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For a surety, the bankruptcy filing of a principal raises a number of issues and several challenges, but it does not necessarily mean a loss for the surety. With some preparatory steps, coupled with prompt and careful post-bankruptcy actions, the surety can protect its rights and minimize its loss.

Upon learning that one of its principals has filed for bankruptcy, a surety should first file a notice of appearance and request for service of papers. At the beginning of a bankruptcy case, a debtor will file what are commonly referred to as “first day motions.” The purpose of the first day motions is to facilitate the continued business operations of the debtor and protect the debtor’s assets from immediate loss. These first day motions are important and will influence how a surety’s bonded contract funds are handled.

One of the central principles of the Bankruptcy Code is that once a business (a debtor) files for bankruptcy, an estate is created. The Bankruptcy Code defines the property of the estate in broad terms, which includes all legal and equitable interests of a debtor in property, wherever located, and regardless of who holds such property. For a surety seeking bonded contract funds in reimbursement of amounts paid on behalf of its principal, the question is whether or not these funds are considered property of the estate. This is often a litigated issue, but more often than not, the bonded contract funds are considered property of the estate.

Important considerations for a surety

Some important considerations for a surety to best position itself to recover include the following:

Notify the owner/obligee of the surety’s interest
Upon being notified of the bankruptcy filing, the surety should alert the owner/obligee of its interest in the bonded contract funds that have not yet been paid to the principal. Under the doctrine of equitable subrogation, when a surety pays the principal’s debts or performs its principal’s obligations, it is afforded superior priority over other types of liens. As a result, a surety called upon to perform generally has a superior interest in the proceeds of the bonded contract.

Motion for relief
Section 362 of the Bankruptcy Code provides that the filing of the petition and commencement of the bankruptcy case operates as a stay of virtually all actions against the debtor. The surety should be mindful of the automatic stay in all of its communications. The automatic stay is intended to protect the debtor and maintain the status quo. To avoid violating the automatic stay, a surety that wants to recover bonded contract funds may want to consider seeking relief from the automatic stay so that it can continue to collect progress payments and administer and receive funds in connection with completing the project.

Cash collateral
One of the most frequently filed first day motions is a motion to approve the use of cash collateral. If a lender has liens on the debtor’s receivables, the debtor will need to ask the court for authority to use cash collateral. The surety will be considered a secured party if it properly perfected its lien in the bonded contract proceeds by filing a UCC-1 statement or by filing the indemnification agreement. A debtor, however, may not realize that the bonded contract proceeds are considered cash collateral. Accordingly, for a surety to protect itself, it may want to consider either objecting to the use of cash collateral or, at the very least, restricting its use. By doing so, the surety will be putting the court and debtor on notice of its rights to the collateral. The surety should also be prepared to request a form of “adequate protection” as the court may or may not award the relief requested by the surety. Adequate protection is another central principle of the Bankruptcy Code and requires that, as long as a debtor holds property in which the creditor holds an interest, the creditor’s interest must be protected from the risk of decrease in value. If a debtor cannot prove that a surety’s interests are adequately protected, the secured creditor may have the stay lifted and foreclose on collateral pursuant to section 362(d).

Assumption or rejection of a surety’s contract
Under the Bankruptcy Code, the debtor has the ability to assume (or reaffirm) or reject (or disallow) executory contracts. An executory contract is not defined under the Bankruptcy Code, but is generally defined as a contract between the debtor and another party for which both sides have remaining obligations. While it is generally a debtor’s decision when to assume or reject an executory contract, a creditor has the ability to request, by motion, that an earlier deadline be imposed on the debtor to decide whether to assume or reject an executory contract. A debtor may have multiple bonded contracts that are incomplete at the time the bankruptcy is filed. Depending on the debtor’s finances and personnel to complete a project, a surety may want the contract assumed or rejected. For instance, if the surety believes the debtor’s continued presence on a job is a detriment, it may want the contract rejected and seek to obtain control of the project.

Proof of claim
The surety should always file a proof of claim in the principal’s bankruptcy case. By filing a proof of claim, the surety notifies all interested parties of its claim and reserves its rights to share in any future distribution of assets. A claim is secured if the creditor possesses a lien on the property in connection with the claim. When the creditor has an interest in property of the debtor but does not have a lien on the debtor’s property, the creditor is a holder of an unsecured claim. Unsecured claims generally comprise the majority of claims. It is important that the surety carefully evaluate whether the claim it has is secured, unsecured, or both.

Creditors meeting and Rule 2004 Examination
The meeting of creditors is held in every bankruptcy case. One of its purposes is to allow parties to obtain information about the debtor’s finances. Creditors are allowed to attend and may ask questions of the debtor. To obtain a more detailed understanding of the principal’s financial position, the surety may also want to consider a Bankruptcy Rule 2004 Examination. Such examination can be requested of a non-debtor who may have information or documentation concerning the bankruptcy—such as a spouse or a business partner. It is akin to a deposition in a bankruptcy setting, conducted by an order of the bankruptcy judge.

For more information, please contact:

Manju Gupta
216.430.2023
mgupta@mcdonaldhopkins.com

Shawn M. Riley
216.348.5773
sriley@mcdonaldhopkins.com

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