TWENTY NINTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS

Transcription

1 TWENTY NINTH ANNUAL SOUTHERN SURETY AND FIDELITY CLAIMS CONFERENCE Clearwater Beach, Florida th th APRIL 18 & 19, 2018 A SURETY'S PRIMER ON BANKRUPTCY PRESENTED BY: RICHARD A. FULTON COATS ROSE, P.C. 9 Greenway Plaza, Suite 1000 Houston, Texas (713) RON WILLS CAPITOL INDEMNITY CORPORATION 1600 Aspen Commons, Suite 300 Middleton, Wisconsin (770) rwills@capspecialty.com

2 A SURETY S PRIMER ON BANKRUPTCY I. INTRODUCTION AND OVERVIEW Bankruptcy is an inconvenience for all those involved. A company or individual files for bankruptcy protection under the United States Code because something has gone wrong. In a construction context, it could be the owner is not paying the general contractor. It could mean the owner is having financial difficulties. It could be that the general contractor is having financial difficulties and is unable to pay its bills. Every surety professional has at some point had to deal with the bankruptcy of either a principal or obligee on a project. This paper will address, in general, the most relevant topics for the surety. A. Notice The bankruptcy starts out with a notice sent out to creditors pursuant to 11 USC, et seq. That notice will inform the creditor, and other concerned parties, of the status of the bankruptcy and under what chapter it is sought. Chapter 7 bankruptcies usually would involve no assets, or very few assets, and the company is basically shutting down and liquidating. A Chapter 11 and Chapter 13 bankruptcies involve some hope of reorganization, and some of the bills being paid. This will all be explained in the notice that the surety, or other interested parties receive from the bankruptcy court. B. Bankruptcy in General and the Automatic Stay Bankruptcy law has developed as a means of individuals and legal entities being able to start over following financial distress. Bankruptcy allows for companies to take a certain level of risks, knowing if they fail, they can start over through bankruptcy. However, bankruptcy means there are creditors that are not going to be paid, or be paid a small portion of what they are due. The surety finds itself involved in bankruptcy when one of the parties to a bonded job, seeks bankruptcy protection. For example, if an owner runs out of money, and cannot pay the general contractor, it may file for bankruptcy protection. For the surety, and for the principal on the bond, it brings about potential claims in the bankruptcy court, along with the concerns for the financial stability of the principal. Clearly, if the principal files for bankruptcy protection, the surety may have payment and performance bond claims to which there is no real hope of reimbursement. The most important thing to note in bankruptcy is that once the bankruptcy case is open, everything is subject to an automatic stay. In other words, once the debtor files for bankruptcy protection, no further action can be taken against that debtor outside of the bankruptcy court proceeding itself, without the bankruptcy judge s permission. C. Obtaining Information This paper will also explore how to obtain information in bankruptcy proceedings. There are legal methods for obtaining information in bankruptcy, to try and determine the location of or the extent of assets of the bankruptcy debtor. D. Trust funds \

3 Another issue that arises in bankruptcy matters concern trust funds. If the principal on the bond has taken possession of construction proceeds, many states treat those funds as trust funds, and not property of the general contractor s estate. To be sure, the surety would seek to recover those trust funds, to use to offset losses on the payment performance bonds. E. Preference claims Preference claims are unfortunate for those targeted by bankruptcy trustees. A preference claim occurs when a bankruptcy trustee attempts to claw back money recently paid to any particular creditor. There are many defenses to preference claims, which will be discussed below. II. AUTOMATIC STAY A. What is the automatic stay? The automatic stay is what happens when the Obligee files for bankruptcy protection. 11 U.S.C. 362(a), which contains eight (8) subparts. Subsection (a) provides, in pertinent part, as follows: a. Except as provided in subsection (b) of this section, a petition filed under section 301, 302, or 303 of this title.... operates as a stay, applicable to all entities, of i) the commencement or continuation, including the issuance or employment of process, of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title; ii) iii) iv) the enforcement, against the debtor or against property of the estate, of a judgment obtained before the commencement of the case under this title; any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate; any act to create, perfect, or enforce any lien against property of the estate; v) any act to create, perfect, or enforce against property of the debtor any lien to the extent that such lien secures a claim that arose before the commencement of the case under this title; vi) any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the case under this title; \

4 vii) viii) the setoff of any debt owing to the debtor that arose before the commencement of the case under this title against any claim against the debtor; and the commencement or continuation of a proceeding before the United States Tax Court concerning a tax liability of a debtor that is a corporation for a taxable period the bankruptcy court may determine or concerning the tax liability of a debtor who is an individual for a taxable period ending before the date of the order for relief under this title. B. What and/or Who Does the Automatic Stay Cover? As a general rule, the automatic stay will prevent taking the following action against the Debtor/contractor without first obtaining relief from the stay, i.e. an order from the bankruptcy court allowing the pursuit of the stayed action: Lawsuits against the debtor/contractor 11 U.S.C. 362(a)(1) Termination of the debtor/contractor s contract and/or declaring the contractor in default and/or seizing the contractor s property 11 U.S.C. 362(a)(1), (2), (3) Setoff of funds owed by an Obligee to the debtor/contractor under one contract against obligations of the debtor/contractor under a different contract U.S.C. 362(a)(7) Acts to create, perfect, or enforce any lien against property of the estate (but see section 362 (b) (3) discussed infra, as an exception) C. What and/or Who Does The Automatic Stay Not Apply to? The exclusions of the automatic stay are found in 11 U.S.C. 362(b) which has 24 subparts. The vast majority of the exclusions have no bearing on the typical owner/contractor/surety relationship and pertain more to criminal proceedings, domestic matters, tax proceedings with the government, and certain leases of commercial property that have been terminated pre-petition. As such, 11 U.S.C. 362(b) will not be repeated here with the exception of 11 U.S.C. 362(b)(3). a. 11 U.S.C. 362(b)(3) provides: (b) The filing of a petition under section 301, 302, or 303 of this title.... does not operate as a stay (3) under subsection (a) of this section of any act to perfect, or to maintain or continue the perfection of, an interest in property to the extent that the trustee s rights and powers are subject to such perfection under section 546 (b) of this title or to the extent that \

