Case Name: INTERFIRST BANK DALLAS, N.A., Appellant, v. UNITED STATES FIDELITY AND GUARANTY COMPANY, Appellee
Court: Texas Courts of Appeals
Jurisdiction: Texas
Decision Date: 1989-07-10
Citations: 774 S.W.2d 391
Docket Number: No. 05-88-00597-CV
Parties: INTERFIRST BANK DALLAS, N.A., Appellant, v. UNITED STATES FIDELITY AND GUARANTY COMPANY, Appellee.
Judges: Before STEWART, ROWE, and BURNETT, JJ.
Reporter: South Western Reporter Second Series
Volume: 774
Pages: 391–406

Head Matter:
INTERFIRST BANK DALLAS, N.A., Appellant, v. UNITED STATES FIDELITY AND GUARANTY COMPANY, Appellee.
No. 05-88-00597-CV.
Court of Appeals of Texas, Dallas.
July 10, 1989.
Rehearing Denied Aug. 8, 1989.
Christopher M. Hewitt, John L. House, Dallas, for appellant.
Stephen K. Yungblut, Gary L. White, Dallas, for appellee.
Before STEWART, ROWE, and BURNETT, JJ.

Opinion:
ROWE, Justice.
NCNB Texas National Bank (Bank), as successor in interest to Interfirst Bank Dallas, N.A., appeals from a judgment which determined that United States Fidelity and Guaranty Company (USF & G) had a superior right to certain funds owed by various prime contractors to certain related subcontractors (Wallace). In six points of error, Bank complains that the trial court erred in concluding that: (1) Wallace forfeited its rights to funds still held by the prime contractors because Wallace committed a material breach of contract by not satisfying claims of all laborers and materialmen; (2) USF & G, as subrogee of the prime contractors, had priority over Bank to the withheld funds; (3) USF & G, as subrogee of lien claimants with unperfected laborers' and materialmen's liens, had priority over Bank to the funds; (4) certain lien claimants had perfected their liens under applicable state law; (5) the terms of USF & G's payment bonds were incorporated into Wallace's subcontracts; and (6) USF & G was entitled to a $30,000.00 reimbursement for its costs and expenses incident to bond claim handling on the International Pavilion Project. For the reasons given below, we modify the trial court's judgment by deleting the $30,000.00 award for reimbursement and, as modified, affirm.
General Background
The issue presented in this case is whether USF & G's subrogation rights in certain funds are superior to Bank's perfected security interest in accounts receivable. The funds in dispute are undisbürsed progress payments and retainages withheld by the prime contractors under various bonded subcontracts. This complicated case proceeded to trial on stipulated facts. As an appellate court, we are bound by the facts as expressly stipulated by the parties. See Geo-Western Petroleum Dev., Inc. v. Mitchell, 717 S.W.2d 734, 736 (Tex.App.—Waco 1986, no writ); Trinity Universal Ins. Co. v. Bellmead State Bank, 396 S.W.2d 163, 172 (Tex.Civ.App.—Dallas 1965, writ ref'd n.r.e.).
On October 16, 1981, USF & G and Wallace entered into a Master Surety Agreement. This agreement provides for USF & G to issue payment bonds on all Wallace subcontracts and secures USF & G's interest by subrogating it to all Wallace's rights in the subcontracts. All of the bonds issued under the Master Surety Agreement require USF & G to pay laborers and mate-rialmen without regard to the perfection of liens. All bonded subcontracts between Wallace and the various prime contractors provide that final payments thereunder are not due until all lienable claims of laborers and materialmen have been satisfied. The subcontracts clearly reflect that Wallace was to use funds due from the prime contractors to pay for labor and materials being incorporated into the various projects. The subcontracts do not, however, expressly incorporate USF & G's contractual sub-rogation rights.
