A.
Introduction
A fundamental
principle in bankruptcy is the equal distribution of assets to similarly
situated pre-petition creditors, which is commonly referred to as a pro-rata
distribution to creditors. In addition to secured creditors, the Bankruptcy Code
provides a hierarchy of various unsecured creditors, which include: (1) general
unsecured creditors (i.e., non-priority), (2) priority unsecured creditors, (3)
creditors holding super-priority claims, and (4) creditors holding claims with
priority over super-priority claims.
An important goal in any bankruptcy case is
for the surety to improve the type or types of claims the surety holds whenever
possible. This improvement of the surety’s position in the bankruptcy case could
lead to receiving distributions based on holding a priority type claim or some
form of collateral. To the extent that there is any estate property free and
clear of secured creditors, and there are enough funds to pay creditors with
priority type claims, those additional funds, if any, should be distributed on a
pro-rata basis to the debtor’s general unsecured creditors.
In order for a
surety to obtain a distribution based on the surety’s claim it must assert its
claim in the debtor’s bankruptcy case. This chapter will address the various
types of claims the contract surety and commercial surety can hold in a
bankruptcy case and discuss the thorny Bankruptcy Code provisions concerning the
restriction on the surety’s reimbursement claim versus its subrogation claim. It
will describe the Bankruptcy Code’s disallowance of the surety’s “contingent”
claim relating to pending bond claims and continued exposure under its bonds,
and address the claims administration process for the allowance of the surety’s
claims. The scope of this chapter is limited to the extent it is written from
the unique perspective of the surety.
B. The Basis of the Surety’s
Claim for the Purposes of the Surety’s Proof of Claim
In the event the
surety has incurred, or will incur, a loss under its bonds or under the
indemnity agreement, the debtor owes a debt to the surety. A “creditor” is
generally defined as anyone who holds a “claim” against the debtor. Thus, the
surety becomes a “creditor” of the debtor to the extent that the surety has a
“claim” against the debtor that arose prior to the debtor filing its bankruptcy
petition.
The Bankruptcy
Code defines the term “claim” as follows:
(A) right to
payment, whether or not such right is reduced to judgment, liquidated,
unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed,
legal, equitable, secured, or unsecured; or
(B) right to an
equitable remedy for breach of performance if such breach gives rise to a right
to payment, whether or not such right to an equitable remedy is reduced to
judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured,
or unsecured.
This definition
of “claim” is extremely broad and extends to practically every claim that a
surety may have against the debtor, even if the claim is totally contingent and
may never become an actual loss for the surety.
The surety’s
claim under the indemnity agreement and the bonds executed prior to the date the
debtor files its Voluntary Petition in bankruptcy or prior to an Involuntary
Petition being filed (collectively the “Petition Date”) will be part of the
surety’s claim even if the surety’s payments or losses occur after the Petition
Date. When a contract surety suffers losses under its bonds or pursuant to the
terms of an indemnity agreement, the surety will seek reimbursement for that
loss, whether the loss is a payment under its performance or payment bonds or
for attorneys’ fees, consultants’ fees and other costs and expenses. The
contract surety may seek reimbursement in the following ways: (1) it may pursue
its principal under a common-law claim for reimbursement and/or indemnity as a
result of the execution of the bond; (2) it may pursue its principal and
indemnitors under an indemnity agreement; (3) it may pursue its own rights
against the obligee or others; (4) it may enforce its subrogation rights to
pursue the rights of others; (5) and/or it may pursue any collateral that it may
hold that it has received from the principal, the indemnitors or any other third
party.
Unlike the
contract surety that issued performance and payment bonds, the commercial surety
providing commercial surety bonds for its principal to an obligee rarely, if
ever, finds the obligee holding funds or monies available for the commercial
surety’s reimbursement in the event that it must make a payment under its bonds.
Rather, a commercial surety bond is generally written for a “solvent” principal
who requires the bond for its business or litigation purposes. Therefore, unless
the commercial surety has collateral from the principal and/or the indemnitors
or a letter of credit from a financial institution, when the commercial surety
incurs a loss under its bond, its most likely source for reimbursement is from
its principal and indemnitors under the indemnity agreement and not the
commercial surety’s exercising its own rights against the obligee, if any exist,
or its subrogation rights to pursue the rights of others.
In a bankruptcy
case, the contract surety or commercial surety may have a reimbursement claim
against the principal or the indemnitors, which is now a debtor under Chapter 7
or Chapter 13 or a debtor in possession under Chapter 11 of the Bankruptcy Code.
Bases of the surety’s reimbursement claim include:
-
The principal
and the indemnitors executed an indemnity agreement prior to their filing a
bankruptcy petition (“pre-petition”), and all of the contract surety or
commercial bonds were executed pre-petition;
-
The surety
made payments to the obligees and/or other claimants as a result of losses
incurred under the pre-petition contract or commercial surety bonds, and the
payments were made pre-petition; and
-
The surety
made payments to the obligees and/or other claimants as a result of losses
incurred under the pre-petition contract or commercial surety bonds, and the
payments were made after the principal’s or indemnitors’ filing of their
bankruptcy petition (“postpetition”), or the payments were made both
pre-petition and postpetition.
When the surety’s
contract or commercial bonds are executed pre-petition, and whether the surety’s
payments on those pre-petition bonds are made pre-petition, post-petition, or
both, the surety is seeking to enforce its common-law reimbursement rights
against the debtor as well as its rights under the surety’s indemnity agreement.
C. Types of Claims the Surety
Can Assert in the Bankruptcy Case
The contract
surety and commercial surety can hold several types of claims in its principal’s
and indemnitors’ bankruptcy cases. The surety’s claim against its principal and
indemnitors can be based on one or more of the following: (1) common-law rights
of indemnity and reimbursement from its principal; (2) contract rights under the
indemnity agreement from its principal and indemnitors; (3) subrogation rights,
including the contract surety’s subrogation rights to any bonded contract funds
and claims; (4) agreement granting the surety liens against real property and
personal property, including security agreements, collateral agreements, deeds
of trust, and mortgages; and (5) letters of credit from a financial institution.
The different bases of the surety’s claim should be noted in its proof of claim,
which focuses on general unsecured claims, various priority claims, and secured
claims. These different types of claims are discussed below.
