Contractor’s Surety Taking Over Project was Not Permitted to Recover Progress Payment Made by Owner to Contractor’s Bank Loan Account

It is commonly known in the construction industry that general contractors who perform public works projects are required to post a payment bond and performance bond, in part, to ensure that subcontractors are paid and the project is completed in the event the general contractor is unable to fulfill its contractual obligations.  A typical circumstance in which these bonds are relied upon is when the general contractor becomes financially unable to pay or perform (i.e. bankruptcy) before the public works project is completed.  Generally, under the payment bond, a surety would pay those subcontractors that have not been paid by the general contractor and, under the performance bond, the surety would take over the work left unperformed by the general contractor.

Most, if not all, sureties require some form of an indemnity agreement from the contractor prior to the issuance of the bonds.  This allows the surety to collect whatever assets, proceeds, and ongoing payments owed to the contractor are needed to satisfy or mitigate the costs incurred by taking over an unfinished project or paying subcontractors.

In a recent Washington Court of Appeals decision, Hartford Fire Ins. Co. v. Columbia State Bank, similar circumstances as those described above occurred.  __ Wn. App. __, 334 P.3d 87 (2014).  Hartford (surety) issued payment and performance bonds to Waka Group, Inc. (general contractor) for its contract with the General Services Administration (“GSA”) for a project on the Dalton Cache Border Station in Haines, Alaska (the “Dalton Project”).  As partial consideration for the bonds, Hartford and Waka executed an indemnity agreement, which included a “Trust Fund” provision.[i]  Unlike the typical circumstances described above, Waka needed working capital to complete its projects, including the Dalton Project.  Thus, it executed and delivered a commercial line of credit, a Note[ii], and business loan to Columbia State Bank to open a “Control Account.”  Waka had the owners for all its projects, including the Dalton Project, make direct deposits to the Control Account.

Subsequently, Waka was unable to complete the Dalton Project and unable to repay the loan evidenced by the Note.  Columbia informed Waka that it was going to call the loan.  Hartford immediately began taking steps to take over and complete the Dalton Project.  Hartford directed the GSA to send all future payments to Hartford.  GSA agreed, however, it could not stop a progress payment of $103,410 from being deposited into Waka’s Control Account.

Hartford demanded Columbia release the progress payment, but Columbia refused.  Thus, Hartford filed a lawsuit and claimed (1) its Indemnity Agreement with Waka formed an express trust for the benefit of Waka’s subcontractors and Hartford and (2) it possessed an equitable lien on the progress payment funds.  Hartford argued the “Trust Fund” provision of the Indemnity Agreement created an express trust and relied on Westview Investments, Ltd. v. U.S. Bank National Association, 133 Wn. App. 835, 138 P.3d 638 (2006), a case with nearly identical facts (except the owner sued the bank) to draw the similarities.

On appeal, however, Division II of the Court of Appeals disagreed, ruling that there was no express trust and that Westview is distinguishable because the express trust in Westview was formed between the owner and the general contractor (not a general contractor and its surety) and was formed to ensure the payment of the subcontractors who were not paid (not to satisfy the obligations of the bond). Further, the Court held the Trust Fund provision did not immediately impress a trust upon the project payments, but instead “provides for an express trust at some point in the future, after Hartford actually made payments under the bond.”  This latter holding was also the reason the Court held Hartford did not have an equitable lien: “The equitable right of subrogation is created at the time the surety issues payment and/or performance bonds.  But the right of enforcement under equitable subrogation becomes available only after the surety suffers a loss by making payments pursuant to the obligation under the bond.”  The Court also held that because Hartford had not yet acted under its performance bond at the time the $103,410 was deposited and there was no evidence that the Dalton Project subcontractors had not been paid, there was no evidence that Hartford suffered a loss at the time of the payment. Accordingly, the Court ruled Hartford had no right to the money paid to Columbia.

Comment: In making its decision based on the lack of evidence that subcontractors were not paid, it appears the Court of Appeals may have overlooked prima facie evidence in this case: the progress payment itself.  Progress payments to a general contractor include payment to subcontractors for work already performed. It is true that the “Trust Fund” provision of the Indemnity Agreement states that it is for the benefit of the bond, but the payment bond is purely for the benefit of paying lower tiered contractors.  The surety is required to pay the subcontractors under the bond.  The bank has no such obligation and, thus, is not going to pay the subcontractors with the deposited money.  Until the Courts change their view on this issue, sureties should change the language of their indemnity agreements to explicitly state that the “trust fund” is for the benefit of the bond and the subcontractors.

[i] The Trust Fund provision stated the following:

If a Bond is Underwritten in connection with the performance of any contract, the entire contract price shall be dedicated to the satisfaction of the obligations of the Bond and this Agreement. All money paid or any securities, warrants, checks or evidences of debt given under contracts relating to or for which a Bond has been issued shall be impressed with a trust for the purpose of satisfying the obligations of the Bond Underwritten for said contract and this Agreement and shall be used for no other purpose until all such obligations have been fully satisfied. (Italics in original).

[ii] Waka also executed and delivered a security agreement to Columbia to provide collateral for the Note.

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