1994 Decisions

Opinions of the United

States Court of Appeals

for the Third Circuit

6-21-1994

In re: Modular Structures, Inc.

Precedential or Non-Precedential:

Docket 92-5577

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Recommended Citation

"In re: Modular Structures, Inc." (1994). 1994 Decisions. Paper 56.

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1 
2 

UNITED STATES COURT OF APPEALS 

FOR THE THIRD CIRCUIT 

 

No. 92-5577 

 

IN RE: MODULAR STRUCTURES, INC. 

 

 Debtor 

FIRST INDEMNITY OF AMERICA INSURANCE COMPANY 

 Appellant 

v. 

MODULAR STRUCTURES, INC.; 

FIRST FIDELITY BANK, N.A. 

THEODORE LISCINSKI, ESQ. 

 Trustee 

 

On Appeal From the United States District Court 

For the District of New Jersey 

(D.C. Civil Action No. 92-02024) 

 

Argued July 2, 1993 

 Before: BECKER, ALITO and ROTH, Circuit Judges

(Opinion Filed June 23, 1994) 

 

Armen Shahinian, Esquire (Argued) 

Joseph Monaghan, Esquire 

Wolff & Samson 

5 Becker Farm Road 

Roseland, NJ 07068 

 Attorney for appellant 
3 

Stephen M. Packman, Esquire (Argued) 

Archer & Greiner 

One Centennial Square 

P.O. Box 3000 

Haddonfield, NJ 08033 

 Attorney for First Fidelity Bank, 

 National Association and Trustee 

Robert W. McCann, Esquire 

Klotz & McCann 

649 Lafayette Avenue 

P.O. Box 64 

Hawthorne, NJ 07507 

 Attorney for Amicus-appellant 

 Surety Association of America 

 

OPINION OF THE COURT 

 

ROTH, Circuit Judge: 

 This appeal arises from the Chapter 7 bankruptcy 

proceedings of Modular Structures, Inc. ("Modular"). Prior to 

filing for bankruptcy on March 8, 1991, Modular had contracted to 

construct a new corporate headquarters in Newark, New Jersey, for 

the Salvation Army. First Indemnity of America Insurance Company 

("First Indemnity") issued a bond to the Salvation Army to secure 

Modular's performance and payment obligations under the contract. 

Eleven months after the institution of the bankruptcy 

proceedings, First Fidelity Bank ("the Bank"), as a secured 

creditor of Modular, filed a Notice of Motion for Turnover of 

Funds to obtain the unearned contract proceeds and retainage held 

by the Salvation Army. First Indemnity filed a cross-motion to 
3 

place the contract proceeds and retainage in escrow in order to 

assure that the funds remained available to secure Modular's 

obligations to pay subcontractors. On March 2, 1992, the 

bankruptcy court denied First Indemnity's cross-motion and 

entered an Order Allowing Turnover in favor of the Bank. First 

Indemnity appealed this decision to the district court which 

affirmed the bankruptcy court. 

 Because we conclude that the district court and the 

bankruptcy court incorrectly determined that the contract 

proceeds and retainage, which the Salvation Army was holding, 

were part of the estate in bankruptcy, we will reverse the order 

directing turnover to the Bank. We also conclude that the 

bankruptcy court made an insufficient examination of whether 

Modular had any legal or equitable interest in the funds held by 

the Salvation Army. We will therefore remand this issue to the 

bankruptcy court for further proceedings in this regard. 

I. 

 On February 27, 1989, Modular entered into a contract 

with the Salvation Army for the design and construction of a new 

corporate headquarters in Newark, New Jersey. In accordance with 

the terms of the contract, First Indemnity, as surety, issued its 

Labor and Material Payment Bond and its Performance Bond to the 

Salvation Army, as obligee, to secure Modular's performance of 

the contract. The bonds bound Modular and First Indemnity to pay 
4 

Modular's laborers and materialmen in connection with the 

contract, which was incorporated by reference into the bonds.1

 In March 1989, the Bank loaned Modular the principal 

sum of $1.5 Million to enable Modular to undertake construction 

contracts such as the one with the Salvation Army. The Bank 

entered into a General Security Agreement whereby it took a 

security interest in all of Modular's accounts receivable, 

contracts and proceeds thereof. Modular also executed a Uniform 

Commercial Code Financing Statement which was filed on April 20, 

1989, thereby perfecting the Bank's lien. 

