractors, retainages are at risk in the event of a bankruptcy proceeding.