State Bank & Trust Co. v. Insurance Co. of the West

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT
__________________________
No. 96-11214
__________________________
STATE BANK & TRUST COMPANY, DALLAS,
Plaintiff-Appellant,
versus
INSURANCE COMPANY OF THE WEST,
Defendant-Appellee.
___________________________________________________
Appeal from the United States District Court
For the Northern District of Texas
Dallas Division
___________________________________________________
December 29, 1997
Before REYNALDO G. GARZA, SMITH, and WIENER, Circuit Judges.
WIENER, Circuit Judge:
Defendant-Appellee Insurance Co. of the West (ICW), acting as
surety, issued performance bonds on behalf of DRT Mechanical Corp.
(DRT) —— a subcontractor —— on two construction projects. DRT had
previously given Plaintiff-Appellant State Bank & Trust Co. (State
Bank) a security interest in its construction tools, equipment, and
inventory (“construction materials”) as collateral for a loan. DRT
defaulted on both the loan and its construction contracts, after
which ICW used DRT’s on-site construction materials to complete the
projects. State Bank brought a conversion action against ICW after
it refused to compensate State Bank for use of the construction
materials in which State Bank held a perfected security interest.
State Bank appeals the district court’s order granting summary
judgment in favor of ICW. Concluding that the district court erred
as a matter of law in its application of the doctrine of equitable
subrogation, we reverse and remand.
I
FACTS AND PROCEEDINGS
State Bank loaned DRT $187,000 (Original Loan) in November
1991. DRT secured the Original Loan by pledges of personal
property in the form of construction materials. State Bank
perfected its security interest in the collateral by filing a Form
U.C.C.—1 with the Texas Secretary of State. In July 1993, DRT,
having paid down the Original Loan to an outstanding balance of
$142,946.98, pledged additional tangible personal property that
fell within the description of collateral in State Bank’s earlier-
filed U.C.C.—1. State Bank advanced DRT additional principal,
increasing the outstanding balance to $172,950.98.
In February 1994, State Bank loaned DRT $300,000 (Defaulted
Loan). To secure repayment of the loan, State Bank and DRT entered
into a commercial security agreement pursuant to which DRT gave
State Bank a security interest in “[a]ll inventory, chattel paper,
accounts, contract rights, equipment, general intangibles and
fixtures,” owned by DRT together with “[a]ll attachments,
2
accessions, accessories, tools, parts, supplies, increases and
additions” thereto. DRT paid off the Original Loan with a portion
of the proceeds of the Defaulted Loan. The security interest
created and perfected in connection with the Original Loan
continued in connection with the Defaulted Loan, and the November
1991 U.C.C.—1 filing remained effective throughout the District
Court’s jurisdiction over this matter.
DRT entered into subcontracts with two general contractors on
two different projects —— one with Clark-Morris Companies (Clark-
Morris), in December 1993, and another with Young Enterprises, Inc.
(Young Enterprises) in October 1994. Each subcontract authorized
the general contractor to use DRT’s construction materials to
complete its work on the project in the event it defaulted on its
obligations.
ICW and its sister surety company, Independence Casualty and
Surety Company, issued payment and performance bonds insuring
completion of DRT’s contractual obligations to Clark-Morris and
Young Enterprises. Under the terms of the performance bonds, the
obligees were to complete the projects in the event DRT defaulted,
and would be entitled to use DRT’s construction materials for that
purpose.
After construction of the projects had begun, DRT notified ICW
of DRT’s inability to complete the projects for which ICW had
issued performance bonds. At approximately the same time, DRT
ceased making the required payments to State Bank on the Defaulted
3
Loan. Following receipt of DRT’s acknowledgment of default, ICW
took over the projects to complete them. Substantial work remained
to be done on the projects, and ICW determined that using DRT’s job
site construction materials would provide the least expensive and
most expedient means of completion. As DRT had not paid its
suppliers for all its on-site inventory by the time ICW took over
the projects, ICW had to pay the remaining balance on such
inventory.
State Bank delivered a letter to DRT requesting that ICW
(1) enter into an “Agreement of Rental;” (2) procure insurance
covering the equipment and naming State Bank as loss payee; and (3)
pay two months rent at $10,000 per month. DRT forwarded the letter
to ICW, which refused to acknowledge State Bank’s claim to a
superior right to possess DRT’s property. State Bank notified DRT
of the acceleration of the loan and demanded that DRT assemble the
collateral for delivery to State Bank.
