Form 13.7
Motion Relief from Stay - Bonded Contract Completion
Surety Counsel
Name and Address
Attorneys for Surety
UNITED STATES BANKRUPTCY COURT
DISTRICT OF ___________
Case No.:
Chapter 11
In re
Principal,
Debtor.
MEMORANDUM OF POINTS AND
AUTHORITIES IN SUPPORT OF MOTION
TO LIFT STAY TO PERMIT SURETY TO
PERFORM OBLIGATIONS UNDER
PERFORMANCE BOND
Hearing:
Date:
Time:
Place: United States Bankruptcy Court
Courtroom ___
Surety hereby moves this Court in accordance with Sections 362(d)(1) and 362(d)(2) of the
Bankruptcy Code to lift the automatic stay to allow it to perform its obligations under its performance
bond with respect to the [Identify Contract] (“Bonded Contract”) As allowed under the General
Agreement of Indemnity (“GAI”) signed by Principal. Under § 362(d)(2), Principal’s performance under
the subcontract will not benefit the estate because, as a bonded contract, Principal has no right to the use
such funds other than for the bonded project and, therefore, the subcontract is not necessary for an
effective reorganization, even presuming Principal shows it has the ability to reorganize, something it has
been unable to do to date.
Additionally, under § 362(d)(1), cause exists to lift the stay because of pre-petition defaults by
Principal whereby the subcontract was assigned to Surety and is therefore not property of the estate. The
stay should be lifted for cause under § 362(d)(1).
I. OPERATIVE FACTS
On [Date], Principal signed a General Agreement of Indemnity (“GAI”) in favor of Surety. A copy of
the GAI was attached as __________. Under that GAI, Principal promised to exonerate and indemnify
Surety from any losses that Surety may incur as a result of surety bonds written for Principal.
In reliance on Principal’ express covenants under the GAI, and at the specific request of Principal,
Surety wrote numerous surety bonds (the “Bonds”) pursuant to which Surety guaranteed performance and
payment by Principal of obligations on certain construction projects in the State of _________________.
The Bonds written by Surety for Principal were specifically identified in Exhibit “A” attached to Surety’s
Limited Objection to Debtor’s Emergency Motion For Use of Cash Collateral filed [Date]. Pursuant to
these bonds, Surety currently has exposure in the aggregate amount of $>.
Specifically at issue in this Motion, on or about [Date], Surety issued performance bond and a
payment bonds, Bond No. > (the “Bond”), in the penal sum of $> on behalf of Principal to support a
contract between Principal, as principal, and [Obligee], as obligee, for the project known generally as
[Project Description] (the “Bonded Contract”).
Principal has acknowledged that it has defaulted, pre-petition, in its obligations owed to bond
obligees and to its subcontractors and suppliers by failing to pay amounts legitimately owed to these
entities. This failure by Principal is a pre-petition default under the GAI. Principal agreed, in that instance,
that “promptly on demand,”
the Indemnitors and/or Principals shall deposit with the Surety . . . a sum of money equal
to an amount determined by the Surety . . . to cover that liability, whether or not the
Surety has·(a) established or increased any reserve, (b} made any payments; or {c)
received any notice of any claims ·therefor.
[GAI, ¶ Second].
Under this express provision of the GAI, Surety made a collateral demand on Principal on [Date].
Principal failed to make any deposit of funds in any amount to Surety, which is also a default under the
GAI and a second breach, pre-petition, of the express terms of the GAI by Principal.
Long before this bankruptcy proceeding was filed, Principal agreed that, in exchange for Surety’s
agreement to undertake great risk guaranteeing millions of dollars of Principal’ contractual obligations, if
and when Surety determined it to be appropriate or necessary, Surety would have the right to take over
and complete any construction project or subcontract work that Surety had bonded. That agreement is
found in the GAI signed by Principal in the Fifth clause:
In the event of any of the following: breach, default, . . . any Principal’s failure to pay
obligations incurred . . . then the Surety shall have the right . . . to take possession of . . .
contracts covered by the Bonds . . . to complete or arrange for the completion of the same
... .
[GAI, ¶ Fifth]1
In preparing the collateral demand letter, Surety calculated that the Bonded Contract, if performed
by Principal, would result in a loss of $> when the project bore its share of the massive overhead carried
by Principal.2 Principal has not started performance on the Bonded Contract and the entire contract
balance remains available to Surety to ensure completion of the Bonded Contract. To mitigate its
expected losses overall--including the expected loss on the Bonded Contract if Principal assumes that
subcontract and attempts to perform--Surety seeks stay relief to exercise its rights under the GAI, to take
possession of the Bonded Contract, and to arrange for completion.