5 such act is accomplished within the period provided under section 547 e (2)(A) of this title; Despite the stay under subsection (a)(4), subsection (b)(3) allows subcontractors to file their lien affidavits in the county records provided that they do so in accordance with the time period provided by applicable state law. b. Other actions which the automatic stay does not prevent include the following: (i) Actions against non-debtor parties, such as a guarantor or surety See Arnold v. Garlock, Inc., 278 F.3d 426 (5th Cir. Tex. 2001); see also GATX Aircraft Corp. v. M/V Courtney Leigh, 768 F.2d 711, 716 (5th Cir. 1985); Carway v. Progressive County Mut. Ins. Co., 183 B.R. 769, (S.D.Tex. 1995) (ii) Surety s drawing on a letter of credit The beneficiary of a letter of credit is not barred by the automatic stay from drawing on the letter of credit simply because the account party is in bankruptcy. See In re Kmart Corp., 297 B.R. 525, 529 (N.D. Ill. 2003); see also PNC Bank, N.A. v. Spring Ford Knitting Co., Inc. (In re Spring Ford Indus., Inc.), 338 B.R. 255 (E.D. Pa. 2006); Letter of credit, as well as the proceeds therefrom, is not considered property of the bankruptcy estate as defined in 11 U.S.C. 541 (a)(1). In re San Jacinto Glass Industries, Inc., 93 B.R. 934, 937 (Bankr. S.D.Tex.1988). D. Motion to Lift the Automatic Stay pursuant to Bankruptcy Rules 4001 and 9014 When the automatic stay applies, and the surety wishes to pursue a claim for property or cash outside of the bankruptcy court, the surety will have its lawyers file a Motion to Lift the Automatic Stay Pursuant to the Bankruptcy Rules 4001 and These types of motions are pursued when there are assets that could be tied to the bankrupt principal or obligee that the surety should be able to obtain outside of the debtor s estate. Perhaps the surety would like to pursue some equipment, or trust funds in possession of the debtor. The surety cannot do this unless they have the bankruptcy court s permission, thus the Motion to Lift the Automatic Stay. It is a simple motion, routinely granted \

6 III. OBTAINING INFORMATION A. Meeting of the Creditors Once a Principal files for bankruptcy protection, the U.S. Trustee overseeing that particular bankruptcy will set a date for a Meeting of the Creditors pursuant to 11 U.S.C Section 341 reads as follows: 1. Within a reasonable time after the order for Relief in a case under this title, the U.S. Trustee shall convene and preside at a Meeting of Creditors. 2. The U.S. Trustee may convene a meeting of any equity security holders. 3. The court may not preside and may not attend, any meeting under this section, including final meeting of creditors. Notwithstanding any local court rule, provision of a state constitution, any otherwise applicable nonbankruptcy law, or any other requirement that representation at the Meeting of Creditors under subsection (a) be by an attorney, a creditor holding a consumer debt or any representative of the creditor (which may include an entity or employee of an entity and may be a representative for more than one creditor), shall be permitted to appear at and participate in the Meeting of Creditors in a case under Chapter 7 or 13, either alone or in conjunction with an attorney for the creditor. Nothing in this subsection shall be construed to require any creditor to be represented by an attorney at any Meeting of the Creditors. 4. Prior to the conclusion of the Meeting of Creditors or equity security holders, the Trustee shall orally examine a debtor to ensure that the debtor in a case under Chapter 7 of this title is aware of a) The potential consequences of seeking a discharge in bankruptcy, including the effects on credit history; b) The debtor s ability to file a petition under a different chapter of this title; c) The effect of receiving a discharge of debts under this title; and d) The effect of reaffirming a debt, including the debtor s knowledge of the provisions of section 524(d) of this title. 5. Notwithstanding subsections (a) and (b), the court, on the request of a party in interest, and after notice in the hearing for cause may order that the U.S. Trustee not convene a Meeting of the Creditors or equity security holders if a debtor has filed a plan as to which the debtor solicited an acceptances prior to the commencement of the case. See 11 U.S.C What this all means is that in Chapter 7 and 13 bankruptcies, the U.S. Trustee (almost always, by and through an appointed, private sector trustee), will convene a meeting of the Creditors. In this Meeting of the Creditors, the individual debtor or representative of the corporate debtor will sit at a desk, or similar device, alongside the trustee. The trustee will ask all the requisite questions as stated above, and also questions relevant \