1. The
Surety’s General Unsecured Claim-Sections 501 and 502 of the Bankruptcy Code
If the surety
does not have a lien against estate property and does not have a basis to claim
a form of priority claim, then the surety’s claim will be a general unsecured
claim, which is also referred to as a non-priority unsecured claim. The surety’s
unsecured claim includes its pre-petition losses, interest, attorneys’ fees and
costs plus any post-petition losses and attorneys’ fees. Even if losses are paid
post-petition, they are treated as part of the surety’s pre-petition claim.
The surety with
an unsecured claim will not be able to claim interest that accrued postpetition.
The surety with an unsecured claim may or may not be able to claim incurred and
paid attorneys’ fees.
In determining
the amount of the surety’s unsecured claim, the surety should include all of the
surety’s paid losses, pre-petition interest, all attorneys’ fees and costs
(incurred and paid both pre-petition and postpetition), and any unpaid premiums.
The total of these amounts is the surety’s liquidated loss. Additionally, the
surety’s unsecured claim should include the balance of the surety’s exposure
under its outstanding bonds (i.e., the penal sums of all outstanding bonds) even
though this part of the surety’s claim is contingent and unliquidated. The
surety’s contingent and unliquidated claim is discussed below in Section E,
infra, and preparing the surety’s proof of claim is discussed below in
Section G, infra.
a. The
Surety’s Reserve Claim.
Pursuant to the
indemnity agreement, the surety has the right to establish a reserve to cover
any possible claim, demand, liability, suit, judgment, loss or other expense
that the principal and indemnitors may be obligated to indemnify the surety
under the terms of the indemnity agreement. To the extent that the principal has
paid or provided collateral to the surety to secure the surety against liability
or loss, the surety would have a secured claim against the collateral. However,
the surety’s establishment of a reserve constitutes a loss on the surety’s
books, and may be the basis for a portion of the surety’s claim, even if the
surety has not actually paid losses up to the amount of the reserve.
b. The
Surety’s Executory Contract Rejection Claims.
Subject to
bankruptcy court approval, a debtor may assume, assume and assign, or reject any
executory contract. Some debtors, either by motion or pursuant to their plan of
reorganization, attempt to assume, assume and assign, or reject as executory
contracts the surety’s contract surety and/or commercial bonds and/or the
underlying contracts for which these bonds were underwritten. If the surety’s
bonds are determined to be executory contracts, then the surety may have
different claims against the debtor depending on whether the contract surety
and/or commercial bonds (and/or the underlying contracts) are assumed, assumed
and assigned, or rejected. Any claim that the surety may have based on the
rejection of its bonds as an executory contract shall be determined, and allowed
or disallowed, “the same as if such claim had arisen before the date of the
filing of the petition.,, The bankruptcy court will set a time within which the
surety’s claim arising from the rejection of its bonds as executory contracts
must be filed.
Practically, the
surety’s damages for the rejection of a contract surety and/or commercial bond
will, most likely, be based on a claim made against the bonds. While the
deadline to file proofs of claim (the “Bar Date”) may have passed, the surety
may have an extended period of time, pursuant to the bankruptcy’s order setting
the Bar Date, for filing claims arising from the rejection of an executory
contract. If the surety previously filed its proof of claim, the surety can
amend its claim to include any additional damages due to the debtor’s rejection
of its bonds.
c. The
Surety’s Claim Resulting From the Return of Property Due to an Avoidance Action
(Preferential or Fraudulent Transfer).
While a
discussion of any avoidance action (preferential transfers under Section 547
and/or fraudulent transfers under Section 548 of the Bankruptcy Code) filed by
the trustee or the debtor against the surety are beyond the scope of this
chapter, it is possible that the surety may obtain collateral and/or property of
the debtor that results in the surety receiving a preferential or fraudulent
transfer prior to the principal’s or indemnitors’ filing its bankruptcy
petition. The timing of the surety’s execution of the bonds and its obtaining
any collateral security will determine whether the surety has received an
avoidable preferential or fraudulent transfer from the debtor under Bankruptcy
Code Sections 547 or 548, respectively. If the debtor or others believe that the
surety has received an avoidable preference or fraudulent transfer, an action
may be brought against the surety in order to require the surety to pay back the
avoidable transfer into the debtor’s estate. To the extent that the surety may
be liable to the debtor’s estate as a result of a preferential or fraudulent
transfer, the court may disallow the surety’s claim pursuant to Code Section
502(d) “unless such entity or transferee has paid the amount, or paid over any
such property, for which such entity or transferee is liable” as concerns such
avoidable transfer.
Assuming that the
surety included the value of the property alleged to be a preferential or
fraudulent transfer as part of its secured claim, if the surety returns the
debtor’s property to the bankruptcy estate, the amount of the surety’s secured
claim will decrease and the amount of the surety’s unsecured claim will
increase. The surety is entitled to increase its unsecured claim to the extent
that the surety must return property subject to the avoidance action to the
debtor’s estate.
2. The
Surety’s Priority Unsecured Claim--Sections 503 and 507 of the Bankruptcy Code
Certain unsecured
claims have priority over general unsecured claims pursuant to Bankruptcy Code
Sections 503 and 507. Bankruptcy Code Section 503 provides for the allowance of
certain administrative expenses of the debtor’s estate. The bankruptcy court may
allow, after notice and hearing, an administrative expense claim for the
“actual, necessary costs and expenses of preserving the estate.”
a. The
Surety’s Administrative Expense Claim.
To the extent
that a surety provides goods or services to a debtor after the petition date,
which are deemed to be an actual, necessary cost and expense of preserving the
debtor’s estate, then the surety may timely file a request for payment of an
administrative expense claim. Bankruptcy Code Section 507 sets forth specific
pre-petition claims that have priority over other general unsecured pre-petition
claims, including the priorities listed in Section 507(a)(l) through (10). The
debtor or trustee must pay administrative expense claims before any
distributions are made to general unsecured creditors.