 Modular commenced work on the Salvation Army project 

but was unable to complete all of its obligations under the 

contract. On March 8, 1991, Modular filed for protection under 

Chapter 7 of the United States Bankruptcy Code, and a Trustee was 

 

1The surety on a construction surety bond guarantees to the owner 

that the contractor will finish the job. If the contractor 

defaults, the surety performs the work, mitigates loss by its 

performance, and pays the subcontractors and suppliers. In 

performing this function, the surety "stands in the shoes" of 

other parties to the construction project through use of the 

equitable doctrine of subrogation: 

[T]he surety in cases like this undertakes 

duties which entitle it to step into three 

sets of shoes. When, on default of the 

contractor, it pays all the bills of the job 

to date and completes the job, it stands in 

the shoes of the contractor insofar as there 

are receivables due it; in the shoes of 

laborers and materialmen who have been paid 

by the surety -- who may have had liens; and 

not least, in the shoes of the government 

[owner], for whom the job was completed. 

National Shawmut Bank of Boston v. New Amsterdam Casualty Co., 

411 F.2d 843, 847-49 (1st Cir. 1969). 
5 

appointed. Modular stated in its bankruptcy schedules that the 

Bank maintained a first, perfected security interest in Modular's 

accounts receivable and contracts and proceeds thereof. On 

August 5, 1991, the Bank obtained a consent order from the 

Trustee granting it a "Superpriority Lien" in Modular's account 

receivables. Following the consent order, the Bank pursued 

collection of Modular's accounts receivable. 

 First Indemnity contends that the unpaid contract 

proceeds and retainage held by the Salvation Army were not 

properly characterized as accounts receivable owing to Modular so 

that the Bank's superpriority lien would apply to them. Pursuant 

to Article 6 of the contract between Modular and the Salvation 

Army, the Salvation Army was not obligated to make final payment 

to Modular until: "(1) the Contract has been fully performed by 

the contractor except for the Contractor's responsibility to 

correct nonconforming work as provided in Subparagraph 12.2.2 of 

the General Conditions and to satisfy other requirements, if any, 

which necessarily survive final payment; and (2) a final 

Certificate for Payment has been issued by the architect . . .." 

App. at 79a. Article 9, section 1.2, of the Contract defined the 

"General Conditions" as the General Conditions of the contract 

for Construction, AIA Document A201, 1987 Edition. Those General 

Conditions included Article 3, section 4.1, which stated that the 

Contractor shall provide and pay for the labor, materials and 

equipment necessary for the proper completion of the work, as 

well as Article 9, section 3.1.2, which provided that a 

Contractor's application for payment "may not include requests 
6 

for payments of amounts the Contractor does not intend to pay to 

a Subcontractor or material supplier because of a dispute or 

other reason." App. at 96a, 104a. Article 9, section 5.1.3, 

permitted the Architect to withhold his certification for payment 

to the extent necessary to protect the Owner from loss as the 

result of the failure of the Contractor to make payments properly 

to Subcontractors or for labor, materials or equipment. See app. 

at 105a. 

 Additionally, Article 9, section 10.2, provided that: 

Neither final payment nor any remaining 

retained percentage shall become due until 

the Contractor submits to the Architect (1) 

an affidavit that payrolls, bills for 

materials and equipment, and other 

indebtedness connected with the Work for 

which the Owner or the Owner's property might 

be responsible or encumbered (less amounts 

withheld by Owner) have been paid or 

otherwise satisfied, . . . (4) consent of 

surety, if any, to final payment and (5) if 

required by the Owner, other data 

establishing payment or satisfactions of 

obligations, such as receipts, releases and 

waivers of liens, claims, security interests 

or encumbrances arising out of the Contract 

to the extent and in such form as may be 

designated by the Owner . . .. 

App. at 106a. Finally, Article 14, section 2.1.2, provided that 

the owner might terminate the contract if the contractor "fails 

to make payment to Subcontractors for materials or labor in 

accordance with the respective agreements between the Contractor 

and the Subcontractors." Article 14, section 2.2, further 

provided that upon such a termination, "the Contractor shall not 

be entitled to receive further payment until the Work is 

finished." See app. at 111a-112a. In sum, Modular was obligated 
7 

to pay its subcontractors before it could receive final payment 

from the Salvation Army. 