II. LEGAL ANALYSIS
A. Relief From Automatic Stay Under 11 U.S.C. §362(d)(1) for Cause is Appropriate.
11 U.S.C. § 362(d) provides, “[o]n request of a party in interest and after notice and a hearing, the
court shall grant relief from the stay . . . (1) for cause, including the lack of adequate protection of an
interest in property of such party in interest; . . . .” “Because there is no clear definition of what
constitutes ‘cause’, discretionary relief from the stay must be determined on a case by case basis.” In re
Castlerock Properties, 781 F.2d 159, 163 (9th Cir.1986) citing MacDonald v. MacDonald (In re
MacDonald), 755 F.2d 715, 717 (9th Cir.1985); accord In re Conejo Enterprises, Inc., 96 F.3d 346, 352
(9th Cir.1996)(“ ‘Cause’ has no clear definition and is determined on a case-by-case basis.”); Christensen
v. Tucson Estates, Inc. (In re Tucson Estates, Inc.), 912 F.2d 1162, 1166 (9th Cir.1990)(what constitutes
“cause” for granting relief from the automatic stay is decided on a case-by-case basis); see also In re C &
S Grain Co., 47 F.3d 233, 238 (7th Cir. 1995)(“As used in § 362(d)(1), the term ‘cause’ is a broad and
flexible concept which permits a bankruptcy court, as a court of equity, to respond to inherently factsensitive situations.”)
As outlined, pre-petition, Principal breached the terms of the GAI, including, but not limited to,
failing to place Surety in funds as required by the express terms of the GAI and the collateral demand
and failing to pay numerous subcontractors and suppliers. Given these clear breaches, the fifth operative
clause of the GAI effected a pre-petition assignment of the Bonded Contract to Surety, allowing it to
take possession and complete it: “In the event of any of the following: breach, default, . . . any
Principal’s failure to pay obligations incurred in connection therewith. . . then the Surety shall have the
right . . . and is hereby authorized . . . to take possession of . . . contracts covered by the Bonds . . . to
complete or arrange for the completion of the same . . . .” Because the Subcontract passed to Surety
1
2
Under the GAI, Principal also granted Surety a security interest in “all the right, title and interest . . . 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.” [GAI, ¶ Third]
Principal’ original Cash Flow Projections reveal an average weekly “cash burn rate” of $>.
pre-petition, the Bonded Contract is not property of the estate and the stay should be lifted to allow
Surety to exercise the rights granted to it by Principal to complete the Bonded Contract.
Such action is supported by those courts having addressed this issue. See, e.g., In re Jones Constr. &
Renovation, Inc., 337 B.R. 579 (Bankr. E.D. Va. 2006). In Jones Construction, the debtor, Jones
Construction & Renovations, Inc. (“Jones Construction”), was a contractor that defaulted on two public
works projects. Each project was supported by bonds issued by Western Surety in accordance with a
general agreement of indemnity. Under that indemnity agreement, Jones Construction--similar to
Principal here--bound itself to indemnify Western Surety and to hold it harmless from and against all
demands of whatever nature as a result of Western Surety’s issuance of bonds. Similar to the GAI that
Principal signed, paragraph 9 of the Jones-Western Surety indemnity agreement assigned to Western
Surety all rights under any bonded construction contract.
After executing the construction contracts, Jones Construction encountered financial problems. Prepetition, Western Surety received a claim against the contract payment bond on one of the public works
projects and later received several other claims due to the inability of Jones Construction to satisfy
payment obligations on the project. Subsequently, Jones Construction filed its bankruptcy petition. On
Western Surety’s motion, the bankruptcy court first analyzed the surety’s equitable subrogation rights
and, more pertinent here, the court also analyzed the surety’s rights under the assignment clause in the
indemnity agreement. Regarding those rights, the court noted “[i]n fact, the indemnity agreement’s
terms unambiguously assign to Western Surety all rights Jones Construction had under the contracts for
which it issued bonds.” Id., 337 B.R. at 586.
The court next reasoned that
[t]he fact that the assignment of rights at issue took place pre-petition and not by some
operation of bankruptcy law does not require a different result. This court has found that
pre-petition assignments are valid and the proceeds of any assignment that vests rights in
the assignee pre-petition are not property of the estate. See, e.g., Tyler v. Prudoff (In re
Prudoff), 186 B.R. 64 (Bankr. E.D. Va. 1995); In re Duty, 78 B.R. 111 (Bankr. E.D. Va.