The contract
surety will generally not have its own administrative claim. However, as
discussed below in Section C, infra, the surety may be subrogated to claimants’
administrative expense claims. For the commercial surety, it should be entitled
to assert an administrative expense claim for premiums for renewals of
commercial bonds during the post-petition period. A commercial surety bond may
be required by the debtor to remain in and/or operate its business, which may be
determined to be an actual, necessary cost and expense of preserving the
debtor’s estate because it affects the debtor’s ability to operate the business
and propose a plan of reorganization. The surety should demand that the debtor
pay any renewal premiums for such bonds that renew during the post-petition
period.
b. The
Surety’s Subrogation Rights (and/or Assignment Rights) to Administrative Expense
Claims. The surety faces
a very difficult and thorny issue with respect to its payment of bond claims and
whether these payments entitle the surety to be subrogated to an administrative
expense claim. The contract surety executes a performance and payment bond prior
to the petition date as a result of a construction contract entered into by the
principal prior to the petition date. After the principal files a bankruptcy
case, laborers and subcontractors supply services to the debtor and materials
are delivered to the bonded construction project. While the services and
materials may be provided during the post-petition period, the question becomes
whether these services and materials are actually the debtor’s postpetition
administrative expenses because they are “the actual, necessary costs and
expenses of preserving the [debtor’s] estate” (the debtor is continuing the
performance of the work and being paid on the bonded construction project) or
whether these are the debtor’s pre-petition obligations because of the existence
of the pre-petition contracts and bonds.
For the contract
surety, the debtor has a continuing post-petition obligation to pay its
subcontractors, material suppliers and laborers that provide these post-petition
services and materials to the bonded projects. The surety will endeavor, based
on demands for “adequate protection” under Bankruptcy Code Section 363(e), to
have the proceeds from the bonded project be used to pay for these post-petition
subcontractors, suppliers and laborers. In the event there are insufficient
remaining bonded contract proceeds to pay for the construction work or pay the
bills relating thereto, a bankruptcy court would probably determine that the
contract surety executed the performance and payment bonds prepetition, and the
surety has a pre-petition claim for the losses under its pre-petition bonds.
While a surety
may not have a basis for its own administrative expense claims, it may be
subrogated to the administrative expense claims of claimants that the surety is
required to pay under its bonds.
Pursuant to Code
Section 507(a)(2), administrative expenses allowed under Code Section 503(b) are
entitled to a priority claim. Under Bankruptcy Code Section 507(d), the surety
may be precluded from being subrogated to the priority rights of a creditor in
the event that the surety pays the claim of a creditor that would otherwise have
priority rights. For example, a surety that pays the debtor’s pre-petition tax
obligations or the debtor’s pre-petition customs duties under the applicable
bonds is not subrogated to the priority rights of the governmental authorities
under Bankruptcy Code Section 507(a)(8).
There is an
exception where the surety may become subrogated to (or receive an assignment
of) the priority rights of creditors. Bankruptcy Code Section 507(d) does not
preclude a surety from being subrogated to administrative expense claims under
Code Section 503(b). Sellers of goods to the debtor are entitled to an
administrative claim for any goods sold 20 days prior to the bankruptcy filing
pursuant to Bankruptcy Code Section 503(b)(9). If the surety pays such suppliers
it should demand an assignment of their claim and of any rights they have under
Code Sections 503 and 507. In addition to an assignment, the surety will be
subrogated to the suppliers’ administrative expense claims. The significance of
this provision is the surety after payment of and receiving an assignment of
this priority claim (and being subrogated to this claim), can claim the same
priority for the amounts it paid under its bond. Code Section 507(a)(2) is one
of the few exceptions that permit the surety to claim the priority nature of the
claim it pays pursuant to its bond obligations in a bankruptcy proceeding.
For a commercial
surety, there are too many types of bonds to make blanket comments about whether
particular post-petition payments under a commercial bond would be deemed to be
the payment of an administrative expense that the surety would be entitled to be
subrogated to the priority status or the post-petition payment of a pre-petition
claim. A surety’s payment of a claim under a pre-petition commercial bond may
result in the surety being subrogated to the claimant’s post-petition
administrative expense claim. For example, a utility provider (i.e., electric,
water or gas) provides post-petition utilities to the debtor and the commercial
surety pays the claim under the pre-petition utility bond. The commercial surety
would be entitled to assert its right to be subrogated to the utility’s
administrative expense claim, and Code Section 507(d) would not prevent the
surety asserting its subrogation rights to the priority nature of the utility’s
claim. The critical issue is whether the claimant provided goods or services to
the estate that were actual, necessary costs and expenses of preserving the
estate.
In summary, the
surety should analyze and pay close attention to claims it pays under its
pre-petition contract surety and commercial bonds that may be considered actual,
necessary costs and expenses of preserving the estate under Bankruptcy Code
Section 503(b)(1). If applicable, the surety should ensure that an application
for an administrative expense claim is made in a timely fashion. Practically,
the surety with subrogation rights and an assignment will generally be the party
to file the application seeking allowance of an administrative expense claim.
Since priority unsecured claims receive distribution before any distributions to
non-priority unsecured claims, the surety can improve its position to a priority
creditor in the bankruptcy case if it pays claimants that are entitled to
administrative expense claims.
c. The
Surety’s Assumption of Executory Contract Cure and Adequate Protection Claims.
As stated
previously, subject to bankruptcy court approval, a debtor may assume, assume
and assign, or reject any executory contract. Some debtors, either by motion or
pursuant to their plan of reorganization, attempt to assume, assume and assign,
or reject as executory contracts the surety’s contract surety and/or commercial
bonds and/or the underlying contracts for which the contract surety and/or
commercial bonds were underwritten. The surety may have different claims against
the debtor depending on whether the bonds and/or underlying contracts, are
assumed, or assumed and assigned, or rejected.
If the debtor
assumes one or more contract surety, commercial bonds, and/or the underlying
contracts as executory contracts, and there has been a default by the principal
under the contract surety, commercial bonds, and/or the underlying contracts,
the bonds and/or underlying contracts may not be assumed by the debtor unless
the debtor cures or provides adequate assurance that it will promptly cure the
default (namely, reimburse the surety for any losses incurred by the surety
under the contract surety and/or commercial bonds), compensates the surety for
any actual loss it may have arising from the default, and provides adequate
assurance for future performance (making sure that there are no future defaults
under the bonds and/or underlying contracts). Therefore, if the debtor seeks to
assume one or more bonds and/or underlying contracts for which the surety has
paid losses and incurred expenses, the surety may obtain reimbursement for those
losses and expenses as an immediate post-petition administrative expense payment
(and not as a general unsecured claim) if the debtor wishes to assume the bonds
and/or underlying contracts and have them remain in full force and effect.
