A Discussion of the Effect of the Insolvency of a Construction Company on the Priorities of a Secured Creditor

• Publication year: 2016
• Citation: Vol. 2016 No. 2
• Author: James C. Bastian, Jr. and Melissa Davis Lowe

A Discussion of the Effect of the Insolvency of a Construction Company on the Priorities of a Secured Creditor

James C. Bastian, Jr. and Melissa Davis Lowe

James C. Bastian, Jr. is a partner at Shulman Hodges & Bastian LLP (the "Firm") in Irvine, California. Mr. Bastian specializes in Commercial Law and Bankruptcy and has handled all aspects of litigation, mergers and acquisitions, trustee, creditor's rights, creditor's committee, and the representation of debtors in the insolvency context. He heads the Firm's Bankruptcy and Reorganization department. Mr. Bastian joined the Firm in 1995 after serving as a judicial law clerk to the Honorable Kathleen T. Lax, United States Bankruptcy Judge for the Central District of California.

Melissa Davis Lowe is a partner at Shulman Hodges & Bastian LLP in Irvine, California, practicing in the Bankruptcy and Reorganization department. Ms. Lowe earned her J.D. in 2006 from Loyola Law School in Los Angeles and earned her Tax LL.M. from Loyola Law School in 2008.

I. Introduction

This article will discuss what happens to creditor priorities when a construction company engaged in public works projects is insolvent or seeks bankruptcy protection. In the last three to four years, countless construction companies engaged in public works projects have found themselves in dire financial straits, with many ending up in bankruptcy proceedings. Many of these companies had validly perfected secured debts owed to institutional lenders and banks of all sizes. While these lenders believed that they held valid first priority liens against all assets, including accounts receivable, they have often unwittingly found themselves effectively holding a junior lien, or worse, holding claims that are totally unsecured.

As discussed in further detail below, a construction company engaged in a public works project is often required to post a surety bond to secure the performance of those contracts and the payment of all job related expenses, including sums owed to subcontractors and suppliers. If the construction company defaults in payment or performance, the surety steps in and effectively becomes the first priority lien holder against all assets related to that particular project. In that circumstance, if you are a secured lender or a trustee in bankruptcy, your rights and priorities may not be what you think.

II. Discussion

A. Relationship Between Contractor and Surety

When a contractor bids on a public works project¹and is successful in obtaining the contract, the contractor must insure its work and payment of expenses through a surety. Because the owner of the real estate where the work is to be completed is a governmental entity or agency, it is required to have certain protections in place to ensure the project is completed. A contractor must thus obtain surety bonds to insure completion of the project and payment of all project related expenses. In fact, the Miller Act² specifically requires that contractors on federal government projects in excess of $100,000 post bonds guaranteeing both performance under the contract and payment under the contract. The purpose of the Miller Act is essentially to provide the surety a lien right that would otherwise be available on a non-public works project. Likewise, California law requires a payment bond on a "public works contract involving an expenditure in excess of twenty-five thousand dollars."³

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The surety and the contractor will typically enter into the following contracts to meet the requirements imposed on a public works contractor: (1) Performance Bond; (2) Payment Bond; (3) General Indemnity Agreement; and (4) Commercial Security Agreement. The Performance Bond ensures that the work promised to be performed by the contractor will in fact be completed. If the contractor fails to complete the work, the surety will step in and ensure that the work is completed through its own contractors.⁴ The Payment Bond ensures that all payments to subcontractors and suppliers will be made, even if the contractor fails to do so.

In exchange, the surety obtains indemnity rights through a General Indemnity Agreement ("GIA") and also equitable subrogation rights as a matter of law.⁵ The GIA typcially includes an assignment clause such that, in the event of the contractor's default, all assets, including but not limited to accounts receivable, equipment, machinery, and trust funds related to the project, will be assigned and transferred to the surety. In addition, the GIA makes clear that all funds due under the contract are trust funds, held for the benefit of the surety.

The surety will also usually obtain a Commercial Security Agreement whereby the contractor grants the surety a security interest in all assets of the contractor relating to the project and, sometimes, all assets of the contractor generally. Although infrequent, the surety may also file a UCC-1 to perfect its security interest in intangibles and other personal property assets.

B. Contractor Defaults

So what happens when a contractor runs into financial difficulty and defaults on the project by failing to make required payments under its contract? In many cases, the contractor will have several different types of creditors, including a lender with a security interest in all of the contractor's assets, perfected by a properly filed UCC-1, unpaid vendors, subcontractors and employees, and unions and employees with claims for unpaid employee benefits.⁶ Perhaps most importantly, a surety will have claims under the GIA. In particular, the surety will have subrogation and assignment rights that may have priority over the secured claim of the lender and claims of other creditors.

1. Surety

In order for the surety to have a valid right of subrogation, there must be the following: (1) existence of an obligation of the debtor to the surety; (2) failure of the debtor to perform; (3) rights in the surety arising from the debtor's failure to perform; and (4) performance by the surety of the obligation that the debtor failed to perform.⁷ In California, the requirements are slightly elevated, and include: (1) payment...