 It is undisputed that First Indemnity, as surety for 

Modular, has been called upon to pay proper claims of 

subcontractors. First Indemnity, therefore, sent a letter, dated 

April 2, 1991, to the Salvation Army explaining that it should 

issue no additional payments to Modular so that any remaining 

funds could properly be used to cure Modular's default. The 

Bank, on the other hand, contends that, despite Modular's 

apparent breach of its contract with the Salvation Army, a letter 

sent by Charles R. Kramer, Jr., Esq., counsel for the Salvation 

Army, to counsel for the Bank demonstrates that the Salvation 

Army considered the contract terms to have been satisfied. The 

letter stated, inter alia, that "The Army is prepared to pay the 

final installment of $104,490.00, but wishes to do so only if 

said payment will not expose The Army to duplicate payments." 

App. at 114r. First Indemnity interprets this letter as 

requiring that the funds held by the Salvation Army not be 

payable to Modular until and unless Modular fully performed its 

contract, including the payment of laborers and materialmen.2 

 

2We note that neither the bankruptcy court nor the district court 

cited this letter in its decision on the turnover order. Our 

reading of the clear language of the letter, in view of the 

contract language discussed above, leads us to conclude that, in 

view of the unpaid subcontractors, the Salvation Army would have 

been exposed to "duplicate payments" if it had released the funds 

to Modular. For that reason, we conclude that contract terms had 

not been satisfied and the Salvation Army was not obligated to 

release the funds to Modular. 
8 

 On November 7, 1991, counsel for the Bank sent a letter 

to the Salvation Army threatening to institute legal action if 

the Salvation Army did not release the funds to the Bank by 

November 22, 1991. The Salvation Army did not comply and the 

Bank filed its motion for turnover of the funds in Modular's 

bankruptcy proceeding. 

 The bankruptcy court found for the Bank on the basis 

that the contract was not a public contract and therefore there 

was no trust fund to protect the funds, and it issued an Order 

for Turnover of the funds. App. at 241r. First Indemnity then 

appealed to the district court which affirmed the decision of the 

bankruptcy court. The district court considered whether under 

New Jersey law the funds should be construed to be held in trust 

for subcontractors and thus entitled to special priority in a 

bankruptcy proceeding. The district court concluded that no 

constructive trust for subcontractors was created by New Jersey 

common law and affirmed the decision of the bankruptcy court. 

App. at 343-44r. 

II. 

 The bankruptcy court had subject matter jurisdiction 

pursuant to 28 U.S.C. 157((b)(1) over this Chapter 7 bankruptcy 

proceeding. The district court had appellate jurisdiction 

pursuant to 28 U.S.C. § 158(a) to review the bankruptcy court's 

turnover order. This Court has appellate jurisdiction pursuant 

to 28 U.S.C. §§ 158(d), 1291 to review the district court's 

affirmance of the turnover order. See In re Moody, 817 F.2d 365 
9 

(5th Cir. 1987) (turnover order entered by the bankruptcy court 

in an adversary proceeding is a "final" order). 

 This court accepts the findings of fact of the 

bankruptcy court unless clearly erroneous. The bankruptcy 

court's conclusions of law and the district court's decision are 

reviewed de novo. See J.P. Fyfe, Inc. v. Bradco Supply Corp., 

891 F.2d 66, 69 (3d Cir. 1989); In re Muncrief, 900 F.2d 1220, 

1224 (8th Cir. 1990). 

III. 

 As an initial matter, the Bank contends that First 

Indemnity did not preserve the issue in the district and 

bankruptcy courts of whether Modular had breached its contract 

with The Salvation Army and that, therefore, First Indemnity has 

waived its arguments based upon any alleged breach of contract. 

We disagree. First Indemnity's position consistently has been 

either that Modular defaulted on its obligations under the 

contract by failing to pay subcontractors and as a consequence 

was owed no money by the Salvation Army or alternatively that 

under New Jersey law those funds were held by the Salvation Army 

in constructive trust for the benefit of the subcontractors. The 

breach of contract basis for argument was presented to the 

bankruptcy court in First Indemnity's February 21, 1992, letter 

brief in opposition to the Bank's motion for turnover: "Thus, 

these contract monies never became part of the debtor's estate. 