Furthermore, the surety may be able to obtain “adequate assurance of future
performance” for the contract surety, commercial bonds and/or the underlying
contracts in the form of collateral to protect the surety in the event of a
future loss payment.
One of the
surety’s difficulties in determining whether it has an assumption of executory
contract cure and/or adequate protection claim is whether the debtor, either in
its plan of reorganization or pursuant to a motion to sell and sale order with
respect to some or all of the debtor’s assets, even recognizes the surety’s
rights when the debtor assumes an executory contract and/or assumes and then
assigns the executory contract pursuant to a plan of reorganization or sale
order. The surety must be extremely vigilant in protecting its post-petition
claims when the debtor files various motions or a plan of reorganization with
the bankruptcy court, which must be thoroughly analyzed to determine the
surety’s rights and how best to protect them.
3. The
Surety’s Super-Priority Claim: Section 507(b) of the Bankruptcy Code
The Bankruptcy
Code establishes a claim that is superior to priority claims, namely a
“super-priority” claim. Bankruptcy Code Section 507(b) provides that if the
debtor (or trustee) provides “adequate protection” to a secured creditor under
Bankruptcy Code Sections 362, 363 or 364 and that adequate protection proves
inadequate, then such creditor’s claim “shall have priority over every other
[administrative expense] claim.” In other words, the creditor with a
super-priority claim holds a claim superior to priority claimants.
In contract
surety cases, it is common for the debtor to make a motion to use the proceeds
from the surety’s bonded projects. The surety should assert that the bonded
contract proceeds are the surety’s “cash collateral” under Code Section 363(a).
In addition to opposing the principal/debtor’s use of bonded contract proceeds,
the surety should demand, pursuant to Bankruptcy Code Section 363(e), that the
bankruptcy court, “prohibit or condition” the debtor’s use of the bonded
contract proceeds “as is necessary to provide adequate protection” of the
surety’s interest in these bonded proceeds. If the debtor is permitted to use
bonded project proceeds, then the adequate protection order should provide for
very strict use of the bonded project proceeds only for expenses related to the
bonded projects. If the “adequate protection” provided to the surety is not
adequate, then the surety should be entitled to a super-priority claim, under
Code Section 507(b), to the extent any bonded project proceeds were used for
anything other than true bonded project expenses.
Many times the
surety’s demand for “adequate protection,” as concerns the bonded project
proceeds, are resolved by stipulation between the debtor and the surety. The
attorneys representing the debtor have an administrative expense claim under
Code Section 503(b)(4), which is a priority claim under Code Section 507(a)(2).
Since super-priority claims are superior to debtor’s counsel’s attorneys’ fees,
counsel for the debtor will, most likely, request that the cash collateral
stipulation provide for a carve out of the surety’s super-priority claim so that
the attorneys’ fees claim is paid prior to the surety’s super-priority claim. It
is recommended that this carve out be set to a specific amount, rather than an
open-ended carve out for any attorneys’ fees and costs that are claimed by
debtor’s counsel. If the surety does receive a super-priority claim, it would be
paid prior to any priority claimants (other than debtor’s counsel’s fees)
receiving any distributions.
4. The
Surety’s Claim That Is Superior to Super-Priority Claims Section 364(c)(1) of
the Bankruptcy Code
The debtor may
request that the surety provide additional credit after the petition date. The
surety’s credit may take the form of financing the debtor if financing is an
appropriate mechanism for the surety to either handle claims on existing bonds
or for other reasons, and/or the surety providing credit to the debtor in the
form of new surety bonds. In either instance, the surety will seek various
protections and rights provided by Code Section 364 and other sections of the
Bankruptcy Code. If a surety determines to provide some form of post-petition
credit, then the surety lean be granted a claim “with priority over any or all
administrative l expenses of the kind specified in section 503(b) or 507(b)” of
the Bankruptcy Code. In other words, if the surety determines to provide
post-petition credit to the debtor, then the surety can be granted a claim ‘that
is superior to both priority and super-priority claims.
Section 364 of
the Bankruptcy Code allows a debtor authorized to operate its business to obtain
post-petition credit in order to continue its post-petition operations. For
example, the debtor may obtain unsecured credit and incur unsecured debt in the
ordinary course of business, which is allowable as an administrative expense
claim under Section 503(b)(l) of the Bankruptcy Code. Furthermore, Bankruptcy
Code Section 364 allows a debtor to obtain post-petition credit other than in
the ordinary course of business by providing additional protections to the
creditor, which include the following:
(1) The debtor,
after notice and a hearing, may obtain unsecured credit or incur unsecured debt
other than in the ordinary course of business, which may be allowable under
Bankruptcy Code § 503(b)(l) as an administrative expense; or
(2) If the debtor
is unable to obtain unsecured credit from a creditor that is protected with an
administrative expense claim, then the debtor may, after notice and a hearing,
obtain credit or incur debt with the creditor receiving a claim that is superior
to administrative expense claims and super-priority claims.
Various secured
claims can also be obtained by the surety providing post-petition surety credit
to the debtor, which is discussed below in Section 3, infra. It is beyond the
scope of this chapter to detail all of the protections and rights that a surety
may request in providing post-petition surety creditor to a debtor. The surety
should seek to obtain protections and rights in the bankruptcy court order that
approves the surety’s extension to the debtor of post-petition surety credit.
5. The
Surety’s Secured Claim: Section 506 of the Bankruptcy Code
The surety may
have a secured claim or claims in the bankruptcy case based on liens it has
against the debtor’s assets. These secured claims may be based on: (1) filing
the indemnity agreement as a Uniform Commercial Code (U.C.C.-1) Financing
Statement; (2) the principal or indemnitors voluntarily providing collateral
pursuant to the surety’s demand for collateral pursuant to the collateral
security clause in the indemnity agreement; (3) obtaining collateral as part of
an order issued in the surety’s quia timet action against the principal
and indemnitors; (4) other judicial liens against property; (5) subrogation
rights, including subrogation to others’ rights in collateral, the surety’s
subrogation rights against third parties, and rights against collateral held by
the bond oblige; (6) setoff rights; and (7) other contractual rights that may
provide the surety with a lien against the principal’s and/or indemnitors’ real
and/or personal property. The following are examples when the surety holds a
secured claim under Bankruptcy Code Section 506:
(1) Indemnity
Agreement Secured Rights. The surety may have filed its indemnity agreement as a
Uniform Commercial Code (U.C.C.-1) Financing Statement with the applicable
state’s secretary of state, thereby obtaining a perfected security interest
against certain assets of the principal and/or the indemnitors, including but
not limited to, rights in the debtor’s contract funds, debtor’s equipment,
causes of action and claims, general intangibles, and any of the debtor’s other
assets and/or rights that may be subject to the surety’s security interests
under the indemnity agreement. The surety should properly perfect these VCC
liens and other liens discussed below as soon as possible with the hope that the
perfection of its lien is more than 90 days prior to the 90-day preference
period.