7 to the particular case in hand. The trustee will also give those in attendance the opportunity to ask questions or make statements. The surety may need to make a determination about the economic feasibility of attending a 341 Creditors Hearing. However, if the surety is aware of irregularities on behalf of the bankrupt principal, or may have some information regarding the location of assets, the business practices of the principal, the construction projects being undertaken by the principal, etc., the surety may want to attend the 341 Hearing to make sure the trustee is aware of the situation, and can act to appropriately protect assets. The actual procedural rule dealing with Meetings of the Creditors or equity security holders is found in Federal Rule Bankruptcy Procedure This particular rule deals with Chapter 7, 11, 12 and 13 bankruptcies, and generally states the duties of the trustee. B. Bankruptcy Rule 2004 General Examination There are other papers in this Conference that discuss the Federal Rule of Bankruptcy procedure 2004 Examination. However, it is appropriate to address in this paper as well, albeit briefly. The Rule 2004 Examination is designed to cover the acts, conduct or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor s estate, or the debtor s right to discharge. See Federal Rule of Bankruptcy 2004(6). The debtor can be compelled to attend the hearing, which is often taken at the Federal Courthouse in a spare courtroom, as there may be many parties in attendance. If the debtor is resisting to showing up for the Rule 2004 Examination, the court can order the attendance of the debtor. The Rule 2004 Examination is basically a deposition of the main person involved with the debtor, whether it be an individual, or a principal of a corporate entity. Unlike the Meeting of the Creditors, which is somewhat of an informal meeting, the 2004 Examination takes on the appearance of a full blown deposition or court appearance. The debtor must answer, under oath, the questions posed, or refuse the answer on the grounds that he/she may incriminate themselves. In addition to asking questions at the 2004 Examination, a request for the production of documents can also be involved in the same proceedings. While the list is not exhaustive, some of the documents that would be beneficial to conducting a 2004 Examination would be as follows: 1. Recent financial statements; 2. Bank account statements; 3. Construction contracts in place at the time of the bankruptcy; 4. The principal s copies of payment and performance bond claims; 5. All construction related documents, such as permits, subcontracts, drawings, engineer notes, daily reports, and all similar data; 6. Job cost details and reports; 7. A general accounting for each construction project undertaken by the principal; \

8 8. All pay applications submitted on every project; The same type of documents that would be requested in a general litigation should also be sought before the Rule 2004 Examination. At the Rule 2004 Examination, counsel for the surety can participate in asking relevant questions on each of the matters listed above, and any other area the surety deems relevant. Often, the surety is interested in at least attempting to have the debt owed to the surety non-dischargeable in bankruptcy. While non-dischargeability is difficult, there are certain circumstances where nondischargeability may actually be an option. For instance, if the surety suspects that the principal has utilized funds (in many states using trust funds), on matters other than the projects, document production, and questions in that area may assist in having the debt declared non-dischargeable. Generally, the strategy in conducting a Rule 2004 Examination is to plan ahead the areas that are important to the surety, and focus on those questions and document requests that will assist the surety in not only obtaining money in the bankruptcy, but protecting the assets that rightfully belong to the surety under the General Indemnity Agreement. While it is likely, by the Rule 2004 Examination, the surety has requested the court lift the automatic stay with regard to the surety taking over the bonded construction projects, and any funds from these projects, using the 2004 Examination to bolster any pending motions to lift the automatic stay may be necessary. All in all, the surety can obtain a great deal of information in a bankruptcy proceeding by utilizing the Section 341 Meeting of the Creditors (Federal Bankruptcy Procedure Rule 2003), and by conducting the more extensive examination under Federal Bankruptcy Rule Finally, the adversary proceeding are much more complicated, expensive, but potentially a more effective method of recalling funds back into the estate, or claiming those funds for the sole use of the surety. C. Fraud and Fraudulent Transfers Clearly, the surety should be concerned about fraud and fraudulent transfers in a bankruptcy setting. There are essentially two types of fraud and fraudulent transfers within the context of a bankruptcy court. First, is a simple common law fraud. If the debtor has committed out and out fraud, and caused financial harm to someone outside of the bankruptcy proceeding, the defrauded person or entity should file an adversary proceeding, seeking to have the principal declared unable to be discharged because of this intentional conduct. An additional fraudulent transfer notion comes up in bankruptcy court, as statutorily, the trustee can try to recover funds that were fraudulently transferred to third parties within a certain time period preceding the bankruptcy. Unfortunately, this particular fraudulent transfer statute, which is found in 11 USC 548 is not necessarily actually fraudulent. It is more akin to payments made during a time frame leading up to the bankruptcy \

