Form 13.5
Surety Objection to Use of Case Collateral
Surety Counsel
Name and Address
Attorneys for Surety
UNITED STATES BANKRUPTCY COURT
DISTRICT OF ______________
In re
Case No.:
Chapter 11
Principal,
Debtor.
LIMITED OBJECTION TO
DEBTOR’S EMERGENCY
MOTION FOR USE OF CASH
COLLATERAL
Hearing:
Date:
Time:
Place: U.S. Bankruptcy Court
Courtroom ___
Surety hereby files its Response in Opposition to the Debtor’s Emergency Motion for Use of Cash
Collateral on an Interim Basis Pending a Final Hearing (“Cash Collateral Motion”). .
MEMORANDUM OF POINTS AND AUTHORITIES
Surety’s Role
Surety is a licensed surety insurer in the State of __________. Debtor-in-Possession Principal and
Individual (collectively, “indemnitors”) are all bound to Surety as indemnitors pursuant to a [Date]
General Indemnity Agreement, attached as Exhibit “>.” Pursuant to this General Indemnity Agreement,
all of the indemnitors have promised to exonerate and indemnify Surety from any losses that Surety may
incur as a result of surety bonds written for Principal. Pursuant to the terms of this Agreement, Principal
also granted a security interest in certain assets to Surety. As Debtor’s Cash Collateral Motion
establishes, the security interest established under the General Agreement of Indemnity was perfected by
Surety by filing on [Date]. This admittedly perfected security interest has not been avoided.
More importantly, the Debtor and Surety agree that Surety holds rights of equitable subrogation to
receivables on bonded construction contracts, which rights are superior to the claims of all other parties
in this bankruptcy case as to those receivables.1
At the specific request of Principal and the other indemnitors, Surety wrote numerous surety bonds
pursuant to which Surety guaranteed performance and payment by Principal of its obligations on certain
construction projects in the State of __________. Principal has undisputedly defaulted on the payment
obligations guaranteed by the bonds. The outstanding bonds written by Surety for Principal include the
[Number] bonds specifically identified in the attached Exhibit “A.” Pursuant to these bonds, Surety
currently has exposure in the aggregate amount of $>.2
Principal has defaulted under the terms of the General Indemnity Agreement, has defaulted in its
obligations owed to bond obligees, and, finally, to its subcontractors and suppliers by failing to pay
amounts legitimately owed to these vendors. Principal’s Cash Collateral Motion and its other bankruptcy
filings in this case identify millions of dollars in undisputed amounts owed by Principal to these bonded
subcontractors and suppliers. Surety is obligated to pay numerous Principal subcontractors and
1
2
Debtor’s Cash Collateral Motion, p. >, and the discussion of Pearlman v. Reliance Insurance Company, 371 U.S.
132 (1962) on page 16 of the Motion.
The court in Liton Gen. Engineering Contractor, Inc. v. United Pacific Insurance, (1993) 16 Cal.App.4th 577, 20
Cal.Rptr.2d 200, outlined Liberty Mutual Surety’s position as surety for Debtor on public works projects as
follows:
Under the principle of sovereign immunity, mechanic's liens may not be asserted on government
projects. . . . The only remedies available on public works are . . . actions on public works
payment bonds (Civ.Code, §§ 3247–3252). Every original contractor to whom a public entity
awards a contract in excess of $25,000 for any public work must, before beginning the work, file a
payment bond with the public entity awarding the contract. (Civ.Code, § 3247). The payment
bond must be executed by “good and sufficient sureties.” (Civ.Code, § 3096) . . . In addition to
protection of the public entity from liability for a defaulting contractor, the purpose of the surety
bond is to provide a distinct remedy to public works subcontractors and suppliers of labor or
materials to public works projects. “[T]he surety's labor and materials bond (payment bond) has
uniformly been held to constitute a primary and direct obligation of the surety to the
subcontractors and materialmen without reference to the liability of the public works contractor—
the principal on the bond. [Citations.]” (Sukut–Coulson, Inc. v. Allied Canon Co. (1978) 85
Cal.App.3d 648, 654, 149 Cal.Rptr. 711.) Hence, Civil Code section 2807 holds a surety liable
immediately upon default of its principal.
Liton Gen. Engineering Contractor, 16 Cal.App.4th at 584, 20 Cal.Rptr.2d at 203 see also Powers Regulator Co.
v. Seaboard Sur. Co. of New York, (1962) 204 Cal.App.2d 338, 344-345, 22 Cal.Rptr. 373, 377 (“The purpose of
the bond provision of the Public Works Act . . . was to give to materialmen and laborers who furnish material for
and render services upon public works an additional means of receiving compensation.”) In summary, Surety
provides an essential function in California regarding public works to protect the unpaid subcontractors and
suppliers to Debtor on the projects for which Surety provided bonds.
suppliers, including [specific examples[. Surety will be making substantial additional payments in the
upcoming weeks to subcontractors and suppliers who have been left unpaid by Principal.