(2) Collateral
Demand under Indemnity Agreement. The surety may have made a pre-petition demand
that the principal and/or indemnitors provide it collateral or be “placed in
funds” pursuant to the collateral security clause in the indemnity agreement.
Based on this demand the surety may have been granted security interests against
cash collateral or other acceptable collateral to secure claims made against its
bonds, and the surety properly perfected such liens against this collateral.
(3) Quia Timet
Secured Rights. If the surety’s demand for collateral under the collateral
security clause in the indemnity agreement is ignored, then the surety may
commence a quia timet action against the principal and indemnitors.
Courts have repeatedly affirmed a surety’s quia timet and specific
performance rights to be collateralized when the surety justifiably fears a loss
as a result of having issued a bond on behalf of its principal, including the
right to compel the posting of collateral for anticipated bond losses. The court
may issue an order in the quia timet suit that grants the surety a
judicial lien against all of the principal’s and indemnitors’ real and/or
personal property in the amount of the surety’s demand.
(4) Judicial
Liens. The surety may have obtained a judgment against the principal and indemnitors under the indemnity agreement and recorded that judgment under state
law as a lien against certain real property and/or exercised its rights of
execution, attachment and garnishment against certain personal property of the
principal and indemnitors.
(5) Subrogation
Rights. The surety may be secured by its subrogation rights to the rights of
others, including the surety’s subrogation rights against third parties and
rights against collateral held by the bond obligee. In the contract surety case,
the surety that performs under its performance and/or payment bonds may have
rights against the remaining bonded contract funds held by the obligee(s).
Rarely is an obligee under a commercial surety bond holding funds that a surety
may claim subrogation rights.
(6) Contractual
Lien Rights. As part of the surety agreeing to issue bonds, the surety may have
obtained separate mortgages and deeds of trust against the principal’s and/or indemnitors’ real property and/or obtained security agreements granting security
interests against the principal’s and/or indemnitors’ personal property.
(7) Setoff
Rights. The surety may have certain setoff rights and/or claims against the
principal and/or indemnitors as a result of money that may be owed by the surety
to the principal and/or indemnitors, such as monies owed by the surety under an
insurance policy, a fidelity or surety bond, the return of unearned premiums, or
any other claim by the principal against the surety.
(8) Letter of
Credit. The surety may have received a letter of credit from the principal’s
bank as collateral for the contract surety (which is rare) or commercial bonds.
The letter of credit and the proceeds of the letter of credit should not be
considered property of the estate, and the surety should not be automatically
stayed or prevented from drawing on the letter of credit because of the
principal’s bankruptcy filing. The surety may draw on the letter of credit in
accordance with the terms of the letter of credit and any separate collateral or
letter of credit agreement that it may have with the principal/debtor, and use
the proceeds to either pay the claims made against the contract surety or
commercial bonds or to reimburse the surety for any claims it has paid.
6. The Surety
Secured Claim: Section 364(c) and (d) of the Bankruptcy Code
As discussed
above, the surety may determine to provide postpetition surety credit to the
debtor. The debtor is permitted under the Code to provide the following
protections to the creditor providing postpetition financing:
(1) a secured
lien against estate property that is not otherwise subject to a lien;
(2) a secured
junior lien against estate property that is subject to a lien; or
(3) under various
circumstances, a senior or equal secured lien against estate property that is
subject to a lien.
The lien granted
under Bankruptcy Code Section 364(d) is called a “priming lien” where the
bankruptcy court may grant a financing creditor a first priority lien against an
asset despite another secured creditor having a lien against that asset, which
was perfected prior in time. To prime another secured creditor’s lien, the
debtor must be unable to obtain credit without giving a first lien against the
asset and the secured creditor whose lien is being primed must be given
“adequate protection” of the secured creditor’s interest in the asset(s) subject
to the priming lien.
If the surety
determines to provide post-petition financing to the debtor, then the surety may
be granted liens against unencumbered property, junior liens against encumbered
property, and in some circumstances, senior liens against encumbered property.
The surety should attempt to have its post-petition lien be against all property
that is included within “property of the estate” as defined in Bankruptcy Code §
541(a). Since the definition of “property of the estate” is so broad, counsel
for the debtor and various creditors’ committees may object to the surety being
granted a lien on every asset that is included in the bankruptcy estate,
including the proceeds of preference actions and other avoidance actions.
However, if the surety’s financing is seen as absolutely required, then this
extremely broad lien may be granted to the surety despite the debtor’s and
creditors’ reservations.
D. Issues Relating To Secured
Claims
1. Section 506(a): Amount of Secured Claim
The surety
holding liens against the debtor’s property has a “secured claim” to the extent
of the value of the surety’s interest in estate property. In other words, to the
extent there is equity that the surety can look to, the surety’s claim would be
secured. For example, if the surety’s claim is $100,000 and the value of the
collateral that is in excess of any superior liens is $100,000 or more, then the
surety is fully secured. However, if the value of the estate property, net of
the amount of liens that are superior to the surety’s lien, is less than
$100,000, then the surety will have an undersecured claim. If the surety holds
an undersecured claim, then it holds both a partially secured claim and a
partially unsecured claim. If the value of the estate property is equal to, or
less than liens that are superior to the surety’s lien, then the surety will
hold an unsecured claim, even though the surety has a lien against estate
property.
To determine
whether the surety with a lien against estate property is secured, partially
secured (i.e., undersecured), or unsecured, the following three variables should
be analyzed: (1) the amount of the surety’s claim, (2) the amount of creditors’
claims with liens that are superior to the surety’s lien, and (3) the value of
the collateral securing the claim. Uncertainty concerning the amount of the
surety’s secured claim is created when the amount of senior lienholders’ claims
are unknown or uncertain (i.e., unliquidated, contingent or disputed). If the
valuation of the estate property subject to liens is an issue, then the
bankruptcy court can hold a hearing to determine such property’s value.