The contractor defaulted and has therefore lost its right to 

these funds. . .." App. at 205r. First Indemnity repeated this 
10 

position at oral argument in its opposition to the turnover 

order. App. at 182a. 

 First Indemnity then argued before the district court 

that: 

 There is no right of payment of 

retainage of the contract balance unless all 

of the subcontractors or suppliers have been 

paid in full. Only in that manner can it be 

stated that all parties have complied with 

their contractual obligations. A.I.A. 

contract forms, as used in the case herein, 

certify that all subcontractors and suppliers 

are paid in full before payment will be made 

from the owner. 

 In the case herein, it is quite clear 

that many of the subcontractors and suppliers 

were not paid. . .. 

App. at 294r. Moreover, in its reply brief to the district 

court, First Indemnity asserted that because of this alleged 

breach of contract the Bank was precluded from attaching the 

funds held by the Salvation Army. See app. at 204a-205a. We 

find, therefore, that there has been no waiver of this issue. 

IV. 

 First Indemnity's primary argument on appeal is that, 

because Modular breached its contract with the Salvation Army, 

none of the funds held by the Salvation Army were owing to 

Modular and thus could not properly be considered part of the 

bankruptcy estate, subject to the Bank's lien and amenable to a 

turnover order. Based upon the record before us, we agree with 

First Indemnity and will reverse the decisions of the district 
11 

and bankruptcy courts.3 We therefore hold, as a matter of law, 

that, assuming the facts are as the present record indicates, the 

funds held by the Salvation Army are not properly part of the 

estate in bankruptcy.4 

 The filing of a bankruptcy petition creates an estate 

in bankruptcy. This estate, pursuant to section 541(a)(1) of the 

Code, contains "all legal or equitable interests of the debtor in 

property as of the commencement of the case." 11 U.S.C. 

§541(a)(1). "'Although section 541 [of the Bankruptcy Code] 

defines property of the estate, we must look to state law to 

determine if a property right exists and to stake out its 

dimensions.'" Universal Bonding Ins. Co. v. Gittens & Sprinkle 

Enter., Inc., 960 F.2d 366, 369 (3d Cir. 1992) (quoting In re 

Nejberger, 934 F.2d 1300, 1302 (3d Cir. 1991)); see also Butner 

v. United States, 440 U.S. 48, 54 (1979) ("Congress has generally 

left the determination of property rights in the assets of a 

bankrupt's estate to state law."). We must look, therefore, to 

New Jersey law to determine whether the funds held by The 

 

3Because we find that the funds held by the Salvation Army are 

not owing to Modular and thus not part of the bankruptcy estate, 

we find it unnecessary both to determine whether, under New 

Jersey law, the funds should be considered held in constructive 

trust for the benefit of subcontractors and to determine what 

priority First Indemnity would have were the funds at issue part 

of the bankruptcy estate and not held in constructive trust for 

the benefit of subcontractors. 

4As explained in Part V infra, we will remand to the bankruptcy 

court for a determination of whether any supplemental facts, not 

in the present record, would demonstrate that Modular had a legal 

or equitable interest in any part of the funds held by the 

Salvation Army. 
12 

Salvation Army are properly the "property" of the bankruptcy 

estate here. 

 The contract between Modular and the Salvation Army 

requires Modular to pay its subcontractors before final payment 

is due to Modular. Moreover, it is undisputed, based upon the 

record currently available in this case, that Modular has failed 

to pay some of its subcontractors. The question, then, is 

whether Modular is owed the funds retained by the Salvation Army. 

Under New Jersey law, "[a] contract right becomes an account as 

performance is made under the contract." Continental Fin., Inc. 

v. Cambridge Lee Metal Co., 241 A.2d 853, 860 (N.J. Super. Ct. 

Law Div. 1968), aff'd, 252 A.2d 417 (N.J. Super. Ct. App. Div. 

1969), aff'd, 265 A.2d 536 (N.J. 1970). Thus, if the contract is 

not performed, nothing comes into existence upon which a lien 

could attach. See Damato v. Leone Contr. Co., 25 A.2d 302 (N.J. 

