IN THE UNITED STATES COURT OF APPEALS

FOR THE FIFTH CIRCUIT

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No. 96-11214

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STATE BANK & TRUST COMPANY, DALLAS,

Plaintiff-Appellant,

versus

INSURANCE COMPANY OF THE WEST,

Defendant-Appellee.

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Appeal from the United States District Court

For the Northern District of Texas

Dallas Division

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December 29, 1997

Before REYNALDO G. GARZA, SMITH, and WIENER, Circuit Judges.

WIENER, Circuit Judge:

Defendant-Appellee Insurance Co. of the West (ICW), acting as

surety, issued performance bonds on behalf of DRT Mechanical Corp.

(DRT)

—— a subcontractor

—— on two construction projects. DRT had

previously given Plaintiff-Appellant State Bank & Trust Co. (State

Bank) a security interest in its construction tools, equipment, and

inventory (“construction materials”) as collateral for a loan. DRT

defaulted on b oth the loan and its construction contracts, after

which ICW used DRT’s on-site construction materials to complete the2

projects. State Bank brought a conversion action against ICW after

it refused to compensate State Bank for use of the construction

materials in which State Bank held a perfected security interest.

State Bank appeals the dist rict court’s order granting summary

judgment in favor of ICW. Concluding that the district court erred

as a matter of law in its application of the doctrine of equitable

subrogation, we reverse and remand.

I

FACTS AND PROCEEDINGS

State Bank loaned DRT $187, 000 (Original Loan) in November

1991. DRT secured the Original Loan by pledges of personal

property in the form of construction materials. State Bank

perfected its security interest in the collateral by filing a Form

U .C.C.—1 with the Texas Secretary of State. In July 1993, DRT,

having paid down the Original Loan to an outstanding balance of

$142,946.98, pledged additional tangible personal property that

fell within the description of collateral in State Bank’s earlierfiled U.C.C.—1. State Bank advanced DRT additional principal,

increasing the outstanding balance to $172,950.98.

In February 1994, State Bank loaned DRT $300,000 (Defaulted

Loan). To secure repayment of the loan, State Bank and DRT entered

into a commercial security agr eement pursuant to which DRT gave

State Bank a security interest in “[a]ll inventory, chattel paper,

accounts, contract rights, equipment, general intangibles and

fixtures,” owned by DRT together with “[a]ll att achments,3

accessions, accessories, tools, parts, supplies, increases and

additions” thereto. DRT paid off the Original Loan with a portion

of the proceeds of the Defaulted Loan. The security interest

created and perfected in conn ection with the Original Loan

continued in connection with the Defaulted Loan, and the November

1991 U.C.C.—1 filing remained effec tive throughout the District

Court’s jurisdiction over this matter.

DRT entered into subcontracts with two general contractors on

two different projects —— one with Clark-Morris Companies (ClarkMorris), in December 1993, and another with Young Enterprises, Inc.

(Young Enterprises) in October 1994. Each subcontract authorized

the general contractor to use DRT’s construction materials to

complete its work on the project in the event it defaulted on its

obligations.

ICW and its sister surety company, Independence Casualty and

Surety Company, issued payment an d performance bonds insuring

comp letion of DRT’s contractual obligations to Clark-Morris and

Young Enterprises. Under the terms of the performance bonds, the

obligees were to complete the projects in the event DRT defaulted,

and would be entitled to use DRT’s construction materials for that

purpose.

After construction of the projects had begun, DRT notified ICW

of DRT’s inability to complete the projects for which ICW had

issued performance bonds. At approximately the same time, DRT

ceased making the required payments to State Bank on the Defaulted4

Loan. Following receipt of DRT’s acknowledgment of default, ICW

took over the projects to complete them. Substantial work remained

to be done on the projects, and ICW determined that using DRT’s job

site construction materials would provide the least expensive and

most expedient means of completion. As DRT had not paid its

suppliers for all its on-site inventory by the time ICW took over

the projects, ICW had to pay the remaining balance on such

inventory.

State Bank delivered a letter t o DRT requesting that ICW

(1) enter into an “Agreement of Rental;” (2) procure insurance

covering the equipment and naming State Bank as loss payee; and (3)

pay two months rent at $10,000 per month. DRT forwarded the letter

to ICW, which refused to acknowledge State Bank’s claim to a

superior right to possess DRT’s property. State Bank notified DRT

of the acceleration of the loan and demanded that DRT assemble the

collateral for delivery to State Bank.

