IN RE: LARBAR CORPORATION DEBTOR CASE NO. 93-50438

UNITED STATES BANKRUPTCY COURT 

EASTERN DISTRICT OF KENTUCKY

LEXINGTON

IN RE:

LARBAR CORPORATION

DEBTOR CASE NO. 93-50438

ROBERT J. BROWN, Trustee PLAINTIFF

V. ADV. NO. 94-5073

KENTUCKY CENTRAL INSURANCE COMPANY;

LIBERTY NATIONAL BANK OF LEXINGTON;

and BANK ONE, Successor DEFENDANT

MEMORANDUM OPINION

The plaintiff is the trustee in bankruptcy of the debtor, Larbar Corporation ("Larbar"), a corporation which was engaged as contractor or subcontractor in erecting highway guardrail.

The defendant, Kentucky Central Insurance Company ("Kentucky Central"), is surety on performance and payment bonds it issued for the benefit of entities contracting with the debtor.

The complaint of the trustee seeks, inter alia, to avoid as preferential the security interest of Kentucky Central in collateral pledged by the debtor to Kentucky Central to indemnify the surety against loss on bonds issued by the surety. It is the position of the trustee that the avoidance and preservation for the benefit of the bankruptcy estate of the security interest of Kentucky Central entitles the estate to the pledged collateral, in particular the receivables on construction contracts of the debtor. It is the position of Kentucky Central that even if its security interest in such receivables is avoided and preserved for the benefit of the bankruptcy estate, the surety is nevertheless entitled to the receivables under two theories of law, a surety's right of equitable subrogation and the fact that such receivables are trust funds for the benefit of the surety.

Both the plaintiff trustee and the defendant Kentucky Central have moved for summary judgment. This matter is submitted on Agreed Stipulations of Fact.

 

FINDINGS OF FACT:

During 1990 and 1991 the debtor Larbar Corporation, after having obtained recognition as a minority contractor, was awarded 2 federal and 27 state contracts, as either contractor or subcontractor, to erect guardrail at highway construction sites in Kentucky. Paragraph 4, Stipulations of Fact; Exhibit Nos. 30 and 34 to Stipulations of Fact.

On May 15, 1989, prior to being awarded the aforementioned contracts, Larbar had entered into an agreement of indemnity with Kentucky Central Insurance Company whereby Kentucky Central agreed to write surety bonds as required by construction contracts awarded to Larbar, guaranteeing Larbar's performance of the contracts and payment by Larbar for labor, materials and supplies utilized by Larbar in performing the contracts. Larbar agreed to indemnify Kentucky Central against any loss on such bonds.

To assure payment by Larbar as indemnitor of its obligations, indebtedness and liabilities to Kentucky Central, the indemnity agreement contains the following relevant provisions:

ASSIGNMENT

THIRD: The Contractor, the Indemnitors hereby consenting, will assign, transfer and set over, and does hereby assign, transfer and set over to the Surety, as Collateral, to secure the obligations in any and all of the paragraphs of this Agreement and any other indebtedness and liabilities of the Contractor to the Surety, whether heretofore or hereafter incurred, the assignment in the case of each contract to become effective as of the date of the bond covering such contract, but only in the event of (1) any abandonment, forfeiture or breach of any contracts referred to in the Bonds or of any breach of any said Bonds; or (2) of any breach of the provisions of any of the paragraphs of this Agreement; or (3) of a default in discharging such other indebtedness or liabilities when due; or (4) of any assignment by the Contractor for the benefit of creditors, or of the appointment, or of any application for the appointment, of a receiver or trustee for the Contractor whether insolvent or not; or (5) of any proceeding which deprives the Contractor of the use of any of the machinery, equipment, plant, tools or material referred to in section (b) of this paragraph; or (6) of the Contractor's dying, absconding, disappearing, incompetency, being convicted of a felony, or imprisoned if the Contractor be an individual: (a) All the rights of the Contractor in, and growing in any manner out of, all contracts referred to in the Bonds, or in, or growing in any manner out of the Bonds; (b) All the rights, title and interest of the Contractor in and to all machinery, equipment, plant, tools and materials which are now, or may hereafter be, about or upon the site or sites of any and all of the contractual work referred to in the Bonds or elsewhere, including materials purchased for or chargeable to any and all contracts referred to in the bonds, materials which may be in process of construction, in storage elsewhere, or in transportation to any and all of said sites; (c) All the rights, title and interest of the Contractor in and to all subcontracts let or to be let in connection with any and all contracts referred to in the Bonds, and in and to all surety bonds supporting such subcontracts; (d) All actions, causes of actions, claims and demands whatsoever which the Contractor may have or acquire against any subcontractor, laborer or materialman, or any person furnishing or agreeing to furnish or supply labor, material, supplies, machinery, tools or other equipment in connection with or on account of any and all contracts referred to in the Bonds; and against any surety or sureties of any subcontractor, laborer, or materialman; (e) Any and all percentages retained and any and all sums that may be due or hereafter become due on account of any and all contracts referred to in the Bonds and all other contracts whether bonded or not in which the Contractor has an interest.