9 D. The Adversary Proceeding Pursuant to 11 USC 523 Often times, differences between the surety and the principal must be litigated through an adversary proceeding. An adversary proceeding is essentially a lawsuit that is brought against the bankrupt debtor ancillary to the main bankruptcy action. See 11 U.S.C In an adversary proceeding, the surety would file a specific complaint against the principal to determine something that cannot be handled in the normal bankruptcy setting. For example, a reason for an adversary proceeding may be that the surety has information the principal has secreted funds, has undisclosed assets or property, or somehow committed fraud. Often, the trustee does not have the time or assets to pursue all of these areas of inquiry. However, the surety may have extra incentive. One of the main reasons for filing an adversary proceeding would be a situation where the surety suspects the principal has conducted fraud or fraudulent transfers or some other violation of 11 U.S.C Under this particular bankruptcy code provision, the bankruptcy court can disallow dischargeability in certain situations. Most notably, a discharge can be denied when money, services, etc., are withheld or obtained by false pretenses or fraud. See 11 U.S.C. 523(a)(2). There are many different aspects of this type of fraud, and the surety can file an adversary proceeding seeking to affect the dischargeability of certain debts, such as amounts owed under the General Indemnity Agreement, for some of the acts or transgressions listed in the statute. For example, a fraudulent transfer may be the transfer of a significant sum of money to a principal insider for some illicit purposes, or simply to avoid payments to the surety. In that instance, counsel for the surety can file an adversary proceeding in the bankruptcy court seeking to deny dischargeability for the funds that were illicitly transferred. If those funds are solely the property of the surety under the General Indemnity Agreement, the surety may be able to obtain all of those funds. However, more likely result is the funds would simply be put back into the pool of money available to all claimants. It is an economic decision to determine if the surety wants to go to that expense. IV. USING THE DEBTOR S PROPERTY IN BANKRUPTCY A. Principal s/debtor s Property During the Automatic Stay Once again, the Motion to Lift the Automatic Stay is important in trying to use and maintain the debtor s property while in bankruptcy. Once again, the debtor, in this situation would be the principal on the payment and performance bonds. Normally, when a payment or performance bond is made, the surety can do many things to protect its own interest. First, the surety, in performance bond and many payment bond situations, would send a notice letter to the obligee requiring that the obligee no longer pay the principal, and advise the obligee the surety will be taking over the funds on the project. Next, the surety would evaluate payment bond claims, take inventory of all equipment, and contract balances, meet with the obligee, and determine the status of the contract in general. Further, the consultant or the representative of the surety would begin the evaluation of the payment bond claims. Finally, the surety in performance bond situations would need to make a determination of allowing the \

10 principal to complete the project, or whether it would be more appropriate to enter into agreement with yet another contractor. However, when a bankruptcy situation arises, all of these situations cannot take place outside the presence of the Bankruptcy Rules of Procedure, and Federal Bankruptcy Law. Therefore, in many situations, if the surety has unobstructed ownership of all of the principal s construction assets, as would be outlined in the General Indemnity Agreement, a Motion to Lift the Automatic Stay may be appropriate. The Motion to Lift the Automatic Stay must be done swiftly, as the construction projects often come with a time is of the essence requirement. Further, the principal s equipment, trailers, and subcontracts need to be rapidly addressed in order to avoid costly delays. These circumstances can only be met with a proper and timely Motion to Lift the Automatic Stay. Under the General Indemnity Agreement, the surety has the right, upon default, to completely take over the principal s operations, funds and contracts. In a bankruptcy setting, this can only be done with the bankruptcy court s permission. A request for adequate protection in the bankruptcy court is essential in fulfilling the obligations of the surety. Without asking the court to lift the automatic stay as to the surety s obligations, and the principal s assets with regard to the various construction projects, the surety will have to go out-of-pocket for all payment and performance bond claims for funds that were not seized before the bankruptcy action took place. Further, it is also a very rare occurrence where the principal notifies the surety that it intends to file for bankruptcy protection, which makes the utilization of the lifting of the automatic stay essential. B. Utilizing the Motion For Relief From the Automatic Stay for the Purpose of Utilizing Equipment and Property of the Debtor Assuming that the surety analyzes the above questions and decides that it is in the surety s best interest to take possession of the contract balances, it is this writer s preferred approach to file a Motion for Relief from the Stay with the bankruptcy court requesting that the court order the obligee (not in bankruptcy) to turn over the contract balances. In that the bonded contractor has an interest in the contract proceeds, they arguably constitute property of the estate to which the automatic stay applies and an order from the bankruptcy court is required before any further action can be taken against those proceeds. This approach would likely be used where there is some urgency to paying claims, finishing uncompleted work, and preventing the dissipation of the contract funds. C. Payment Bond Claims Outside of the bankruptcy context, when faced with a suit by a payment bond claimant in which their principal/bonded contractor is not joined, sureties will generally insist on requiring that their principal be joined in the same suit. In Texas, a surety can be sued alone if bonded contractor/principal files bankruptcy. However, once the bonded contractor files bankruptcy, the payment bond claimant should be aware that it is not required to join the bonded contractor. TEX. CIV. PRAC. & REM. CODE (b) provides several exceptions, most notably, the notoriously insolvent exception \