DRT informed State Bank that some of the requested collateral

—— specifically, job site construction materials

—— remained in the

custody of ICW. State Bank’s president wrote to ICW demanding that

it account for and assemble DRT’s property and notify State Bank

that it could recover such property, but ICW refused State Bank’s

demand. After completing the projects, ICW tendered what remained

of DRT’s construction materials to State Bank, but it declined

ICW’s offer to turn over the property.

S tate Bank brought a conversion action against ICW in st ate1 Melton v. Teacher’s Ins. & Annuity Ass’n of America

, 114 F.3d

557, 559 (5th Cir. 1997).

2 River Prod. Co., Inc. v. Baker Hughes Pr od. Tools, Inc. , 98

F.3d 857, 859 (5th Cir. 1996)(citing F ED

. R. C IV

. P. 56(c)).

3 The part ies agree that Texas law applies in this diversity

case; however, to the extent that Texas law does not address an

issue, we look to federal law for guidance.

5 court, which action was removed to the district court based on

diversity of citizenship. State Bank filed a motion for summary

judgment as to liability and ICW sought summary judgment

disposition of the entire case. The district court denied State

Bank’s motion and granted ICW’s, holding that, under the doctrine

of equitable subrogation, ICW had a right superior to State Bank’s

to possess and use the collateral. State Bank timely appealed.

II

ANALYSIS

A. S TANDARD OF R EVIEW

A district court’s decision to grant summary judgment is

reviewed de novo

, applying the same standards as the district

court. 1 Summary judgment is appropriate when the evidence, viewed

in the light most favorable to the nonmoving party, presents no

genuine issue of material fact and shows that the moving party is

entitled to judgment as a matter of law. 2

B. A PPLICABLE L AW 3

In the typical surety ship arrangement, a surety bonds a

contractor’s performance of its contract with a project owner. If4 Pearlman v . Reliance Ins. Co. , 371 U.S. 132, 138, 83 S.Ct.

232, 235, 9 L.Ed.2d 190 (1962).

5 See Trinity Universal Ins. Co. v. Bellmead State Bank of

Waco

, 396 S.W.2d 163, 168 (Tex. Civ. App.

— Dallas 1965, writ ref’d

n.r.e.) (“It is

. . . well settled in our law that the surety whose

funds go to discharge contractor's obligations is thereby

subrogated to the rights of the owner to apply the contract

balances to the completion of the project and payment of bills

incurred in that connection.”) (citations omitted). The completing

surety is subrogated to the rights of other parties to the bonded

project as well. A surety that fulfills a defaulting contractor’s

obligations is subrogated to the rights of (1) The contractor,

insofar as it is due receivables, (2) the materialmen and laborers

wh o may have been paid by the surety, and (3) the owner for whom

the project was completed. N at’l Sh awmut Bank of Boston v. New

Amsterdam Casualty Co. , 411 F.2d 843, 845 (1st Cir. 1969).

6 Prairie State Nat’l Bank of Chicago v. United States

, 164

U.S. 227, 239, 17 S.Ct. 142, 147, 41 L.Ed 412 (1896).

7 Trinity , 396 S.W.2d at 168.

6 the bonded contractor defaults, forcing the surety to complete the

performance, the completing surety “has an ‘equitabl e right’ to

indemnification out of a retained fund.” 4 The surety is subrogated

to the rights of the project owner/obligee so that the retained

contract price inures to the completing surety’s benefit. 5 The

rationale for equitable subrogation stems from the no tion that

those contract proceeds that are reserved for disbursement until

the contract’s completion are “as much for the indemnity of him who

may be a guaran tor of the performance of the contract as for him

for whom it is to be performed.” 6

The completing surety’s right of subrogation arises in equity,

as an outgrowth of the suretyship relationship its elf; 7 it is not8 Interfirst Bank Dallas v. United States Fideli ty and Guar.

Co. , 774 S.W.2d 391, 399 (Tex. App.—— Dallas 1989, writ denied).

9 Id. at 398; Shawmut , 411 F.2d at 845-46.

10 Although equitable subrogation typically arises in the

context of a surety’s bonding a general contractor’s performance of

its obligations to the project ow ner, that ICW bonded a

subcontractor’s performance of its obligations to general

contractors does not alter our analysis.

11 774 S.W.2d 391 (Tex. App.

—— Dallas 1989, writ denied). In

Interfirst Bank

, the surety bonded a subcontractor’s performance of

its contract with a general contractor. I d. at 393. The

subcontractor then obtained a loan, as collateral for which it gave

the lender a security interest in its accounts receivable. I d. at

393-94. The lender perfected its interest by filing. I d. at 394.