 

TRUST FUND

 

FOURTH: If any of the Bonds are executed in connection with a contract which by its terms or by law prohibits the assignment of the contract price, or any part thereof, the Contractor and Indemnitors covenant and agree that all payments received for or on account of said contract shall be held as a trust fund in which the Surety has an interest, for the payment of obligations incurred in the performance of the contract and for labor, materials, and services furnished in the prosecution of the work provided in said contract or any authorized extension or modification thereof; and further, it is expressly understood and declared that all monies due and to become due under any contract or contracts covered by the Bonds are trust funds, whether in the possession of the Contractor or Indemnitors or otherwise, for the benefit of and for payment of all obligations in connection with any such contract or contracts for which the Surety would be liable under any of said Bonds, which said trust also inures to the benefit of the Surety for any liability or loss it may have or sustain under any said Bonds, and this Agreement and declaration shall also constitute notice of such trust.

 

UNIFORM COMMERCIAL CODE

 

FIFTH: That this Agreement shall constitute a Security Agreement to the Surety and also a Financing Statement, both in accordance with the provisions of the Uniform Commercial Code of every jurisdiction wherein such Code is in effect and may by [sic] so used by the Surety without in any way abrogating, restricting or limiting the rights of the Surety under this Agreement or under law, or in equity.

Kentucky Central delayed perfecting its security interest in the receivables and tangible assets of Larbar granted by the May 15, 1989 indemnity agreement. The agreement was belatedly filed as a financing statement in the office of the Fayette County Court Clerk on February 25, 1993.

By letter dated March 3, 1993 Larbar notified Kentucky Central that Larbar was unable to complete 13 of its construction contracts on which Kentucky Central had obligated itself as surety on bonds in the aggregate amount of $3,117,654.35. Exhibits Nos. 33 and 34 to the Stipulations of Fact. The letters requested that Kentucky Central take over those projects. By letter dated March 4, 1993 Kentucky Central notified Larbar that effective immediately Kentucky Central was taking over those projects for which Kentucky Central had provided bonds.

On March 16, 1993 Larbar filed its petition for relief under chapter 7 of the Bankruptcy Code. Robert J. Brown, the plaintiff in this adversary proceeding, is the duly appointed and qualified trustee in Larbar's bankruptcy case.

On May 12, 1993 Kentucky Central, by counsel, moved the court on an emergency basis to require the trustee to assume, reject or abandon the contracts listed on Exhibit 1 to the motion and the accounts receivable related thereto. The contracts identified in Exhibit 1 to the motion are identical to the 13 contracts which Larbar had previously notified Kentucky Central that Larbar was unable to complete. The motion of Kentucky Central was noticed for hearing on May 26, 1993.

In the interim between the date of the filing of the motion and the hearing thereon the 60-day period within which the trustee might have assumed these contracts as well as all of the other construction contracts of the debtor expired with the result that the contracts were deemed rejected by operation of law. 11 U.S.C. 365(d)(1).

The trustee's written response filed on the date of the May 26, 1993 hearing states that the trustee rejects the 13 contracts at issue, but that rejection of the contracts shall not constitute an abandonment of the receivables due the debtor under the contracts or other collateral in which Kentucky Central might be claiming a security interest. Exhibit 1 to Kentucky Central's motion indicates the debtor had accounts receivable totaling $111,258.46 on the 13 contracts but that most of the receivables had been attached by suppliers of materials to the projects.