DRT informed State Bank that some of the requested collateral
—— specifically, job site construction materials —— remained in the
custody of ICW. State Bank’s president wrote to ICW demanding that
it account for and assemble DRT’s property and notify State Bank
that it could recover such property, but ICW refused State Bank’s
demand. After completing the projects, ICW tendered what remained
of DRT’s construction materials to State Bank, but it declined
ICW’s offer to turn over the property.
State Bank brought a conversion action against ICW in state
4
court, which action was removed to the district court based on
diversity of citizenship. State Bank filed a motion for summary
judgment as to liability and ICW sought summary judgment
disposition of the entire case. The district court denied State
Bank’s motion and granted ICW’s, holding that, under the doctrine
of equitable subrogation, ICW had a right superior to State Bank’s
to possess and use the collateral. State Bank timely appealed.
II
ANALYSIS
A. STANDARD OF REVIEW
A district court’s decision to grant summary judgment is
reviewed de novo, applying the same standards as the district
court.1 Summary judgment is appropriate when the evidence, viewed
in the light most favorable to the nonmoving party, presents no
genuine issue of material fact and shows that the moving party is
entitled to judgment as a matter of law.2
B. APPLICABLE LAW3
In the typical suretyship arrangement, a surety bonds a
contractor’s performance of its contract with a project owner. If
1
Melton v. Teacher’s Ins. & Annuity Ass’n of America, 114 F.3d
557, 559 (5th Cir. 1997).
2
River Prod. Co., Inc. v. Baker Hughes Prod. Tools, Inc., 98
F.3d 857, 859 (5th Cir. 1996)(citing FED. R. CIV. P. 56(c)).
3
The parties agree that Texas law applies in this diversity
case; however, to the extent that Texas law does not address an
issue, we look to federal law for guidance.
5
the bonded contractor defaults, forcing the surety to complete the
performance, the completing surety “has an ‘equitable right’ to
indemnification out of a retained fund.”4 The surety is subrogated
to the rights of the project owner/obligee so that the retained
contract price inures to the completing surety’s benefit.5 The
rationale for equitable subrogation stems from the notion that
those contract proceeds that are reserved for disbursement until
the contract’s completion are “as much for the indemnity of him who
may be a guarantor of the performance of the contract as for him
for whom it is to be performed.”6
The completing surety’s right of subrogation arises in equity,
as an outgrowth of the suretyship relationship itself;7 it is not
4
Pearlman v. Reliance Ins. Co., 371 U.S. 132, 138, 83 S. Ct.
232, 235, 9 L. Ed. 2d 190 (1962).
5
See Trinity Universal Ins. Co. v. Bellmead State Bank of
Waco, 396 S.W.2d 163, 168 (Tex. Civ. App. — Dallas 1965, writ ref’d
n.r.e.) (“It is . . . well settled in our law that the surety whose
funds go to discharge contractor's obligations is thereby
subrogated to the rights of the owner to apply the contract
balances to the completion of the project and payment of bills
incurred in that connection.”) (citations omitted). The completing
surety is subrogated to the rights of other parties to the bonded
project as well. A surety that fulfills a defaulting contractor’s
obligations is subrogated to the rights of (1) The contractor,
insofar as it is due receivables, (2) the materialmen and laborers
who may have been paid by the surety, and (3) the owner for whom
the project was completed. Nat’l Shawmut Bank of Boston v. New
Amsterdam Casualty Co., 411 F.2d 843, 845 (1st Cir. 1969).
6
Prairie State Nat’l Bank of Chicago v. United States, 164
U.S. 227, 239, 17 S. Ct. 142, 147, 41 L.Ed 412 (1896).
7
Trinity, 396 S.W.2d at 168.
6
dependent on assignment, lien, or contract.8 As such, the surety’s
right of subrogation is not a security interest and thus is not
subject to the filing requirements of U.C.C. Article 9.9
As noted, the district court held that by virtue of equitable
subrogation ICW was entitled to use DRT’s construction materials
located at the project sites to complete the construction,
notwithstanding State Banks’s pre-existing, perfected security
interest in those materials.10 In so holding, the court relied on
Interfirst Bank Dallas v. United States Fidelity and Guar. Co. as
controlling authority.11 The district court reasoned that (1)
8
Interfirst Bank Dallas v. United States Fidelity and Guar.
Co., 774 S.W.2d 391, 399 (Tex. App.—— Dallas 1989, writ denied).
