United States Surety Company v. Keycorp (N.D. Ohio Aug. 13, 2007), 2007 U.S. Dist. LEXIS 58996, involved a surety, a contractor and the contractor’s bank.

The contractor was a painting contractor who worked on public projects, namely bridges. As is required by law in Ohio, a contractor who is awarded a public contract ($25,000 or more) must furnish a contract and payment bond indemnifying the owner in the event of default and also assuring that subcontractors and suppliers will be paid should the contractor fail to pay them when it should.

Here, as is often the case, the contractor executed an indemnity agreement in favor of the surety who issued the bonds for the public works contracts. In this agreement, the contractor granted the surety “a lien position with regard to any contract proceeds on U.S. Surety bonded contracts.”

At the time the bonds were issued, the contractor had borrowed money from its bank on numerous occasions. In order to secure repayment of this borrowed money, the contractor had executed written agreements giving the bank security interests in equipment, inventory, accounts receivable, contract receivables, etc., both those existing and those arising in the future.

In late 2004 and 2005 the bank accepted contract payments from the contractor totaling over $480,000. The surety filed suit and protested the bank’s acceptance of these payments.

While the surety’s lawsuit was based on a wide range of legal theories, three facts stood out in the eyes of the court:

  1. there was no contractual relationship between the bank and the surety;
  2. the surety did not rely on any representations as to how the contract payments would be handled; and
  3. when the bank received the payments, the surety had not yet paid any claims on the bonds and therefore was not entitled to indemnification.

For these reasons, the court ruled that the bank had a prior, superior interest in the “disputed funds” and did not accept them wrongfully. The court granted the bank judgment as a matter of law, and the surety was not entitled to recover any of the funds from the bank.

The outcome might have been different if the surety had paid claims for which it was entitled to be indemnified by the contractor, or it had given notice of its superior claim against the funds before they were disbursed to the bank.

For a discussion of “equitable subrogation” and variations of the facts in the above case, see the August 2002 newsletter online at http://www.bricker.com/Publications/articles/623.pdf.