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Principal File Bankruptcy? All Is Not Lost: The Surety's Ability to Subrogate to Suppliers' Reclamation and Administrative Claims

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. The surety can maximize its recovery by staying vigilant and timely asserting its subrogation rights.

When a principal files for bankruptcy, and the surety is called upon to perform under a performance or payment bond, the surety should determine which goods were supplied to the principal/debtor immediately prior to the filing. Under the Bankruptcy Code,1 not all claims are treated the same. The Bankruptcy Code provides that certain unsecured claims have priority over general unsecured claims, and creates specific rights to recover goods supplied to the debtor immediately prior to the bankruptcy filing. This practice pointer addresses two types of rights to which a surety may be subrogated: (1) reclamation rights and (2) administrative priority claims under § 503(b)(9) of the Bankruptcy Code.

The principles of subrogation allow a surety to step into the shoes of the principal, owner, or a third party – such as a supplier – even in the context of a bankruptcy proceeding. For the surety to have these rights, it must first perform its bond obligations. For instance, when a principal defaults in the performance of a bonded contract, the surety may cure the default and thus become subrogated to the right of the owner, who holds the unpaid contract balances, to apply those balances to the surety’s costs of curing the default. When a principal fails to pay for services, equipment, or material, the surety may cure the default under its payment bond by paying the unpaid subcontractors, materialmen, and laborers. The surety then becomes subrogated to the right of those entities to assert a lien against the property being improved, thereby entitling the surety to the contract balances held by the owner.

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