9
Id. at 398; Shawmut, 411 F.2d at 845-46.
10
Although equitable subrogation typically arises in the
context of a surety’s bonding a general contractor’s performance of
its obligations to the project owner, that ICW bonded a
subcontractor’s performance of its obligations to general
contractors does not alter our analysis.
11
774 S.W.2d 391 (Tex. App. —— Dallas 1989, writ denied). In
Interfirst Bank, the surety bonded a subcontractor’s performance of
its contract with a general contractor. Id. at 393. The
subcontractor then obtained a loan, as collateral for which it gave
the lender a security interest in its accounts receivable. Id. at
393-94. The lender perfected its interest by filing. Id. at 394.
The subcontractor subsequently defaulted on its obligations and
both the lender —— seeking to realize on its collateral —— and the
surety —— through equitable subrogation —— claimed entitlement to
undisbursed progress payments and retainages withheld by the
general contractor. Id. The court held that the surety’s rights
to the contract proceeds were superior to the lender’s perfected
interest in the subcontractor’s receivables because the surety’s
right to equitable subrogation is not a security interest within
the purview of Article 9 of the U.C.C. and, as such, the lender
could not gain priority over the surety by perfecting its interest
in the contract proceeds. Id. at 398-99.
7
there is no conceptual difference between permitting a surety to
apply contract balances towards project completion and permitting
it to use the defaulting subcontractor’s tools, equipment, and
inventory for the same purpose, and (2) because, under Interfirst
Bank, a surety’s equitable right to contract proceeds has priority
over a secured creditor’s right to execute on its security interest
in the same proceeds, ICW’s right to use DRT’s construction
materials has priority over State Bank’s security interests in the
same property.
On appeal, State Bank argues that surety priority under
Interfirst Bank is limited to situations in which the surety and
the secured creditor make competing claims to contract proceeds;
that when, as here, the collateral on which the secured creditor
seeks to execute is tangible personal property, equity does not
entitle the surety to be equitably subrogated to its principal’s
rights in the property. In support of its argument, State Bank
maintains that, as between the surety and an assignee of the
contract proceeds, equitable subrogation gives the surety priority
because the assignee’s interest in the proceeds never becomes an
actuality. The assignee’s interest is derivative of the
assignor/contractor’s right to the proceeds.12 Also, until the
12
See Deer Park Bank v. Aetna Ins. Co., 493 S.W.2d 305, 306
(Tex. Civ. App. —— Beaumont 1973, n.w.h.) (“[T]he general rule is
that an assignee ... acquires no greater right than was possessed
by his assignor, and simply stands in the shoes of the latter.”);
Interfirst Bank, 774 S.W.2d at 397 (“[A]n assignee ... cannot take
8
assignor/contractor performs its contract, the
assignor/contractor’s right to the proceeds remains a mere
potentiality. Consequently, urges State Bank, the assignee has no
right to make a claim against the project owner/obligee until the
contractor/obligor has performed.13 State Bank observes that if the
assignee could claim entitlement to the proceeds notwithstanding
the contractor’s default, the assignee would enjoy a greater right
to the proceeds than would its assignor.
We agree that when tangible personal property —— distinct from
contract proceeds —— is at issue, the rationale for elevating the
surety over the secured creditor has no application. Unlike the
contractor’s inchoate or potential rights in the contract proceeds,
the contractor comes into the construction contract with present
and effective ownership and the right to possess and use its own
tools, equipment, and inventory. If the contractor has previously
given a creditor a security interest in these materials —— even
those subsequently acquired —— the creditor’s right to realize on
its collateral is not contingent on the contractor’s full
performance of its obligations.
As the creditor’s interest in its tangible collateral is not
greater rights than his assignor.”).
13
See Deer Park Bank, 493 S.W.2d at 306 (“While it is true that
a debt having a potential existence may be the subject of an
assignment, still such assignment is ineffectual in so far as the
potential debtor is concerned until such potential debt becomes an
actual debt.”) (quoting Alfalfa Lumber Co. v. City of Brady, 149
S.W.2d 204 (Tex. Civ. App. —— Austin 1912, no writ)).