Super. App. Div. 1956) (holding that a tax lien could not attach 

to the unpaid balance of a construction contract because of the 

contractor's failure substantially to perform his contract); see

also United States v. Commonwealth of Pa. Dep't of Highways, 349 

F. Supp. 1370, 1381-82 (E.D. Pa. 1972) (where contractor's 

failure to pay subcontractors constituted a breach of its 

contract, the remaining contract funds were not due to the 

contractor and thus not part of the bankrupt estate); Atlantic 

Ref. Co. v. Continental Casualty Co., 183 F. Supp. 478, 482-83 

(W.D. Pa. 1960) (holding that "a failure by the contractor here 

to pay for labor and materials is just as much a failure to 
13 

perform and carry out the terms of the contract as an abandonment 

of the work would have been"). 

 In the present case, Modular did not fulfill its 

contractual obligation to pay all of its subcontractors. First 

Indemnity, as surety for Modular, is required to pay any 

subcontractor not paid by Modular. The funds held by the 

Salvation Army must be employed to satisfy these claims, either 

in direct payments to the subcontractors or in reimbursement to 

First Indemnity for the payments it has made as surety, standing 

in the Salvation Army's shoes, to the subcontractors. If the 

Salvation Army were to be required to pay the monies it is 

holding into the bankruptcy estate, First Indemnity apparently 

would have to seek recovery for its payments to the 

subcontractors only as an unsecured creditor, in competition with 

the other unsecured creditors. This is a result contemplated 

neither by the contract, as we have explained it, nor by New 

Jersey law. 

 New Jersey has recognized in cases of government 

contracts that payments held by the government, as owner of a 

construction project, did not become part of the bankrupt's 

estate. This concept was first enunciated by the United States 

Supreme Court in Pearlman v. Reliance Ins. Co., 371 U.S. 132 

(1962). In Pearlman, a priority dispute arose between the 

trustee of the bankrupt estate and the surety with respect to 

contract funds retained by the United States, the owner of the 

construction project at issue. The court held that the monies at 

issue had not become part of the bankrupt's estate; instead, the 
14 

retained funds remained the property of the owner, and by way of 

subrogation,5 became the surety's property to the extent 

necessary to reimburse it for its payment to laborers and 

materialmen. See id. at 141. The Court explained: 

Ownership of property rights before 

bankruptcy is one thing; priority of 

distribution in bankruptcy of property that 

has passed unencumbered into a bankrupt's 

estate is quite another. Property interest 

in a fund not owned by a bankrupt at the time 

of adjudication whether complete or partial, 

legal or equitable, mortgages, liens or 

simple priority or right are, of course, not 

a part of the bankrupt's property and do not 

vest in the trustee. The Bankruptcy Act 

simply does not authorize a trustee to 

distribute other people's property among a 

bankrupt's creditors. 

Id. at 135-36. The Court then concluded: 

We therefore hold in accord with the 

established legal principles stated above 

that the government had a right to use the 

retained funds to pay laborers and 

materialmen; that the laborers and 

materialmen had a right to be paid out of the 

funds; that the contractor had he completed 

his job and paid his laborers and materialmen 

would have become entitled to the fund, and 

that the surety having paid the laborers and 

materialmen is entitled to the benefit of all 

these rights to the extent necessary to 

reimburse it. 

 

5The subrogation scheme that is part of the Pearlman doctrine has 

been explained in National Shawmut Bank, see footnote 1, supra. 

See also Trinity Universal Ins. Co. v. United States, 382 F.2d 

317, 320 (5th Cir. 1967), cert. denied, 390 U.S. 906 (1968): 

The surety is not only a subrogee of the 

contractor, and therefore a creditor, but 

also a subrogee of the government [owner] and 

entitled to any rights the government has to 

the retained funds. If the contractor fails 

to complete the job, the government can apply 

the retained funds and any remaining progress 

money to costs of completing the job. 
15 

Id. at 141;6 see also Polish v. Johnson Serv. Co., 333 F.2d 545 

(3d Cir. 1964) (following Pearlman); Framingham Trust Co. v. 

Gould-National Batteries, Inc., 427 F.2d 856, 859 (1st. Cir. 

1970) (explaining that "we cannot escape the conclusion that in 

both a practical and a legal sense, the payment of previously 

unpaid laborers and materialmen is a cost of completing the 

 

6The adoption of the Bankruptcy Code in 1978 has not undercut 

Pearlman's vitality. 

In [Pearlman], the Supreme Court found that 

where by the doctrine of subrogation a surety 

becomes the virtual owner of property that 

would otherwise be the property of the 

debtor, the property will not become an asset 

of the estate. Although the attempt of the 

Congress in enacting the Code was to give the 

broadest possible scope to what are assets of 

the estate, it is doubtful if that decision 

has been overruled. 