Surety’s Interest in Cash Collateral
Debtor’s Cash Collateral Motion suggests that only Bank holds a duly perfected security interest in
the assets of Principal. However, the principal asset of the Debtor, and the asset upon which the Debtor
intends to rely to fund its bankruptcy case (and seeks permission from this Court to use as cash
collateral), is the receivables from the construction contracts bonded by Surety. As Debtor notes in its
Cash Collateral Motion, under the United States Supreme Court authority of Pearlman v. Reliance
Insurance Company, 371 U.S. 132 (1962), and many, many subsequent state, federal, and bankruptcy
court decisions consistent therewith, the rights of Surety in the receivables from bonded construction
contracts are superior to the right of the Debtor-in-Possession, to Bank, and to any other party claiming
an interest therein. The Pearlman decision firmly establishes Surety’s immediate and superior rights to
all bonded contract funds. Surety’s rights are an “interest” in the funds, as that term is used in Section
363 of the Bankruptcy Code.3 Because Principal failed to meet its obligations under the bonded
contracts, and Surety is now obligated to pay the subcontractors and suppliers on the bonded projects,
Surety’s rights to the bonded contract funds are superior to the Debtor and all other creditors. See also,
In re Alliance Properties, 104 B.R. 306 (Bankr. S.D. Cal. 1989); see also In re Colt Engineering, Inc.,
288 B.R. 861 (Bankr. C.D. Cal. 2003). Accordingly, the interest of Surety in all proceeds of the bonded
contracts is entitled to adequate protection pursuant to § 363 (e) of the Bankruptcy Code.
In addition, to the extent that the Debtor seeks to use bonded contract receivables for the purposes
such as corporate insurance, loan payments, or to pay its attorneys, such uses violate the express trust
that exists on the bonded contract funds. By pre-petition agreement of the Debtor and Surety, the
General Indemnity Agreement impresses a trust on any bonded contract proceeds:
ELEVENTH: TRUST FUND – To the extent permitted under applicable law, the
Indemnitors and Principals covenant and agree that all of their interest, title and rights in
any contract or undertaking referred to in any Bond, or in, or growing in any manner out
of any Bond, including but not limited to payments for or on account of any contract,
shall be held as a trust fund and/or as a constructive or equitable trust in which the
Surety has an interest, and shall inure to the benefit of the Surety for any liability or loss
it may have or sustain under any Bond including but not limited to the payment of
obligations incurred in the performance of any contract and for labor, materials, and
services furnished in the prosecution of the work provided in any 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 covered by any
Bond are trust funds, whether in the possession of the Indemnitors or Principals or
otherwise, for the benefit of and for payment of all such obligations in connection
3
The interests protected by § 363 of the Bankruptcy Code include equitable, as well as legal interests. In re Maxon
Eng’g Serv., Inc., 332 B.R. 495, 498 (Bankr. D.P.R. 2005)(citing H.R. Rep. No. 95–598 at 338–40 (1977), U.S.
Code Cong. & Admin. News 1978, pp. 5963, 6294–97).
with any such contract for which the Surety would be liable under any Bond, said
trust also inures to the benefit of the Surety for any liability or loss it may have or
sustain under any Bond, under this Agreement, or under any Other Agreements, and this
Agreement constitutes notice of such trust. [Emphasis of trust purpose added]
As this Court is aware, property held in trust by a Debtor does not become a part of the bankruptcy
estate,4 and the provisions of the 11th paragraph of the General Agreement specifically establish and
impose on the bonded contract proceeds an enforceable trust.5
As is often the case, in the short time before hearing on the Debtor’s request for interim use of cash
collateral, Surety has had insufficient time to fully review the budget and cash flow projections provided
by the Debtor. Surety has requested supplemental information from the Debtor regarding the amounts of
payroll that actually advance the bonded construction contracts versus home office payroll, specifics of
the predicted timing of anticipated receipts, and regarding Debtor’s apparent intention to substantively
consolidate itself with a non-debtor to make use of that other company’s cash. While Debtor’s counsel
has been generally cooperative, Surety has not received this critical information at the time this
objection is prepared. Debtor bears a lofty burden to be permitted interim use of cash collateral, and
leaving the secured creditors without requested information should ordinarily result in a denial of the
requested use.
Adequate Protection
4
5
“The United States Supreme Court has stated that Congress had plainly excluded from the estate the property of
others held by the debtor in trust at the time of the filing of the petition. We stated in In re Gurs, 34 Bankr. 755,
757 (9th Cir. BAP 1983), that where the debtor possesses only a legal and not an equitable interest in property,
the equitable interest does not become part of the bankrupt estate. Other sections of the Code, such as Sections
548 and 547, cannot be used to allow a bankrupt estate to benefit from property that the debtor did not own.” In
re Torez, 63 Bankr. 751, 753-54 (Bankr. 9th Cir. 1986), aff'd, 827 F.2d 1299 (9th Cir. 1987); see also Begier v.