9
derivative of the contractor’s right to collect payment under its
contract, the surety cannot claim an equitable right to possess and
use its defaulted principal’s construction materials to complete
the project that the surety has bonded. In fact, granting such use
at no cost would result in a windfall to the surety, who would thus
avoid the anticipated expense of providing materials necessary for
project completion.14
The courts that have considered this issue have held that
secured creditors holding perfected security interests in a
defaulting contractor’s tangible personal property retain their
priority over a completing surety’s equitable claims.15 ICW
responds that these cases, and their rationale, are inapposite;
that ICW is only claiming an equitable right to use DRT’s property
—— not an outright ownership interest in it —— whereas these cases
concern competing claims to proceeds from the property’s sale,
i.e., ownership interests. ICW notes that it offered to turn over
DRT’s construction materials to State Bank after completing the
project, but that State Bank refused. ICW argues that State Bank’s
security interest was still intact, so that if it believed that ICW
14
State Bank draws attention to one court’s conclusion that
extending the doctrine of equitable subrogation to tangible
personal property amounts to “nothing less than an appropriation of
a secured creditor’s collateral to reimburse the performing
surety.” Aetna Casualty and Sur. Co. v. J.F. Brunken & Son, Inc.,
357 F. Supp. 290, 293 (D.So.Dak. 1973).
15
Id.; United States Fidelity and Guar. Co. v. United Penn
Bank, 524 A.2d 958 (Pa. Super. Ct. 1987), appeal denied 536 A.2d
1333 (Pa. 1987).
10
had damaged the property or that the property had otherwise
decreased in value, State Bank should have brought a claim for such
diminution rather than conversion.16
ICW cites no authority in support of its “right to use”
argument. It justifies its position with nothing more than the
bald assertion that “[f]undamental fairness dictates that the
surety use the defaulting contractor’s tools and equipment to
minimize loss and expense,” and that “to hold otherwise would deny
ICW the right to minimize the cost of resolving DRT’s default.”
ICW’s argument is misguided. The surety’s right to contract
proceeds flows not from cost minimization considerations but from
“the common sense proposition that the contract retainage funds
would never become available to any creditor unless the surety
completed the project.”17 On the other hand, when collateral
16
In addition to suffering from the infirmities noted below,
ICW’s “right to use” argument fails to account for the inventories
that were consumed in the projects’ completion —— which inventories
cannot be returned to State Bank —— as well as the equipment and
tools, if any, whose economic lives were exhausted through ICW’s
use. Moreover, as State Bank notes, ICW’s contention is
inconsistent with the position it took in refusing DRT’s and State
Bank’s requests to surrender the collateral. ICW gave no
indication that its detention of the property was temporary and
that it ultimately intended to surrender possession of the
collateral. Rather, ICW claimed that its rights were “paramount to
all others’ including secured lending institutions” and that it had
“paramount rights to the contract balances, and claims, and
materials, and tools, and equipment on the job site.” ICW did not
offer to return that portion of the collateral which had not been
either consumed in the projects or otherwise disposed of until five
weeks after State Bank brought this action.
17
In re Merts Equip. Co., 438 F. Supp. 295, 297 (M.D.Ga. 1977).
11
consists of tangible personal property, the surety’s completion of
the contract is not a condition precedent to the conception of the
collateral itself; rather, the creditor who holds a perfected
security interest in a contractor’s tools, equipment, and inventory
may execute on its collateral regardless of whether the contractor
has performed its obligations to third parties. Thus, equity need
not intervene to elevate the surety over the secured creditor, as
“the surety has done nothing with respect to [the tools, equipment,
and inventory] which raises up in the surety an equity superior to
that of later judgment creditors.”18
We hold that ICW obtained no equitable rights in DRT’s
construction materials by virtue of either its own contract with
DRT or DRT’s subcontracts with the general contractors, Clark-
Morris and Young Enterprises. As subrogee of the general
contractors, ICW has rights that are derivative of theirs and
therefore can be no greater.19 Inasmuch as State Bank perfected its
security interest in DRT’s property some two years before DRT
entered into its subcontracts with Clark-Morris and Young
Enterprises, State Bank’s interest in the property takes priority
over their unperfected, conditional assignments in the
subcontracts. Likewise, State Bank has priority over ICW’s after-
acquired assignment from DRT in its performance bonds.
18
United Penn Bank, 524 A.2d at 965 (quoting In re Merts 438
F. Supp. at 298).
19
Guillot v. Hix, 838 S.W.2d 230, 232 (Tex. 1992).
12
III
CONCLUSION
For the foregoing reasons, the district court’s grant of
summary judgment is reversed and this case is remanded for further
proceedings consistent with this opinion.
REVERSED and REMANDED.
13