11 See generally Nichols v. International Harvester Credit Corp., 533 S.W.2d 896 (Tex. Civ. App. San Antonio 1976) (suit against guarantor alone permitted since maker of note in bankruptcy); and Brooks v. American Nat l Bank 103 S.W.3d 246, 250 (Tex. Civ. App. Beaumont 1937, writ dism d) (bankruptcy establishes insolvency). The filing of a petition in bankruptcy by a surety s principal will not toll the statute of limitations in connection with a suit against the surety. In Roylex, Inc. v. Langston Bros. Constr. Co., Inc., 585 S.W.2d 768 (Tex. Civ. App. Houston [1st Dist.] 1979, writ ref d n.r.e.), the court made it clear that because [the predecessor of] TEX. CIV. PRAC. & REM. CODE (b) permitted the filing of suit against a surety when the surety s principal filed bankruptcy, limitations was not tolled as to the surety. V. EFFECT OF THE PAYMENT BOND CLAIMANTS WHEN THE BONDED CONTRACTOR/PRINCIPAL FILES BANKRUPTCY If the surety wishes to seek reimbursement under its agreement of indemnity, it can still pursue the indemnitors if they are not part of the bankruptcy proceeding, and thus not subject to the automatic stay. For example, if a corporate entity principal filed for Chapter 7 Bankruptcy protection, the surety could look to the indemnitors (generally the owners of the bankrupt principal), for reimbursement. Naturally, the indemnitors would like to be included in the automatic stay, but there is little legal precedents for doing so. See Credit Alliance Corp. v. Williams, 851 F.2d 119 (4th Circ. 1988). If the indemnitors would like to be included in the automatic stay afforded to causes of action against the bankrupt principal, they should consider including themselves in the bankruptcy proceeding. Otherwise, the principals are likely to be held accountable under the terms of the general indemnity agreement. VI. PREFERENTIAL PAYMENT CLAIMS A. What are Bankruptcy Preferential Payments? Bankruptcy preferential payments are active grounds for litigation in the construction and surety world. In a nutshell, preferential payments are any payments that were made by the bankruptcy debtor, to any third party vendor, or outside source, in the 90 days leading up the bankruptcy filing. Generally, all sureties and contractors will be the target of a preferential payment allegation if payments or transfers were made within 90 days of the bankruptcy filing. As stated above, the pot of money from which most claimants seek to recover comes from those funds retained by the trustee. The trustee has a single-minded interest in increasing the size of its pot. Preferential payments and the recovery of preferential payments are often seen as a profitable way to make the pot grow. Generally, bankruptcy preferential payments become the focus of an adversary action filed by the bankruptcy trustee against some or all individuals and entities that received payments from the bankruptcy debtor in the 90 days leading up to the filing of the bankruptcy. This type of litigation is costly, often involving several parties, and can appear to be a war of attrition. There are many different defenses to a preferential payment allegation in an adversary proceeding. These defenses will be identified below, and the major defenses will be discussed in detail \

12 B. The Applicable Bankruptcy Code Provisions, see 11 USC 547 Preferential payments made under federal bankruptcy law are generally described in 11 U.S.C. 547(b). 1 The requirements the trustee must meet in order to successfully prosecute a preference claim are: 1. The property that was transferred must have been one in which the debtor had some interest; 2. The transfer of the property (i.e., payments) must have been made to the creditor, or in some way benefited the creditor; 3. The payment to the creditor must have been in payment of an antecedent debt owed by the bank principal to the creditor before the transfer was made; 4. The transfer must have been made while the debtor was insolvent; and 5. The transfer of funds or payments must have left the creditor better off than if the transfer or payment had not been made and the creditor had simply asserted its claim in the Chapter 7 bankruptcy. In order to succeed in a preference action, the Trustee must prove all five (5) elements. 2 The principle behind preference payments, as they are defined in the bankruptcy code, stem from the goal of the bankruptcy court, wherein all creditors are to be treated as equals within their class. 3 Targets of preference payments adversary proceedings would rarely deserve this process as fair and equitable. C. The Debtor Must Have an Interest in the Property at Issue, see Begier vs. IRS, 110 S Ct. 2258, 2263 (199), see also in re IT Group, Inc. 326 BR (Bankr. D. DEL. 2005) The first element necessary for the Trustee to prove its preference action is that the property or payment transferred from the Debtor to the Creditor (in this case the Surety) must have been one in which the Debtor held an interest. 4 Preference actions are usually based upon payment of money or money equivalents, or a payment of the debt in some manner. In the context of a Surety, or a payment bond claimant, the payments are generally cash. However, preference payments could take just about any form, and are not necessarily limited to cash. As a Surety, payments made from a bankrupt Obligee to one of its contractors could conceivably be the subject matter of a preference payment U.S.C. 547(b). 2 See also, T.B. Home Sewing Enterprises, Inc. v. Tulip Production, 173 B.R. 782 (Bankr. N.P. Ga., 1993). 3 See Begier v. IRS, 110 S.Ct. 2258, 2263 (1990). 4 The general scope of the debtor s bankruptcy estate includes legal and equitable interests of the debtor in property at the time the suit is filed. If the debtor does not have any equitable interest in property he holds in trust for another, then this interest is not property of the estate, and the funds should not be utilized to generally pay creditors. Begier v. IRS, 110 S.Ct. 2258, 2263 (1990) \