The surety
frequently finds that the amount of its claim is unliquidated and contingent due
to pending claims against its bonds and the outstanding exposure under its bonds
where future claims can be made against these bonds. Nonetheless, the surety
should file its proof of claim as a secured claim. The surety’s lien against
estate property will continue notwithstanding the fact that the surety’s claim
is unliquidated and contingent, and may subsequently be disallowed under
Bankruptcy Code Section 502(e).
2. Section 506(b): Surety’s Claim for Interest, Attorneys’ Fees and
Costs
To the extent the
surety holds a fully secured claim (i.e., the value of the collateral subject to
the surety’s lien is greater than the surety’s allowed claim), the surety is
entitled to make a claim against the collateral for interest on its claim, and
reasonable attorneys’ and consultants’ fees, costs and other charges provided
for in the indemnity agreement, To the extent the surety holds an undersecured
claim, the surety will not be able to claim post-petition interest and
post-petition costs and expenses under Bankruptcy Code Section 506(b).
Separate and
apart from Code Section 506(b), the surety may be able to claim post-petition
attorneys’ fees as an undersecured creditor (or even an unsecured creditor)
pursuant to the Supreme Court case of Travelers Cas. & Sur. Co. of Am. v.
Pacific Gas & Elec. Co., wherein the Court stated, “we generally presume
that claims enforceable under applicable state law will be allowed in bankruptcy
unless they are expressly disallowed” under Bankruptcy Code Section 502. In
Pacific Gas & Elec., the Supreme Court overruled prior precedent disallowing
postpetition attorneys’ fees, but the Court refused to decide whether
postpetition attorneys’ fees were disallowed under Section 502(b)(1) because the
surety was an unsecured creditor.
Since Pacific
Gas & Elec., lower courts have allowed unsecured creditors to recover
attorneys’ fees incurred post-petition. In Qmect Inc. v. Burlingame Capital
Partners IL LP, the U.S. Bankruptcy Court for the Northern District of
California determined that an unsecured creditor was entitled to include its
contract-based post-petition attorneys’ fees in its claim. Similarly, in In
re STNL Corp. the Ninth Circuit Bankruptcy appellate panel discussed the
split of authority concerning this issue both before and after the Pacific
Gas & Elec. decision. In its analysis, the Appellate Panel discussed what it
referred to as the “minority line” of cases that allowed a claim for
post-petition attorneys’ fees even though the claim was unsecured. In its
conclusion, the appellate panel agreed with the reasoning in the Qmect opinion
and minority line of cases and concluded that “claims for post-petition
attorney’s fees cannot be disallowed simply because the claim of the creditor is
unsecured.”
In In re
Agway, Inc., the Bankruptcy Court for the Northern District of New York
discussed whether an unsecured creditor with a contractual right to recover its
attorneys’ fees could claim post-petition attorneys’ fees. The Agway
court acknowledged the continued split of authority on this issue and the
“minority line” of cases discussed in STNL Corp. The Agway court
sided with the STNL Corp. opinion and concluded that the surety’s allowed
claim should include its attorneys’ fees incurred postpetition. However, the
case of In re Electric Machinery Ent., Inc. disallowed the surety’s claim
for post-petition attorneys’ fees. The surety should include in its secured
claim (as well as its undersecured and unsecured claim) all post-petition
attorneys’ fees both incurred and paid.
E. The Surety’s Contingent and
Unliquidated Claim-Section 502(E) of the Bankruptcy Code
A portion of the
surety’s claim may be contingent and unliquidated due to pending claims against
its bonds and the outstanding exposure under its bonds where future claims can
be made against these bonds. The surety’s contingent and unliquidated liability
is a “claim,” which is defined very broadly under Bankruptcy Code Section
101(5). The surety must calculate its contingent and unliquidated exposure to be
included in its proof of claim. The surety’s contingent and unliquidated claim
will be equal to the total penal sums of all outstanding bonds less any payments
made to date.
The major concern
for the surety is that its contingent claim may be disallowed. Pursuant to
Bankruptcy Code Section 502(e)(1), “the court shall disallow any claim for
reimbursement or contribution of an entity that is liable with the debtor on or
has secured the claim of a creditor” to the extent that “such claim for
reimbursement or contribution is contingent as of the time of allowance or
disallowance of such claim for reimbursement or contribution.
In In re
Agway, Inc., pursuant to Code Section 502(e)(l), the debtor objected to the
surety’s claim for reimbursement or contribution to the extent such claim was
contingent at the time of allowance or disallowance. The surety requested that
the bankruptcy court defer ruling on whether to disallow the contingent portion
of its claim. The Agway court disagreed and disallowed the surety’s contingent
claim, but stated that the surety had a remedy, under Code Section 5020), to
have its claim reconsidered once the claim became fixed and liquidated.
In the vast
majority of cases, the surety will have a contingent and unliquidated claim due
to pending claims and continued exposure under its outstanding bonds. In the
event an objection is filed to the surety’s proof of claim, and the claim
remains in part contingent, the surety’s contingent claim for reimbursement may
be disallowed. The remedy for the surety is to have its claim reconsidered “for
cause,” pursuant to Bankruptcy Code Section 5020), when, and if, it makes
additional payments under its bonds.
F. The Surety’s Reimbursement
Claim Under Section 502 of the Bankruptcy Code and the Surety’s Subrogation
Claim Under Section 509 of the Bankruptcy Code
A surety that
pays a claim under a bond has two types of claims: “(1) a claim for
reimbursement or contribution, and (2) a subrogation claim; and it is clear
under the Code that it cannot have an allowed claim in both categories because
that would permit it to effectuate a double recovery.” Generally, the Bankruptcy
Code preserves for the surety either a right of reimbursement (indemnity) or a
right to be subrogated to the claim of the entity that the surety has paid.
However, the surety is not entitled to two recoveries, and it must decide upon
which of the two rights (seeking reimbursement under the indemnity agreement or
pursuing its subrogation rights) the surety wants to rely.