2 Daniel R. Cowans, Cowans Bankruptcy Law and Practice § 12.30 at 

587-88 (West 1989); accord J. Michael Franks & Michael E. Evans, 

A Defense of Established Landmarks: Claims of Construction 

Sureties to Contract Funds Under Chapter 11, 25 Tort & Ins. L.J. 

28, ___ (1989): 

To the extent that a consensus developed, it 

became generally accepted that enactment of 

the Code would not weaken the principles of 

Pearlman. The Pearlman decision itself 

characterized the surety's entitlement to 

benefits of subrogation in terms of a "firmly 

established rule," which was not to be 

"casually overruled." Certainly, the Code's 

definition of a bankruptcy estate differs 

from the estate that was created by the 

former Bankruptcy Act and considered in 

Pearlman. But, following the first wave of 

decisions under the Code with respect to 

sureties' rights, and through early 1985, it 

could be said rather confidently that 

Pearlman had weathered such assaults as the 

Code made available against it. 
16 

contract"); In re Pacific Marine Dredging and Construction, 79 

B.R. 924, 929 (Bankr. D. Or. 1987) (debtor's failure to pay for 

labor and materials was breach of public construction contract; 

consequently debtor had no legal or equitable interest in fund 

retained by owner and fund was not part of bankruptcy estate). 

 This concept of surety was recognized by the New Jersey 

Superior Court, Chancery Division in Stevlee Factors, Inc. v. 

State, 346 A.2d 624 (N.J. Super. Ct. Ch. Div. 1975). There the 

superior court, chancery division, broadly embraced and followed 

the subrogation rationale and doctrine enunciated in Pearlman, 

holding that "[s]ince the sureties stand in the place of those 

whose claims they have paid, the funds must be paid to the 

sureties just as the funds would have gone in the absence of a 

bond -- to the labor and materialmen rather than to the general 

creditors." 346 A.2d at 627. The court also cited Jacobs v. 

Northeastern Corp., 206 A.2d 49, 54 (Pa. Super. 1965), which 

stated, "Payment of the retained balance became due and available 

only upon the performance by the sureties of Northeastern's 

obligation. It is clear that all labor and materials claims must 

be fully discharged before there is entitlement to the full 

contract payment." Stevlee Factors, 346 A.2d at 627-28.7 

 

7Cf. Transamerica Ins. Co. v. Barnett Bank of Marion County, 540 

S.2d 113 (Fla. 1989), where the court held that a surety's 

equitable subrogation rights had priority over a bank's perfected 

security interest. The court stated: 

[T]he overwhelming and essentially unanimous 

post U.C.C. decisions in this country, 

federal as well as state courts, have held 

that (1) the surety's equitable right of 

subrogation is not a consensual security 
17 

 We find that the reasoning in Stevlee Factors

represents an incorporation of Pearlman into New Jersey common 

law. In the absence of contrary authority, we conclude that we 

must apply the Pearlman doctrine, which convinces us to find, 

based upon the record currently available in this case, that 

Modular's failure to pay its subcontractors was a breach of its 

contract such that it was not owed the funds held by the 

Salvation Army. As a consequence, those funds did not become a 

part of the estate in bankruptcy. 

 Our conclusion is not undercut by this Court's decision 

in Universal Bonding Ins. Co. v. Gittens & Sprinkle, Entr., Inc., 

960 F.2d 366 (3d Cir. 1992), where we held that "monies owed but 

not yet paid to Gittens by state, municipal and federal agencies 

do not constitute statutory or equitable trusts in the hands of 

the government agencies and therefore may be collected by 

Gittens." Id. at 367-68 (emphasis added). In contrast to the 

situation in Gittens, in the present case, because of Modular's 

failure to pay its subcontractors, Modular was not "owed" the 

monies held by the Salvation Army. Indeed, the court's rationale 

in Gittens is completely consistent with our holding here. If 

the funds had been "owed" to Modular, they would have become 

"accounts" under New Jersey law, see Continental Finance, 241 

 

interest, (2) no U.C.C. filing is necessary 

to perfect the surety's interest, and (3) the 

surety's interest continues to be, as it was 

under pre Code law, superior to the claim of 

a contract assignee. 