13 D. Payments Benefited the Creditor, see Webster v. EI Cane Construction, Inc. 204, Bankr. WL (Bankr. D.D.C. 2004) The second required element of a preference action, on behalf of the bankruptcy trustee, requires the payment made to the creditor actually does benefit the Creditor. An interesting question crops up in this area because of the particular relationship between Obligee and Surety. Is the Surety a creditor? More likely than not, the Surety would be considered a Creditor because when the Obligee paid construction proceeds to the Surety, it would benefit the Surety as an offset to payment and performance bond claim payments that may be made in the future. However, these are counter-arguments to that approach. In this scenario, the Surety would have received payments from the Obligee because the Principal is in default, or the Principal received payments for work performed. An argument can be made that pre-petition payments made on behalf of an Obligee to the Surety or Principal, were nothing more than the Surety acting as a conduit for payment to payment bond beneficiaries. 5 In one case, the court rejected a contractor s argument that it was merely acting as a pass-through for payments to subcontractors and vendors. This Court held the contractor did retain some of the funds itself as profits, and pointed out the contractor did exercise dominion and control over the contract proceeds in order to discharge its own contractual obligations to pay its subcontractors. 6 Analogizing this to a Surety situation, the court will likely hold that payments made on behalf of the Obligee to the Surety or Principal, pre-petition would constitute payments made to a Creditor, and benefiting a Creditor. However, the Surety can avoid the preference action by successfully arguing that it had taken control of the construction fund proceeds and was entitled to confiscate related items under its General Agreement, the statutory requirements, or the bond. Similarly, the third requirement of a preference claim, is that the payment must have been made of, or on account of an antecedent debt owed by the Debtor to the Creditor before the transfer was made. This term antecedent debt simply means a debt that existed before payment was made. Logically, if payment was made from the Obligee to the surety under the General Agreement of Indemnity, the debt would have existed before the payment was made. However, once again, the Surety may successfully argue the payments were not a debt, and were nothing more than an assignment of proceeds as described above. E. When is the Principal Insolvent? See 11 USC 101 (32) and 547 (F) The fourth element of a successful preference action by the Trustee would require a showing that the principle debtor was insolvent when the alleged preference payment was made. If the Surety can show that the Principal was solvent when the payments were made, then the Trustee would fail in its preference action. The term insolvent means a financial condition where the sum of an entity s debt is greater than all of the 5 See, generally, Webster v. E.I. Kane Construction, Inc., 2004 Bankr. WL (Bankr. D.D.C.2004). Where bankruptcy law deals with property rights governed by state law, federal courts will look to the state law and state court cases to determine what are the property rights. Chicago Board of Trade v. Johnson, 44 S.Ct. 232 (1923). 6 Id \

14 entity s property, at a fair valuation, exclusive of exempt property, or property that was transferred, concealed or removed with the intent to hinder, delay or defraud such entity s creditors. 7 There is a statutory presumption of insolvency on and during the 90 days immediately preceding the filing of the petition for bankruptcy. 8 The presumption is all the Trustee needs to utilize, unless the Surety or another Creditor can show that the bankrupt principal was in fact solvent during this time period. If a Creditor, such as the Surety, does come forward with some evidence of solvency, the Trustee loses the benefit of the presumption and has to prove its case. Closely monitor the principal s financial condition during any time period leading up to bankruptcy. If a catastrophic event occurred, and bankruptcy quickly followed, an accounting expert can be utilized to prove the bankruptcy estate was solvent during the relevant time period. Likewise, if the principal has been operating in a deficient situation, and borrowing from one job to pay another, the insolvency/solvent issue may not be the best defense. F. The Creditor Must Be Better Off if it Made its Claim in the Bankruptcy Proceeding The final requirement under the Bankruptcy Code to successfully prosecute a preference claim concerns the fact the payment must have left the Creditor better off than if the payment had not been made and the creditor had asserted its claim in the Chapter 7 liquidation. 9 Clearly, the surety, if it is to claim that it is entitled to the funds outside the bankruptcy estate pursuant to the General Agreement of Indemnity, or is avoiding the preference action on that basis, will be better off with its payment, than it would be if the funds were simply included in a Chapter 7 liquidation pot. However, the analysis is not quite that simple. For example, the Surety is no better off if it simply required property it had a right to receive under its General Agreement of Indemnity or by statute. Both the insolvency and liquidation issues will probably require expert accounting testimony. For a payment bond beneficiary claimant, this issue becomes quite important as the payment bond beneficiaries have been denied their rights to file payment bond claims, as they had already been paid. 10 Likewise, the surety could argue that pre-petition payments made under the General Agreement of Indemnity were funds that it could have sought directly from the Owner (presumably at some point this did take place), if the principal s accounts were not confiscated directly. 7 See 11 U.S.C. 101(32). 8 See 11 U.S.C. 547(f). 9 See 11 U.S.C. 547(b)(5); and see also the test for this element established by the Supreme Court in Palmer Clay Products Company v. Brown, 56 S.Ct. 450(1936); see also, Elliot v. Frontier Properties, 778 Fed.2d 1416 (9th Cir. 1986). 10 See Cunningham v. T&R Demolition, 301 B.R.195 (Bankr. N.D. Tex. 2003). In that particular case, the court agreed that the subcontractor was not better off than it would have been under the Chapter 7 liquidation, as he could have filed a bond claim against the Debtor s surety if the payment had not been made. See also Webster v. E.I. Kane Construction, Inc., 2004 Bankr. WL (Bankr. E.D.C.2004) (the opposite occurred in that particular case) \