The subcontractor subsequently defaulted on its obligations and

both the lender

—— seeking to realize on its collateral

—— and the

surety —— through equitable subrogation —— claimed entitlement to

undisbursed progress payments and retainages with held by the

general contractor. Id. The court held that the surety’s rights

to the contract proceeds were super ior to the lender’s perfected

interest in the subcontr actor’s receivables because the surety’s

right to equi table subrogation is not a security interest within

the purview of Article 9 of the U.C.C. and, as such, the lender

could not gain priority over the surety by perfecting its interest

in the contract proceeds. Id. at 398-99.

7 dependent on assignment, lien, or contract. 8 As such, the surety’s

right of subrogation is not a security interest and thus is not

subject to the filing requirements of U.C.C. Article 9. 9

As noted, the district court held that by virtue of equitable

subrogation ICW was entitled to use DRT ’s construction materials

located a t the project sites to complete the construction,

notwithstanding State Banks’s pre-existing, perfected security

interest in those materials. 10 In so holding, the court relied on

Interfirst Bank Dallas v. United States Fidelity and Guar. Co. as

controlling authority. 1 1 The district court reasoned that (1)12 See Deer Park Bank v. Aetna Ins. Co. , 493 S.W.2d 305, 306

(Tex. Civ. App. —— Beaumont 1973, n.w.h.) (“[T]he general rule is

that an assignee ... acquires no greater right than was possessed

by his assignor, and simply stands in the shoes of the latter.”);

Interfirst Bank

, 774 S.W.2d at 397 (“[A]n assignee

... cannot take

8 there is no conceptual difference between permitting a surety to

apply contract balances towards project completion and permitting

it to use the defaulting subcontractor’s tool s, equipment, and

inventory for the same purpose, and (2) because, under Interfirst

Bank

, a surety’s equitable right to contract proceeds has priority

over a secured creditor’s right to execute on its security interest

in the same proceeds, ICW’s right to use DRT’s construction

materials has priority over State Bank’s security interests in the

same property.

On a ppeal, State Bank argues that surety priority under

Interfirst Bank is limited to situations in which the surety and

the secured credito r make competing claims to c ontract proceeds ;

that when, as here, the collateral on which the secured creditor

seeks t o execute is tangible personal property, equity does not

entitle the suret y to be equitably subrogated to its principal’s

rights in the property. In support of its argument, State Bank

maintains that, as between the surety and an assignee of the

contract proceeds, equitable subrogation gives the surety priority

because the assignee’s interest in the proceeds never bec omes an

actuality. The assignee’s interest is derivative of the

assignor/contractor’s right to the proceeds. 12 Also, until thegreater rights than his assignor.”).

13 See Deer Park Bank

, 493 S.W.2d at 306 (“While it is true that

a debt having a potential exist ence may be the subject of an

assignment, still such assignment is ineffectual in so far as the

potential debtor is concerned until such potential debt becomes an

actual debt.”) (quoting Alfalfa Lumber Co. v. City of Brady

, 149

S.W.2d 204 (Tex. Civ. App. —— Austin 1912, no writ)).

9 assignor/contractor performs its contract, the

assignor/contractor’s right to the proceeds remains a mere

potentiality. Consequently, urges State Bank, the assignee has no

right to make a claim against the project owner/obligee until the

contractor/obligor has performed. 13 State Bank observes that if the

assignee could cl aim entitlement to the proceeds notwithstanding

the contractor’s default, the assignee would enjoy a greater right

to the proceeds than would its assignor.

We agree that when tangible personal property

—— distinct from

contract proceeds —— is at issue, the rationale for elevating the

surety over the secured creditor has no application. Unlike the

contractor’s inchoate or potential rights in the contract proceeds,

the contractor comes into the construction contract wit h present

and effective ownership and the r ight to possess and use its own

tools, equipment, and inventory. If the contractor has previously

given a creditor a security interest in these materials

—— even

those subsequently acquired —— the creditor’s right to realize on

its collateral is not contingent on the contractor’s full

performance of its obligations.

As the creditor’s interest in its tangible collateral is not14 S tate Bank draws attention to one court’s conclusion that

extending the doctrine of equitable subrogation to tangible

personal property amounts to “nothing less than an appropriation of

a secured creditor’s collateral to r eimburse the performing

surety.” A etna Casualty and Sur. Co. v. J.F. Brunken & Son, Inc.