Id. at 116. 
18 

A.2d at 860. Because, however, Modular had not paid all the 

subcontractors, under the terms of Modular's contract with the 

Salvation Army the funds were not owed to Modular. If the 

subcontractors had been paid and the monies held by the Salvation 

Army were in fact owed to Modular, the Pearlman doctrine would 

not then be applicable. 

 Moreover, we find unpersuasive the bankruptcy and 

district courts' reasoning that the Pearlman doctrine applies 

only to public contracts with the government and not to private 

contracts. There is no such limitation mentioned or implied by 

the court in Stevlee Factors. While Stevlee Factors also 

involved a public contract, we find that it represents an 

encompassing approval of Pearlman without limitation only to 

public contracts. See 346 A.2d at 626-28. The basis cited by 

the New Jersey court for the adoption of the Pearlman doctrine is 

the equitable doctrine of subrogation which "has received wide 

application by the courts of this State and is referred to as a 

right highly favored in law." Id. at 627 (citing Standard 

Accident Ins. Co. v. Pellecchia, 104 A.2d 288 (N.J. 1954); A.&B. 

Auto Stores of Jones St., Inc. v. Newark, 279 A.2d 693 (N.J. 

1971)). 

 Moreover, such a limitation of the equitable doctrine 

of subrogation only to public contracts would be illogical. The 

equitable obligation of the owner to pay subcontractors from 

contract funds remaining in the owners hands is not confined to 

government projects, see e.g. Mid-Continent Casualty Co. v. First 

National Bank & Trust Co., 531 P.2d 1370, 1376 (Okla. 1975) 
19 

(surety has priority over secured lender in dispute over 

remaining contract funds regardless of whether project is private 

or public). The Supreme Court in Pearlman based its holding on 

common law principles of property rights and subrogation, not 

upon principles or rights arising from statutes governing public 

contracts. See Pearlman, 371 U.S. at 139-40. There is also 

nothing in the Court's reasoning in Pearlman that implies that 

its doctrine should apply only to public contracts. The fact 

that the issue arose in a Miller Act case would appear to be 

fortuitous. As explained by the Court of Appeals for the First 

Circuit in Framingham Trust Co. v. Gould-National Batteries, 

Inc., 427 F.2d 856, 857-58 (1st Cir. 1970): 

The government's well established right to 

have the laborers and materialmen paid out of 

the unpaid progress payments or unpaid 

balance does not arise from any legal 

obligation to such suppliers but simply from 

its equitable obligation to those who provide 

it with labor and materials. We see no 

reason why that same equitable obligation to 

the laborers and materialmen should not exist 

on the part of the non-government owner, who 

receives the same benefit from those 

suppliers -- construction work and materials 

-- as did the government in the 

aforementioned cases. Moreover, the nongovernment owner, like the government, has an 

interest in seeing its suppliers paid so that 

the work necessary for completion of the 

contract can be done with minimum disruption 

and expense. 

(citations and footnotes omitted). 

 We conclude that, based upon the record currently 

available in the present case, Modular breached its contractual 

obligation to pay its subcontractors and was therefore not "owed" 
20 

the monies held by the Salvation Army. Under those 

circumstances, those funds are not properly considered part of 

the estate in bankruptcy and are not subject to the Bank's 

superpriority lien. We will therefore reverse the bankruptcy 

court's turnover order. 

V. 

 With that said, we are uncomfortable with the 

development of the record in the present case. Because of the 

bankruptcy court's conclusion that the funds held by the 

Salvation Army were part of the estate in bankruptcy, it did not 

find it necessary to hold a hearing to determine if any other 

factors might establish that any part of the funds were "owed" to 

Modular. For example, the extent to which Modular failed to pay 

its subcontractors has never been documented adequately. Nor did 

the bankruptcy court undertake to explore whether Modular had any 

other basis upon which to claim the funds being held by the 

Salvation Army. We conclude that further proceedings may be 

necessary to determine if Modular has grounds to claim any of 

these funds. We will, therefore, remand this case to the 

bankruptcy court to conduct such further proceedings it deems 

appropriate in light of the above. 
21 

VI. 

 For the foregoing reasons, we will reverse the order of 

the district court and will remand this case to the district 

court with directions to remand it to the bankruptcy court for 

further proceedings consistent with this opinion.