15 In any event, pursuing the insolvency and liquidation defenses would require, in most cases, expensive expert opinions, and should be pursued if feasible, with an eye towards some other defenses that may in fact hold better chances of success. VII. DEFENSES TO PREFENCE CLAIMS A. Were the Principal s Payments in the Ordinary Course of Business? Determining if the potential preference payments were made in the ordinary course of business is generally the leading defense in the preference action. The ordinary course defense is available to a Creditor and permits the Creditor to retain transfers made from the Debtor to the Creditor during the preference period. 11 However, three requirements are necessary to prove this exception to the avoidable transfer: 1. The payment was made for a debt incurred in the ordinary course of business of the parties; 2. The payment was made in the ordinary course of business of the parties; and 3. The payment was made in accordance in the ordinary business terms. 12 The preference rule and the ordinary course of business exception to the preference rule are intended to balance the interest of the Debtor and the Creditor. 13 A Third Circuit Court of Appeals quote states very clearly this principle: On the one hand the preference rule aims to ensure the Creditors are treated equitably, both by deterring the failing Debtor from treating preferentially its most obstreperous or demanding Creditors in an effort to stave off a hard ride into bankruptcy, and by discouraging the creditors from racing to dismember the Debtor. On the other hand, the ordinary course exception to the preference rule is formulated to induce Creditors to continue dealing with the distressed Debtor so as to kindle its chances of survival without a costly detour through, or humbling ending in, the sticky web of bankruptcy. 14 This stated principle indicates that bankruptcy law favors an attempt at avoidance of bankruptcy, by encouraging continued business dealings with the potential bankruptcy debtor. Along these lines, the debt incurred, and eventually paid needs only to have been occurred in an ordinary manner, based on the consistency with other business 11 See, In Re Forklift LP Corp., 340 B.R. 735 (Bankr.D.Del., 2006). 12 Id at 738. See also, In Re Fred Hawes Organization, Inc. (Logan v. Basic Distribution Corp.), 957 Fed.2d 239, 243 (6th Cir. 1992). 13 Id. 14 In re Molded Acoustical Products, Inc., 18 F.3d 217, 219 (3d Cir.1994) \

16 transactions between the parties. 15 Likewise, a transaction between the parties can be ordinary even if it occurs only occasionally between the parties. 16 The factors to determine if payments were made in the ordinary course of the parties business, include (1) the length of time the parties engaged in the type of dealing at issue; (2) whether the subject payments were in the amount more than usually paid; (3) whether the payments at issue were tendered in a manner different from previous payments; (4) whether there appears to be an unusual action by the Debtor or the Creditor to collect or pay the debt; and (5) whether the Creditor did anything to gain an advantage (such as gain additional security in light of the Debtor s deteriorating financial condition. 17 When the parties have a long history of business together, the court can look at the history of dealings; but where the parties have a shorter history of dealings, the Creditor is required to put on more extensive evidence of the industry standards. 18 For example, a pattern of late payments can establish ordinary course of business between the parties. 19 Clearly, expert testimony would be required to prove the standards of the industry in determining if a payment was made in the ordinary course of business. In the Third Circuit Court of Appeals, for example, the Court requires the Creditor to establish a range of terms that would be ordinary for firms similar in some general way to the Creditor. 20 This subjective look at the industry standards will require exact expert opinion. B. Were the Principal s Payments Trust Funds? The trust fund issue has been raised defensively in preference actions all across the country, with varying results. This area of the law generally refers to the notion that the bankrupt principal (such as the general contractor) did not actually own the funds paid to either the Surety, or vendors and subcontractors, therefore, precluding the preference action filed by the Trustee. In many states, the Construction Trust Fund Doctrine is codified expressly by state statute. 21 In many other states, the Construction Trust Fund theories and principles have been adopted through common law and equity principles. 22 Regardless of whether the construction trust funds scheme is statutory, or based upon common law and equity principles, the theory can be used to quash the ability of the Trustee to recover preference payments made during the preference period. 15 Id. citing, In re Valley Steel Corp., 182 B.R. 728, 735 (Bankr.W.D.Va.1995). 16 See J.P. Fyfe, Inc. of Florida v. Bradco Supply Corp., 891 F.2d 66, (3d Cir.1989). 17 Id. citing, In re Parkline Corp., 185 B.R.164, 169 (Bankr.D.N.J.1994). 18 Id. citing, In re U.S. Interactive, Inc., 321 B.R. 388, (Bankr.D.Del.2005). 19 Id. citing, In re Big Wheel Holding Company, 223 B.R.669, 674 (Bankr.E.Del.1998). 20 See, In re Molded Acoustical Products, Inc., 18 F3d 217, 226 (3d Cir.1994). 21 See generally, Selby v. Ford Motor Co., 590 F.2d 642 (6th Cir.1979); Carrier Corp. v. J.E. Schecter Corp., 347 F.2d 153 (2d Cir.); and Georgia Pacific Corp. v. Sigma Service Corp., 712 F.2d 962 (5th Cir.1983). 22 See generally, United States v. Durham Lumber Co., 80 S.Ct.1282 (1960). See also, Chicago Board of Trade v. Johnson, 44 S.Ct. 232 (1923) \