1987). In Duty, Judge Shelley, citing the seminal surety case of Pearlman,3 concluded
that a debtor’s pre-petition assignment to Johnston-Willis Hospital . . . of all his rights to
receive settlement proceeds from a personal injury matter vested in the hospital, and as a
result the proceeds were not assets of the bankruptcy estate. In reaching its decision, the
court observed that “it is well established law that the trustee in bankruptcy takes only the
title of the debtor in property of the estate.” Id. at 117 (citing Pearlman, 371 U.S. 132).
The court also concluded that “the trustee could not avoid Johnston-Willis’ interest . . .
because Johnston-Willis is not asserting a lien on the proceeds, but rather an ownership
interest through the assignment that vested prior to [the debtor’s] filing.” Id.
Id. at 586-87. The court granted the surety’s motion, noting
3
Pearlman v. Reliance Insurance Co., 371 U.S. 132 (1962), the seminal decision on a surety’s rights.
Jones Construction executed the indemnity agreement and conveyed the assignments in
question, was in need of contract payment and performance bonds in order to comply with the
provisions of the general contracts with which it had been awarded [under state law], and
intended to make the assignments in consideration for Western Surety’s commitment to serve as
Jones Construction’s surety and issue bonds. . . . As such, the rights conveyed . . . in the
indemnity agreement were transferred upon the event of default, became vested in Western
Surety and never became property of the estate . . .
Id. at 587; accord In re Brooks, 248 B.R. 99 (Bankr.W.D.Mich. 2000)(debtor’s pre-petition assignment of
right to receive payments under settlement agreement prevented payments from inclusion in property of
the debtor’s estate).
The reasoning in Jones Construction is directly applicable here. Principal defaulted under the terms
of the GAI pre-petition. Under the clear terms of the GAI4, Surety “shall have the right and is hereby
authorized to take possession of . . . contracts covered by the Bonds . . . to complete or arrange tor the
completion of the same . . . .” (GAI, Fifth) Once Principal defaulted under the terms of the GAI, any
bonded contract became the property of Surety to complete or arrange to complete. The Court should lift
the automatic stay for cause under § 362(d)(1) to allow Surety to exercise its rights under the GAI to
take possession of the Bonded Contract and to arrange for its completion.
B. Relief From Automatic Stay Under 11 U.S.C. §362(d)(2) Is Appropriate Because There is
No Profit for the Estate in the Bonded Contract and the contract is not necessary for an
Effective Reorganization.
11 U.S.C. § 362(d)(2) provides “[o]n request of a party in interest and after notice and a hearing, the
court shall grant relief from the stay . . . such as by terminating, annulling, modifying, or conditioning
[the] stay . . . with respect to a stay of an act against property . . . if (A) the debtor does not have an
equity in such property; and (B) such property is not necessary to an effective reorganization.” Surety is
a party in interest as it is a creditor and issued the bonds supporting the Bonded Contract and stands to
lose the most when Principal is unable to complete the Bonded Contract and/or fails to pay its suppliers
on that project after the subcontract funds are spent.
Although equity is defined as “the value, above all secured claims against the property, that can be
realized from the sale of the property for the benefit of the unsecured creditors,” Stephens Industries, Inc.
v. McClung, 789 F.2d 386, 392 (6th Cir. 1986), it can be applied analogously to a contract that a debtor
has performed, which may constitute “property,” and the profit, if any, in the contract is the “equity.”
Because the Bonded Contract, when burdened with its share of Principal’ overhead, will result in a loss to
the estate, Principal has no “equity” in the Bonded Contract.
4
In interpreting an indemnity agreement issued in the context of surety bonds under California law, courts are
governed by well-settled rules of contract interpretation. City of Chino v. Jackson 97 Cal.App.4th 377, 382
(2002); Fidelity & Deposit Co. v. Whitson, 187 Cal.App.2d 751, 756 (1960). If the language is unambiguous,
the court must enforce the plain meaning. Clarendon America Ins. Co. v. North American Capacity Ins. Co.,
186 Cal.App.4th 556, 566 (2010).
As to the “necessary to an effective reorganization” requirement, Principal cannot make that showing
regarding the Bonded Contract. To be “necessary,” “requires . . . not merely a showing that if there is
conceivably to be an effective reorganization, this property will be needed for it; but that the property is
essential for an effective reorganization that is in prospect. This means . . . that there must be a reasonable
possibility of a successful reorganization with a reasonable time.” United Savings Association of Texas v.
Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365, 375-76 (1988) (citations and internal quotation
marks omitted). The evidence in this case demonstrates that Principal does not have a reasonable
possibility of a successful reorganization and, further, that the Bonded Contract is not “essential” to any
such reorganization, if it were possible.
First, Principal has been singularly unable in this Chapter 11 case to project a budget and adhere to it
or file a required report without amending it. For example, …
Principal cannot, at least as reported on a number of filings, fund its operations without significant
infusions of cash, none of which are forthcoming as Principal has no DIP financing.
Unfortunately, and maybe, purposefully, Principal has made any meaningful analysis by Surety or
Bank difficult, if not impossible, for a number of reasons. First, cash flow budgets on which the interim
use of cash collateral has been based have changed with the wind, with a budget being filed but then
changed the very next day, and subsequent budgets filed bearing no relationship to reality. Second,
despite requiring in each cash collateral order lodged that Principal provide a daily report of “all payments
received by Debtor on the previous day (the “Daily Report”),” Principal has only sporadically reported
any payments, certainly not “daily.” Based on its own projections of cash inflow versus outflow, Principal
will be unable to fund any meaningful reorganization.
It is well-established that “the cash flow realities of the construction business frequently mandate that
a contractor engaged in numerous projects use funds advanced for one job to pay subcontractors or
suppliers on another . . . .” State v. Ferrari, 398 So.2d 804, 808 (Fla.1981)(noting further that “it is
common practice for a contractor to use incoming funds to discharge his most pressing obligations and
replace them later with the proceeds of other jobs.”). These cash flow realities result from a contractor,
like Principal, having to supply labor and materials to a project, then waiting weeks before a progress
payment application is submitted and approved by the owner, before the money is paid to Principal.
During these weeks, Principal is required to make payroll every two weeks, and to pay its suppliers. Such
activity requires Principal to front these funds, something Principal is unable to do.
Further, on the Bonded Contract, as with other Bonded Contracts, Principal is required to sequester
all funds received on the project and apply them solely to the debts incurred on the specific project.
Principal’s cash flow position as set forth on its own financial statements filed with the Court show it
cannot fund the Bonded Contract as would be required. Additionally, as noted in In re Pacific Marine
Dredging and Construction, 79 B.R. 924, 929 (Bankr.D.Or.1987), a contractor that fails to pay labor and
material obligations has no legal or equitable interest in withheld contract funds and, therefore, the funds
were not property of the bankruptcy estate. The Third Circuit came to a similar conclusion in In re
Modular Structures, Inc., 27 F.3d 72 (3rd Cir.1994), holding where a contractor had not paid its
subcontractors, it had no right to contract funds held by the project owner. Under these authorities,
Principal will not have any rights in any of the funds from the Bonded Contract.
Although it appears at this time that Principal will not be able to successfully reorganize, it is
undisputed that Principal cannot fund payments to its employees and suppliers prior to receiving payment
by way of progress payments on the Bonded Contract. Given all funds received on this bonded project
must be sequestered, Principal will not have an interest in any of the funds to be paid to it under the
Bonded Contract. In short, Principal will not benefit from performing the Bonded Contract and, therefore,
the subcontract cannot be “necessary for an effective reorganization;” in fact, it may be a detriment to any
reorganization, if one is possible at all. Therefore, under § 362(d)(2), the stay should be lifted to allow
Surety to effectuate the rights granted to it under the GAI to take possession of the Bonded Contract and,
at its discretion, complete or arrange for its completion.
III. CONCLUSION
Under the express terms of the GAI between Surety and Principal, the subcontract at issue in this
motion, the Bonded Contract, was assigned, pre-petition to Surety. The Bonded Contract is therefore not
property of the estate. Under the terms of the GAI, Surety is entitled to take possession of the subcontract
and arrange for its performance. Surety files this motion under § 362(d)(1) and (d)(2) to obtain the
Court’s order lifting the stay as a precaution only. Under § 362(d)(2), cause exists to modify the stay to
allow Surety to perform its obligations under the performance bond to take over the Bonded Contract and
to arrange for its completion. Under (d)(2), the Bonded Contract is not necessary for an effective
reorganization and there is no “equity” in subcontract. For all the foregoing reasons, Surety requests the
Court lift the automatic stay to allow Surety to take possession of the Bonded Contract and to arrange for
its performance.
DATED ______________.
COUNSEL FOR SURETY
/s/