On June 15, 1993 an order was entered finding that the 13 contracts as identified in Exhibit 1 to the order "are rejected." However, the order provides that the issue of whether Kentucky Central is entitled to set-off the net profit, if any, on one contract, against the net losses on other contracts is reserved pending the filing of a final proof of claim by Kentucky Central and a subsequent hearing before the court. Meanwhile, Kentucky Central was authorized to receive payments under and make disbursements related to the 13 contracts, and to execute documents, including releases, related to the contracts. The order is not tantamount to any order of abandonment of receivables of the debtor in general and does not purport to encompass other construction contracts of the debtor rejected by operation of law.

The parties have stipulated that of the contracts rejected by the order of June 15, 1993 only one (Grasso/Incisa U.S.A., Inc. Joint Venture), known as the Harlan Diversion Project, has thus far produced a profit in excess of the sums expended by Kentucky Central for completion of the project. The net profit realized upon completion of this project was $24,944.89.

The parties have stipulated there is an undetermined amount of contract proceeds receivable from the Kenton County project [IDR-IR-1-75-8(63)187] with respect to which the debtor was a subcontractor of the prime contractor Incisa U.S.A., Inc. This contract was rejected by the debtor pursuant to the order of June 15, 1993.

On May 25, 1990, with the acquiescence of Kentucky Central and Incisa U.S.A., Inc., the debtor executed a Financing Statement and Security Agreement whereby the debtor granted Bank of Lexington & Trust Company a security interest in and assigned to the bank the proceeds of the subcontract between the debtor and Incisa U.S.A., Inc. Exhibits 42 and 43 to the Agreed Stipulations of Fact. Bank of Lexington & Trust Company and its successor in interest by merger, Liberty National Bank of Lexington, did not cause the Financing Statement and Security Agreement executed by the debtor to be filed in the office of the Fayette County Clerk. Thus, the security interest of Liberty National Bank of Lexington in this receivable to secure payment of an indebtedness represented by notes, the latest of which is a note dated July 13, 1993 in the amount of $130,362.13 payable to Liberty National Bank of Lexington, was never perfected by filing. The defendant Bank One is successor in interest to Liberty National Bank of Lexington by merger. On August 17, 1995 an agreed judgment was entered in this adversary proceeding avoiding the lien of the aforementioned banks on this receivable of the debtor and preserving their lien for the benefit of the estate.

There is one other contract not covered by the order of June 15, 1993 which was not assumed by the debtor but was rejected by operation of law. This contract is identified as Johnson County SSP 058 0460 0009 on which Mountain Enterprises was prime contractor. Kentucky Central made no payments on the subcontractor bond it issued to the debtor on this contract. Mountain Enterprises has issued a check for $950.56 representing the profit made by the debtor on this contract.

The order of June 15, 1993 authorized Kentucky Central to collect and disburse funds only with respect to the 13 contracts identified in the exhibit to the order. Nevertheless Kentucky Central has collected and is holding monies earned by the debtor on contracts on which Kentucky Central made no payments on bonds it issued to the debtor on such contracts. These contracts include five of the contracts completed by the debtor prior to bankruptcy and the Johnson County contract on which Mountain Enterprises was prime contractor.

The order of the Commonwealth of Kentucky Transportation Cabinet entered November 3, 1993, authorizing payment to Kentucky Central of monies due the debtor on five of the contracts completed by the debtor prior to bankruptcy, on which Kentucky Central made no bond payments [Exhibit No. 45 to Agreed Stipulations of Fact], is void. The order, which exercises control over receivables of

 

the bankruptcy estate, was not authorized by the court. 11 U.S.C. 549.

 

CONCLUSIONS OF LAW:

The trustee's complaint seeks to avoid as preferential Kentucky Central's belatedly perfected security interest in the construction contract receivables and other assets of the debtor granted by the indemnity agreement of May 15, 1989. Kentucky Central has pleaded as a defense title 11 U.S.C. 547(c)(4). This section of the Bankruptcy Code precludes the trustee from avoiding a transfer of property of the debtor to a creditor as preferential, to the extent that, after such transfer, such creditor gave new value on an unsecured basis to or for the benefit of the debtor.