17 One bankruptcy court, in generally discussing the trust fund issues and theories, in the context of preference payments, placed a great deal of emphasis on the fact that trust fund laws in the various states impose duties upon the owners and contractors to make sure that all subcontractors and vendors are paid with the construction loan proceeds. 23 The Trust Fund Doctrine is not uniformly followed through all jurisdictions, in exactly the same manner. The bankruptcy practitioner should be able to advise on a state by state, and case by case basis if the Trust Fund defense is viable, for either a Surety, or another claimant. C. The New Value Defense A defense that may not necessarily be something the Surety could utilize, is the concept of new value. A new value defense can be found at 11 U.S.C. 547(c)(4). 24 Under this defense, payments to a creditor during the preference period can be compared to goods or services supplied by him during the same period without regard to the sequence of events. If the creditor is paid more than he supplied, the difference would be an avoidable transfer. However, if the creditor was paid less than he supplied there is no avoidable transfer. 25 In short, if there is basically a contemporaneous exchange between a vendor or supplier and the principal during the preference period, the new value defense can be utilized. While this type of defense does not have many practical applications to the Surety, it needs to be discussed in the event the situations arise in the bankruptcy court. In order to receive protection under the bankruptcy code, the creditor must have supplied new value to the debtor. Id. 11 U.S.C. 547(c)(4). This defense is somewhat difficult to utilize, but nevertheless should be considered if applicable. D. Can a Bond Claim be Revived After a Successful Preference Action? After all the defenses have been put forth, and the preference action is completed, one singular question can remain. Can a subcontractor or vendor, who failed to make a bond claim during any of the statutorily prescribed periods, revive its bond claim if it fails in its defense of a preference action. The answer is not easy. It is likely that a bankruptcy court could not revive a bond claim if it was never filed during any statutory prescribed period. The potential bond claimants paid by the principal during the preference period, are simply out of luck with regard to their bond claims if they are unsuccessful in defending the preference claim action by the Trustee. On the other hand, the fact they were denied the opportunity to make a bond claim should remove the claim from a preference characterization. However, an interesting situation may arise if a bond claim was properly perfected by a claimant, and then seemingly extinguished when the principal made the payment during the preference period. Can a bond claim that was actually timely filed, then seemingly 23 See generally, Bethlehem Steel Corp. v. Tidwell, 66 B.R. 932 (Bankr.M.D.Ga, 1986) U.S.C. 547(c)(4). 25 See, Garland v. Union Electric Co., 19 B.R. 920 (Bankr. E.D.Mo. 1982) \

18 extinguished come back to life? The answer to that question has not been fully adjudicated, and will be decided on a case by case basis. One way for a potential payment bond claimant to protect itself, would be to have any payments made, after filing a bond claim, subject to an agreement by the Surety, that it will honor the bond claim, if the payments made by the principal are later the subject of a successful preference action. Claimants would need to utilize a great amount of foresight in obtaining this type of agreement, or may do it as a matter of course when receiving payments from a principal after a bond claim is timely filed. To the diligent payment bond claimant which regularly calendars all notice requirements, there is perhaps nothing more unsettling than the holding in St. Paul Travelers Insurance Company v. Century Asphalt Materials, 529 F.3d 313 (5th Cir. 2008). Century Asphalt Materials involved a common scenario in the construction industry, one in which a bonded general contractor (GC) paid his subcontractors prior to the filing of a petition in bankruptcy. The checks did not clear until after the filing of the bankruptcy petition. Ultimately, the Chapter 7 Trustee filed an adversary proceeding seeking the return of the payments as unauthorized post-petition transfers. After returning the funds, the subcontractor filed an adversary complaint in bankruptcy court against the St. Paul, the contractor/debtor s surety, asserting a claim under Chapter 2253 of the Texas Government Code. The bankruptcy court granted summary judgment in favor of the subcontractor, despite the fact that the subcontractor clearly missed the deadline to send the statutorily required notice under Chapter The bankruptcy court reasoned that: 1) substantial compliance is all that is necessary to perfect a claim under Chapter 2253 and as long as the subcontractor provided notice within the time period after it returned the funds to the Trustee, it substantially complied; and 2) it could apply equitable tolling because the case fell within the category of extraordinary circumstances that made it impossible for the claimant to timely assert its claim. Needless to say, St. Paul appealed to the District Court which reversed in favor of St. Paul. On appeal to the Fifth Circuit, Century Asphalt urged the Fifth Circuit to construe Chapter 2253 liberally in favor of payment bond claimants and reverse in its favor, holding that it substantially complied with the requirements of Chapter In refusing to do so, the Fifth Circuit stated: We are persuaded that no matter how liberally we construe Chapter 2253, it does not contain a notice exemption for bond claims on payments that were avoided in bankruptcy. Even if the bankruptcy court's order had the effect of reverting the parties to their original positions, as if Contractor Technologies had never paid Century, Chapter 2253's notice provisions are grounded in the date of delivery, not in the date of payment or failure to pay. Chapter 2253 requires that the notice be mailed on or before the 15th day of the third month after each month in which any of the claimed labor was performed or any of the claimed material was delivered. The result of Century Asphalt Materials may seem particularly harsh to subcontractors and suppliers who elected not to assert a payment bond claim or even send the surety a notice because they were paid by the bonded contractor and saw no need to do so. If nothing else, Century Asphalt Materials is a lesson to those dealing with the bonded \