International Revenue Service, 110 S.Ct. 2258 (1990) (“A 'debtor' does not own an equitable interest in property
he holds in trust for another, that interest is not 'property of the estate,' nor is such an equitable interest 'property
of the debtor' for purposes of §547(b).”); United States v. Whiting Pools, Inc., 462 U.S. 198, 205 nt. 10, 103 S.Ct.
2309, 2314 nt. 10, 76 L.Ed.2d 515, 522 nt. 10 (1983)(“Congress plainly excluded property of others held by the
debtor in trust at the time of the filing of the petition.”); In re California Trade Technical Schools, Inc., 923 F.2d
641 (9th Cir. 1991) (funds held “in trust” were not property of the debtor for preferential transfer purposes).
In re Alcon Demolition, Inc., 204 Bankr. 440, 448-49 (Bankr. D. N.J. 1997)(court found elements of trust
established by terms of indemnity agreement.); Federal Ins. Co. v. Fifth Third Bank, 867 F.2d 330 (6th Cir.
1989)(court found funds held in trust from provision in bonded construction contract); In re Gonzales, 22 Bankr.
58 (Bankr. 9th Cir. 1982) (contractual provision validly created trust of contract funds). Indemnity agreement
trust provisions create an enforceable trust. In re Marques, 2006 WL 3850025, Case No. 05-31854-DWS (Bankr.
E.D. Pa. Nov. 30, 2006); In re Maxon Eng’g Serv., Inc., 2005 W.L. 2896958, Case No. 04-04781 (Bankr. D. P.R.
May 5, 2005) (indemnity language created trust under Puerto Rican law); see also In re Marrs-Winn Co., Inc.,
103 F. 3d 584 (7th Cir. 1996) (a trust provision in a subcontract met the requirements of a trust under Missouri
law); Matter of Jenkins, 110 B.R. 74 (Bankr. M.D.Fla. 1990).
Given the Debtor’s recitation of dire consequences if interim use of cash collateral is denied in its
entirety before final hearing, Surety understands the Court may desire to grant limited use. If the Court
will grant interim use, in observance of the mandate of Section 363(e), numerous bankruptcy courts have
conditioned use of cash collateral in a manner that was specifically designed to provide adequate
protection of the surety’s interest in bonded contract funds. These bankruptcy courts provided adequate
protection for a surety’s superior equitable interest in bonded contract funds by requiring that the funds
from each individual bonded project be segregated by the debtor-in-possession, and that the use by the
debtor of the bonded contract funds from a particular project be strictly limited to the direct job expenses
incurred in the performance of that same bonded project, and payment of claims for which the surety
could become liable. See, e.g., In re Ram Construction Company, 32 B.R. 758, 759 (Bankr. W.D. Pa.
1983); In re Glover Construction Co., Inc., 30 B.R. 873, 882 (Bankr. W.D. Ky. 1983); In re Maxon
Eng’g Serv., Inc., 332 B.R. 495 (Bankr. D.P.R. 2005)(surety has an equitable interest in bonded contract
proceeds; debtor permitted to use the funds, but only with adequate protection of the surety’s interest by
requiring proceeds be segregated and used on a job-by-job basis, not used by the debtor to satisfy
general obligations).
Debtor is already responsible to segregate cash collateral in its custody, possession, and control
pursuant to Section 363(c)(4). This Court should order that adequate protection of the surety’s interest
be given by segregation during the period of interim use. In this way, on an interim basis, the Court
could permit the debtor-in-possession to use the surety’s cash collateral, while protecting the surety’s
superior rights of equitable subrogation, as well as the surety’s trust fund rights, in the bonded contract
proceeds.
Conclusion
While Surety specifically reserves the right, with adequate notice and time, to file a full brief
establishing the factual and legal basis for its superior equitable interest in the bonded contract funds and
its trust fund rights, the Debtor’s own factual statements contained in the Cash Collateral Motion
regarding the existence of the indemnity agreement and regarding Surety’s role as a surety insurer that
provided the performance and payment bonds that enabled Principal to perform public projects furnish
the factual basis for a determination that Surety has an “interest” in the bonded contract funds; an
interest that is entitled to be adequately protected pursuant to the Bankruptcy Code.
Accordingly, Surety requests that the Court deny the Debtor-in-Possession any use of the bonded
contract funds on an interim basis. Surety does not oppose use of other cash collateral, which may be
subject to the unavoided UCC security interest of Surety, pending the final hearing on the Motion for
Use of Cash Collateral. If the Court will authorize any use of bonded contract proceeds on or before
[Final Hearing Date], then Surety asks this Court to provide adequate protection of its interest in the
bonded contract funds by conditioning use of cash collateral on the segregation of bonded contract funds
received by project, with specific limitation on the use of any such funds to direct performance expenses
of the same bonded contract for which payment was made by the obligee.
DATED ______________.
COUNSEL FOR SURETY
/s/