After bankruptcy, in fulfillment of its obligations under payment and performance bonds it had issued for the debtor, Kentucky Central paid, net of all receipts, $368,726.24 to satisfy prepetition obligations of the debtor to subcontractors, laborers, and materialmen on construction contracts on which the debtor had defaulted. These payments were to or for the benefit of creditors of the debtor or the project owners (the Commonwealth of Kentucky or the United States of America) rather than for the benefit of the debtor. The payments did not benefit the debtor or the estate of the debtor in that upon payment of these claims Kentucky Central became subrogated to such claims against the debtor's estate. Thus, the payments did not reduce the aggregate amount of the claims against the bankruptcy estate. The payments did not offset the preferential lien acquired by Kentucky Central by enhancing the prepetition value of the debtor's estate.

In any event, the enhancement of the estate, if any, occurred after bankruptcy. There is substantial authority for the view that new value advanced by a creditor after bankruptcy cannot be used to offset a preference received by the creditor prior to bankruptcy. Matter of Century Brass Products, Inc., 71 B.R. 77 (Bankr. D. Conn. 1987); In re Bellanca Aircraft Corp., 56 B.R. 339, 396-397 (Bankr. D. Minn. 1985), aff'd., 850 F.2d 1275, 1284 (8th Cir. 1988). Accordingly, the court concludes that the trustee's complaint to avoid as preferential the security interest of Kentucky Central in the contract receivables and other assets of the debtor granted by the indemnity agreement dated May 15, 1989 and perfected on February 25, 1993 should be sustained. Upon avoidance, the security interest of Kentucky Central in property of the debtor is preserved by operation of law for the benefit of the bankruptcy estate. 11 U.S.C. 551. But this is hardly the end of this matter.

The court agrees with the contention of Kentucky Central that under the doctrine of equitable subrogation when, on default of a contractor, a surety completes the work called for by a contract and pays all the bills related thereto, the surety's right to payments due the contractor under that particular contract, to the extent of any loss suffered by the surety on the contract, relates back to the date of the surety's issuance of bonds for the contract. The surety's right to the proceeds of the contract takes precedence over a subsequently acquired security interest in such proceeds, in this instance the security interest of Kentucky Central, which has been avoided and preserved for the benefit of the bankruptcy estate and on which the trustee's claim to the contract receivables of the debtor is based.

Under Kentucky law, when a surety fulfills its bond obligations by taking over and completing a construction contract, the surety does not have to comply with the provisions of the Uniform Commercial Code (UCC) governing secured transactions in order to prevail on its claim to some payments due the contractor under the contract as against a creditor holding a subsequently perfected security interest in proceeds of the contract. The surety's claim to the contract proceeds, to the extent of funds expended by the surety, is superior to that of a subsequent lien creditor, unless the surety has waived the priority accorded the surety under the doctrine of equitable subrogation in favor of such creditor. National Surety Company v. State National Bank of Frankfort, 454 S.W.2d 354 (Ky. 1970). For other cases pro and con on whether compliance with the notice filing provisions of the UCC is required in order for the surety to prevail, see Annotation Uniform Commercial Code - Article 9, 30 A.L.R. 3d 9, 39-41, Supplement, pp. 33-34. See also In re Construction Alternatives, Inc., 2 F.3d 670 (6th Cir. 1993). Unlike Ohio law on which the decision in Construction Alternatives is based, Kentucky law does not require compliance with the notice filing provisions of the UCC in order for the surety to prevail. Kentucky law, which is binding on the court in this case, accords the surety relief under the doctrine of equitable subrogation.