The interplay
between Bankruptcy Code Sections 502 and 509 address these two types of claims
held by the surety, one for reimbursement under the indemnity agreement and the
other for reimbursement pursuant to the surety’s subrogation rights. The surety
may enforce its rights to reimbursement under Section 502 or enforce its
subrogation rights under Section 509, but may not enforce both rights. The
surety should carefully preserve and not waive its subrogation rights in its
proof of claim to the extent that the surety may prefer to proceed under its
subrogation rights, including other claims against the debtor, rather than just
its reimbursement rights under the indemnity agreement.
Notwithstanding
the surety’s rights of reimbursement and subrogation, the surety’s claim may not
be entitled to obtain a distribution on its allowed claim until the creditor or
creditors who are the beneficiaries of the contract surety and/or commercial
bonds (whether as obligee or claimant) have been paid in full. In this regard,
Bankruptcy Code Section 509(c) provides:
The court shall
subordinate to the claim of a creditor and for the benefit of such creditor an
allowed claim, by way of subrogation under this section, or for reimbursement or
contribution, of an entity that is liable with the debtor on, or that has
secured, such creditor’s claim, until such creditor’s claim is paid in full,
either through payments under this title or otherwise.
For example, in
the event that the obligee claimant under a unpaid $50,000 and the surety files
a proof of claim for reimbursement in the sum of $150,000, but the penal sum of
the commercial bond is only $100,000, even if the surety pays the obligee
claimant the penal sum of the commercial surety bond of $100,000, the obligee
claimant will still be unpaid in the amount of $50,000 by the principal debtor.
Pursuant to Code Section 509(c), if the obligee claimant files a proof of claim
for the unpaid $50,000 and the surety files a proof of claim for reimbursement
in the sum of $100,000, the surety’s allowed claim in the sum of $100,000 may be
subordinated to the $50,000 claim of the obligee claimant, and the surety should
not receive a distribution from the debtor’s estate until the obligee claimant
is paid in full.
G. The Surety’s Proof of Claim
and the Claims Administration Process
The proof of
claim is the means by which the surety advises the debtor, the court, creditors,
and other interested parties of the existence, amount, and categories of the
surety’s claim against the debtor. Filing a proof of claim is not mandatory.
However if a creditor is not listed with an undisputed amount in the debtor’s
filed schedules, then filing a proof of claim is necessary to permit the
creditor to participate in distributions that may be made to unsecured
creditors.
To participate in
the debtor’s distributions, if any, to creditors as a result of the surety’s
claims arising from the issuance of the bonds and/or execution of the indemnity
agreement, and to obtain recovery from any collateral that is property of the
debtor’s estate to the extent that the surety has properly perfected its secured
claim, the surety should file a proof of claim.
The claims
administration process for the debtor is spelled out in much greater detail in
other publications, and is generally discussed in this chapter. The claims
administration process includes the surety timely filing its proof of claim
whether the surety’s claim is liquidated, unliquidated, contingent,
non-contingent, disputed or undisputed. The proof of claim must state the type
of claim or claims being asserted by the surety, the basis for the surety’s
claims, and the amount of the surety’s claims. The proof of claim shall conform
substantially to the appropriate Official Form for the particular proof of
claim.
In addition to
this form, the surety should attach to its proof of claim form a narrative
describing the types of claims that the surety is asserting (unsecured, priority
and/or secured), the basis for the surety’s claim, and the amount of the
surety’s claim. The amount of the surety’s claim is often larger than the amount
of the surety’s losses that have been paid to date. Sureties include this
additional amount for reserves posted or the total contingent liability of the
surety calculated as the total penal sum liability for all outstanding bonds. In
addition to the surety’s total exposure under its bonds, a statement of the
surety’s current loss should be included, with the total loss to date broken
down per category (i.e., loss, expense, attorneys’ fees, etc.).
The surety does
not have to attach to its proof of claim copies of all its bonds or copies of
checks or other evidence of payment under the bonds. The surety may attach a
list of the bonds and/or a list of all of the payments made under the bonds to
the proof of claim, but this is not necessary. The surety should attach a copy
of the indemnity agreement. For its secured claim the surety should describe the
following: (1) the surety’s liens and security interests against the debtor’s
property and attach all evidence and documents concerning perfecting the
surety’s liens and security interests; (2) any judgment the surety has obtained
against the debtor, attaching a copy of the judgment to the proof of claim; (3)
any other documents demonstrating the perfection of any liens against the
debtor’s real or personal property; (4) a reservation of all rights the surety
has with respect to any setoffs that the surety may have against the debtor and
any of the debtor’s claims; (5) a reservation of surety’s subrogation rights to
any rights against the debtor, or assets of the debtor and to the rights of
others.
Finally, the
attached statement should reserve the surety’s right to amend and/or supplement
its proof of claim to add any additional liabilities and reflect the surety’s
updated actual loss and expense.
In order for the
surety’s general unsecured proof of claim to become an allowed claim and receive
a distribution from the debtor’s estate, the proof of claim must be filed timely
in accordance with the Bankruptcy Code and the Bankruptcy Rules. In a Chapter 7
or Chapter 13 case, the surety’s proof of claim will be timely filed if it is
filed no later than 90 days after the first date set for the “meeting of
creditors.” In a no-asset Chapter 7 case, the notice of the bankruptcy filing
may provide that it is unnecessary for creditors to file a proof of claim. If
assets are subsequently discovered, another notice will be sent to creditors
that includes a deadline to file proofs of claim. In a Chapter 11 case, the
surety’s proof of claim must be filed no later than the Bar Date set by the
bankruptcy court. Typically, in Chapter 11 cases, the debtor requests the
establishment of a Bar Date to file claims, and notice of this Bar Date will be
sent to all creditors who have requested notice in the case. Occasionally, a Bar
Date will be set by the bankruptcy court in the initial notice of the bankruptcy
filing. As soon as the surety is aware of its principal’s or indemnitors’
bankruptcy filing, it should inquire when its proof of claim is due, and where
its proof of claim should be filed. In larger Chapter 11 cases the proof of
claim may be required to be filed with a special claims agent rather than the
bankruptcy court.
The surety’s
claim might also become an allowed claim without filing a proof of claim. If the
debtor’s schedule of liabilities lists the surety’s pre-petition claim in the
correct amount and does not list the claim as disputed, unliquidated or
contingent, then the surety does not need to file a proof of c1aim. However, it
is extremely rare for the debtor to list the contract surety’s or commercial
surety’s pre-petition claim as undisputed, liquidated and non-contingent. To be
prudent, the surety should always file its proof of claim on a timely basis
unless the bankruptcy case is a no-asset Chapter 7 case. The surety’s proof of
claim will supersede the surety’s claim in the debtor’s schedule of liabilities.
