Performance Bonds And Priority Of Article 9 Security Interests

Posted in on March 13, 2014

The current recession has been particularly difficult for the construction industry. With some projects faltering and credit tight, property owners, contractors and lenders are struggling to assess risk. For construction projects where completion is secured by a performance bond, it is important to understand the basic legal rights of all those concerned.

Generally, when a surety issues a performance bond it requires a contractor to assign or grant a security interest in all payments owed to the contractor by the owner. Under the Uniform Commercial Code (UCC), the surety would have to file a financing statement to perfect its right to receive funds owed under the contract in the event the contractor defaults. Without such a filing, the surety’s security interest in contract receivables would be subordinate to the rights of any secured lender with a financing statement on record. However, sureties rarely if ever file a financing statement or record a general indemnity agreement in order to perfect a security interest.

Rather than rely on the UCC and the law of contracts, sureties rely on the equitable doctrine of subrogation. Equitable subrogation rights are not security interests covered by Article 9 of the UCC; therefore, a financing statement is unnecessary to establish priority over secured lenders. Upon default, the surety first subrogates to the rights of the contractor. As a result of equitable subrogation, a surety has a well established right to receive contract payments and ultimately retainage in order to complete a defaulting contractor’s construction obligations. Upon completion of the project, the surety may then step into the shoes of the owner to assert a general unsecured claim against the contractor for any remaining deficiency.

Banks and their attorneys must understand that a blanket security interest perfected under Article 9 does not extend to contract proceeds and retainage where the work is covered by a performance bond. A secured lender’s claim is subordinate to the equitable claims of a surety, even where the lender extended credit to the contractor in order to fund operations necessary to complete a project. A subordination is necessary to gain priority over a surety with respect to contract proceeds; however, such arrangements are very rare.

The doctrine of equitable subrogation is quite broad. In limited circumstances a surety may assert a claim to funds due to a principal under other construction contracts with the same owner. Such a claim is based on the contractor’s right of set-off against the owner. The bankruptcy code does not defeat a claim of equitable subrogation. A trustee in bankruptcy may not claim contract proceeds where a surety has a claim based on equitable subrogation. Funds due to a contractor on a bonded project are simply not part of the bankruptcy estate if the surety had equitable rights prior to the bankruptcy filing. Federal law limits the applicability of equitable subrogation with respect to contracts with the federal government, but that issue is beyond the scope of this article.

Lenders are therefore cautioned against establishing a credit facility based on a contractor’s accounts receivables if the contractor performs a substantial amount of bonded work. A lender with a perfected blanket security interest may only look to other secured assets to satisfy a credit default. Under current case law, equitable subrogation rights do not extend beyond contract proceeds and retainage. Therefore, a lender need not be concerned with a pre-existing unrecorded indemnity agreement with respect to the lender’s priority over other assets. So long as a lender ensures proper execution of a security agreement and proper perfection/priority of its security interest under Article 9, its claim will remain superior to any surety, except with respect to contract proceeds and retainage covered by a performance bond.