The State National Bank case recognizes an exception to a surety's right of equitable subrogation to the proceeds of a construction contract taken over by the surety where the surety has consented to assignment of the proceeds of the contract as security for a loan made by a subsequent lienholder. That is what happened with respect to one of the contracts involved in this case. Kentucky Central concurred in the assignment to Bank of Lexington & Trust Company of the proceeds of the subcontract between the debtor and Incisa U.S.A., Inc. on the Kenton County project [IDR-IR-1-75-8(63)187] as security for a loan in the amount of $200,000 which the bank made to the debtor. Kentucky Central waived its right of equitable subrogation on this contract to the extent of the balance due on this loan. The security interest of Bank of Lexington & Trust Company and its successors in interest in the proceeds of this subcontract having been avoided and preserved for the benefit of the bankruptcy estate by the agreed judgment of August 17, 1995, this lien claim must be satisfied as a condition to Kentucky Central's right of equitable subrogation to any of the proceeds payable to the debtor by Incisa U.S.A., Inc. on the Kenton County project.

The court disagrees with Kentucky Central as to the scope of the doctrine of equitable subrogation. The equitable relief accorded a surety under this doctrine does not entitle the surety to any profit on a contract the surety completes. Under the doctrine of equitable subrogation the surety is entitled to reimbursement from receivables due under the contract only to the extent of payments made by the surety in satisfaction of its obligations under a bond.

When, on default of a contractor, the surety completes and pays all the bills of the job, the surety stands in the shoes of the contractor insofar as there are receivables due on the contract; it stands in the shoes of laborers and materialmen who have been paid by the surety; and it stands in the shoes of the project owner, in this instance either the state or federal government. National Shawmut Bank of Boston v. New Amsterdam Casualty Co., Inc., 411 F.2d 843 (1st Cir. 1969).

However, in whichever of these shoes the surety stands, equity precludes the surety from retaining the profit on contracts it has bonded, and further precludes applying the profit on one contract to offset losses on other contracts bonded by the surety for the contractor. Glen v. American Surety Co., 160 F.2d 977 (6th Cir. 1947); Maryland Casualty Co. v. Murchison National Bank, 32 F.2d 48 (4th Cir. 1929); United States Fidelity & Guaranty Co. v. Worthington & Co., 6 F.2d 502 (5th Cir. 1925); KRS 412.080; Napier v. Duff, 281 Ky. 779, 136 S.W.2d 1083 (Ky. 1939). In order to reach the profit on contracts or other assets of the defaulting contractor the surety must hold a perfected, nonavoidable lien on such assets of the debtor. Aetna Casualty & Surety Co. v. Brunken & Son, Inc., 357 F. Supp. 290 (D. S.Dakota 1973). Unfortunately for the surety in this instance its lien that encumbers the proceeds of contracts on which a profit was realized and other assets of the debtor has been avoided and preserved for the benefit of the bankruptcy estate.

The trust fund theory advanced by the surety overlaps the

equitable subrogation theory and is irrelevant with respect to contract receivables awarded to the surety under the latter theory. Thus, the trust fund theory is relevant only with respect to any profit received or to be received by the debtor on contracts.

None of the funds constituting profit on contracts came into the possession of the debtor/contractor/indemnitor prior to bankruptcy. On the date of bankruptcy such funds had not materialized or were in the possession of the project owners or prime contractors who were not parties to the indemnity agreement. None of these funds had been set apart as trust funds nor were they identifiable at the time the trust instrument was executed. A trust is not created if the subject matter of the trust cannot be ascertained until a future time. Ridley v. Sheppard, 168 S.W.2d 550 (Ky. 1943).

The trust fund language of the indemnity agreement parrots that of the agreement considered in In re Construction Alternatives, Inc., 2 F.3d 670 (6th Cir. 1993), as set out in footnote 4 to the opinion of the court in that case.

For the reasons articulated in the Construction Alternatives case, the court finds that no express trust enforceable under applicable nonbankruptcy law, Kentucky law, was created under the facts of this case. 11 U.S.C. 541(c)(2). The judicial lien that arose in favor of the trustee under 11 U.S.C. 544(a) on the intervention of bankruptcy attached to the receivables of the debtor before the amounts due thereon became identifiable as trust funds.

 

Dated:

 

By the court -

 

 

 

__________________________

JOE LEE

CHIEF JUDGE

 

 

Copies to:

 

Ann E. Samani, Esq.

Philip A. Hanrahan, Esq.

William T. Shier, Esq.

Randy D. Shaw, Esq.

U. S. Trustee