, 357 F. Supp. 290, 293 (D.So.Dak. 1973).

15 I d. ; U nited States Fidelity and Guar. Co. v. United Penn

Bank , 524 A.2d 958 (Pa. Super. Ct. 1987), a ppeal denied 53 6 A.2d

1333 (Pa. 1987).

10 derivative of the contractor’s right to collect payment under its

contract, the surety cannot claim an equitable right to possess and

use its defaulted p rincipal’s construction materials to complete

the project that the surety has bonded. In fact, granting such use

at no cost would result in a windfall to the surety, who would thus

avoid the anticipated expense of providing materials necessary for

project completion. 14

The courts that have considered this issue have held that

secured cred itors holding perfected security interests in a

defaulting contractor’s tangible personal property retain their

priority over a com pleting surety’s equitable claims. 1 5 ICW

responds that these cases, and their rati onale, are inapposite;

that ICW is only claiming an equitable right to use DRT’s property

—— not an outright ownership interest in it

—— whereas these cases

concern competi ng claims to proceeds from the property’s sale,

i.e., ownership interests. ICW notes that it offered to turn over

DRT’ s construction materials to State Bank after completing the

project, but that State Bank refused. ICW argues that State Bank’s

security interest was still intact, so that if it believed that ICW16 In addition to suffering from the infirmities noted below,

ICW’s “right to use” argument fails to account for the inventories

that were consumed in the projects’ completion

—— which inventories

cannot be returned to S tate Bank —— as well as the equipment and

tools, if an y, whose economic lives were exhausted through ICW’s

use. Moreover, as State Bank notes, ICW’s contention is

inconsistent with the position it took in refusing DRT’s and State

Bank’s requests to surrender the colla teral. ICW gave no

indication that its detention of the property was temporary and

that it ultimately intended to surrender possession of the

collateral. Rather, ICW claimed that its rights were “paramount to

all others’ including secured lending institutions” and that it had

“paramount rights to the contract ba lances, and claims, and

materials, and tools, and equipment on the job site.” ICW did not

offer to return that portion of the collateral which had not been

either consumed in the projects or otherwise disposed of until five

weeks after State Bank brought this action.

17 In re Merts Equip. Co.

, 438 F. Supp. 295, 297 (M.D.Ga. 1977).

11 had damaged the property or that the property had otherwise

decreased in value, State Bank should have brought a claim for such

diminution rather than conversion. 16

ICW cites no authority in support of its “right to use”

argument. It justifies its position with nothing more than the

bald asser t ion that “[f]undamental fairness dictates that the

surety use the defaulting contractor’s tools and equipment to

minimize loss and expense,” and that “to hold otherwise would deny

ICW the right to minimize the cost of resolving DRT’s default.”

ICW’s argument is misguided. The surety’s right to contract

proceeds flows not from cost minimization considerations but from

“the common sense proposition that the co ntract retainage funds

would never become available to any creditor unless the surety

completed the project.” 17 On the other hand, when collateral18 United Penn Bank

, 524 A.2 d at 965 (quoting I n re Merts 438

F. Supp. at 298).

19 Guillot v. Hix , 838 S.W.2d 230, 232 (Tex. 1992).

12 consists of tangible personal property, the surety’s completion of

the contract is not a condition precedent to the conception of the

collateral itself; rather, the creditor who holds a perfected

security interest in a contractor’s tools, equipment, and inventory

may execute on its collateral regardless of whether the contractor

has performed its obligations to third parties. Thus, equity need

not intervene to elevate the surety over the secured creditor, as

“the surety has done nothing with respect to [the tools, equipment,

and inventory] which raises up in the surety an equity superior to

that of later judgment creditors.” 18

We hold that ICW obtained no equitable rights in DRT’s

construction materials by virtue of either its own contract with

DRT or DRT’s subcontracts with the general contract ors, ClarkMorris and Young Enter prises. As subrogee of the general

contractors, ICW has rights that are derivative o f theirs and

therefore can be no greater. 19 Inasmuch as State Bank perfected its

security interest in DRT’s property some two years before DRT

entered into its subcontracts with Clark-Morris and Young

Enterprises, State Bank’s interest in the property takes priority

over their unperfected, conditional assignments in the

subcontracts. Likewise, State Bank has priority over ICW’s afteracquired assignment from DRT in its performance bonds.13 III

CONCLUSION

For the foregoing reasons, the district court’s grant of

summary judgment is reversed and this case is remanded for further

proceedings consistent with this opinion.

REVERSED and REMANDED.