If the surety’s
proof of claim is executed and filed in accordance with the Bankruptcy Rules,
then it “shall constitute prima facie evidence of the validity and amount of the
c1aim.” The surety’s claim will be “deemed allowed, unless a party in interest
...objects.” Practically, the debtor or trustee will not file an objection, if
one is filed at all, for several months after the surety files its proof of
claim. When an objection is filed, the surety will be required to prove the
liquidated portion of its claim (i.e., payments made to date) and the contingent
and unliquidated portion of its claim may be disallowed under Bankruptcy Code
Section 502(e)(l), which provides as follows:
Notwithstanding
subsections (a), (b) and (c) of this section and paragraph (2) of this
subsection, the court shall disallow any claim for reimbursement or contribution
of any entity that is liable with the debtor on or has secured the claim of a
creditor, to the extent that
(A) such
creditor’s claim against the estate is disallowed;
(B) such claim
for reimbursement or contribution is contingent as of the time of allowance or
disallowance of such claim for reimbursement or contribution; or’
(C) such entity
asserts a right of subrogation to the rights of such creditor under section 509
of this title.
The bankruptcy
court must disallow the surety’s claim for reimbursement to the extent provided
in Bankruptcy Code Section 502(e)(l).
If the surety’s
proof of claim is a liquidated claim as a result of the indemnity agreement,
several provisions in the indemnity agreement may assist the surety in having
its claim allowed if an objection to the surety’s claim is filed. These types of
indemnity agreement provisions include:
-
The debtor’s
obligation to indemnity and reimburse the surety under the terms of the
indemnity agreement;
-
The surety’s
entitlement to reimbursement for any and all payments made by the surety in good
faith, under the belief that the surety is or was liable for the sums and
amounts paid and/or that it was necessary or expedient for the surety to make
such payments; and
-
The prima facie
evidence of the fact and the amount of the debtor’s liability to the surety
documented by vouchers, statement of payments, or other evidence of the surety’s
payment.
Assuming that the
surety’s proof of claim under the indemnity agreement is not disallowed under
Bankruptcy Code Section 502(e)(1), the surety may use other provisions in the
indemnity agreement to have its proof of claim (unsecured, priority and/or
secured claims) allowed in the debtor’s bankruptcy case.
H. Jury Trials: When to File a
Proof of Claim
28 U.S.C. Section
l57(e) provides that bankruptcy judges may conduct a jury trial only if the
following three conditions are satisfied: (1) the right to a jury trial applies,
(2) the bankruptcy judge is specifically designated to conduct jury trials by
the district court, and (3) all parties expressly consent. Based on this
provision, if a party has a right to a jury trial and does not want the
bankruptcy court to conduct the jury trial the party could seek to have the
proceeding transferred to the district court. Therefore, if a party determines
that the district court is the preferred forum to hold the jury trial, then the
party can seek to have the action moved to district court based on the party not
consenting to the bankruptcy court conducting the trial.
It must be noted,
however, that if a creditor files a proof of claim in the bankruptcy court, then
the creditor waives its right to a jury trial. Therefore, if a creditor wants to
maintain its right to a jury trial, the creditor should wait as long as possible
prior to filing a proof of claim. This may be contrary to current corporate
policy. However, creditors are formally notified when they must file a proof of
claim or have their claim barred in the bankruptcy case. In a Chapter 11
proceeding, a deadline to file claims is usually set when a plan of
reorganization is filed. Creditors should not miss filing their claims on a
timely basis if they want to be included in any pro-rata distributions from the
bankruptcy estate. The point is by delaying the filing of a proof of claim, a
creditor may be able to have its jury trial held in district court, while still
filing their proof of claim in a timely basis.
I. Subordination of the Surety’s
Claim
Section 510 of
the Bankruptcy Code contains two major concepts that may be applicable to the
surety. Pursuant to Section 510(a), “a subordination agreement is enforceable in
a case under this title to the same extent that such agreement is enforceable
under applicable non-bankruptcy law.” Many sureties obtain a subordination
agreement from their principals, indemnitors and even various lenders and other
creditors of the principal and the indemnitors. To the extent that the surety
has a valid pre-petition subordination agreement that gives the surety
additional rights, that subordination agreement will be enforceable in the
debtor’s bankruptcy case based upon applicable non-bankruptcy law. Similarly, if
the surety has executed such a subordination agreement in favor of other
entities, the surety will be bound in a bankruptcy case to the terms of that
subordination agreement to the same extent.
Section 510(c) of
the Bankruptcy Code addresses another issue, namely whether a creditor’s claim
should be equitably subordinated to the claims of one or more other creditors
for various reasons that the bankruptcy court determines. In this regard,
Bankruptcy Code Section 510(c) provides:
Notwithstanding subsections (a) and (b) of
this section, after notice and a hearing, the court may -
(1) under principles of equitable
subordination, subordinate for purposes of distribution all or part of an
allowed claim to all or part of another allowed claim or all or part of an
allowed interest to all or part of another allowed interest; or
(2) order that any lien securing such a
subordinated claim be transferred to the estate.
There are many
non-surety cases that discuss the issue of equitable subordination. This is not
an issue that most sureties need to be concerned about when acting in their
customary and normal underwriting and/or claims activities.
J. Transfers of Claims
Once the surety’s
liquidated claim has been allowed, the surety may want to consider whether the
best means to maximize its recovery is through a sale of the surety’s allowed
c1aim. The method to effectuate such a sale and transfer of claim, and the facts
to be considered in establishing a purchase price are beyond the scope of this
chapter.
K. Conclusion
The surety may
hold several types of claims, including unsecured, priority, super-priority
and/or secured claims in the debtor’s bankruptcy case. To the extent possible
the surety should endeavor to improve its position during the case by
negotiations with debtor’s counsel (relating to cash collateral, the surety
seeking cancellation of its bonds that are financial accommodations, renewal
premiums that accrue during the case, etc.), moving for “adequate protection,”
asserting its rights throughout the case, and other means. The surety must act
proactively to protect and improve its claims in the debtor’s bankruptcy case.
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