By documents dated December 16, 1981, Bank made loans to Wallace to provide operating capital for its construction business. In exchange, Wallace granted Bank a security interest in its accounts and the proceeds of its accounts. Bank properly perfected this security interest. It is clear that Wallace was to devote all funds advanced by Bank to completing the subcontracts according to their terms. Moreover, the Master Surety Agreement was already in place when Bank first advanced funds to Wallace on December 16, 1981, and Bank was familiar with these contractual undertakings as they occurred. Indeed, payment bond coverage on all Wallace subcontracts was an integral feature of Bank's loan commitments.
On August 6, 1984, Wallace filed voluntary bankruptcy. The bankruptcy court entered an order dated September 6, 1984, directing that all payments owed to Wallace under the bonded subcontracts be made to USF & G. On July 30, 1986, the bankruptcy court entered an order directs ing Wallace to abandon to Bank all its remaining accounts receivable. This order further provided that "this order shall not prejudice or otherwise affect any rights which any sureties may assert as to any of the accounts receivable so abandoned in which they may assert an interest." Thus, the bankruptcy court released the funds from the debtors' estates without determining whether Bank or USF & G had a superior right to such funds.
At the time of its bankruptcy, Wallace had failed to pay in full its obligations to laborers and materialmen under the subcontracts. Accordingly, USF & G was called upon to satisfy these unpaid obligations under the terms of its bonds. The total of these unpaid obligations exceeded the amount of retainages available under the subcontracts. USF & G contends that it is entitled to apply the retainages to help satisfy Wallace's unpaid obligations. Bank argues that it has a superior right to such funds by virtue of its perfected security interest in accounts receivable.
Four Allen Center Project, Houston, Texas
On April 30, 1982, Carl P. Wallace Company, Inc., entered into a subcontract with Texas Construction, Inc., the prime contractor, whereby Wallace agreed to provide all labor and materials necessary for the installation of plumbing for the Four Allen Center Project. On that same date, USF & G, as surety, and Wallace, as principal, executed a subcontract labor and material bond and subcontract performance bond in favor of the prime contractor. On the date of the bankruptcies, the prime contractor owed Wallace $121,144.47 — $86,833.49 in progress payments and $34,310.98 in re-tainage withheld pursuant to the subcontract. Also as of that date, Wallace owed several subcontractors for labor and materials.
The prime contractor notified USF & G that Wallace had defaulted under its subcontract and made demand upon USF & G pursuant to the payment bond. USF & G paid the claims of the Wallace subcontractors pursuant to its bond obligations. Only one of the subcontractors had perfected a mechanics' lien in the amount of $772.00. The rights of the other subcontractors to perfect liens had expired prior to the dates upon which USF & G received notice of, or paid, the claims. The prime contractor then paid USF & G the entire $121,144.47 balance remaining in the Wallace subcontract. Bank has made demand for $120,-372.47, which represents the $121,144.47 balance less the $772.00 paid to the perfected lien claimant.
Buena Vista Palace Hotel Project, Buena Vista, Florida
On September 8, 1981, Carl P. Wallace Company, Inc., entered into a subcontract with the prime contractor, Pavarini Construction Company, whereby Wallace agreed to furnish all labor and materials necessary for the installation of a heating, ventilating, and air conditioning system and plumbing for the Buena Vista project. On September 16, 1981, USF & G, as surety, and Wallace, as principal, executed a subcontract labor & material bond and a subcontract performance bond in favor of the prime contractor. Wallace had completed the performance of the work under its subcontract before its bankruptcy. There was a balance remaining with the prime contractor in the Wallace subcontract in the sum of $88,053.48, which represented retainage withheld pursuant to the terms of the subcontract.
Three subcontractors to Wallace were owed for materials and labor as of the date of bankruptcy. The prime contractor notified USF & G of the money owed to these subcontractors and USF & G paid the claims in full. None of these subcontractors had perfected a mechanics' lien relating to the project. In fact, the rights of each of these subcontractors to perfect a mechanics' lien expired prior to the dates upon which USF & G received notice of, or paid, their claims. The prime contractor paid USF & G the $88,053.48 balance remaining in the Wallace subcontract. Bank has made demand for this balance.
Farmers Insurance Building Project, Columbus, Ohio
On January 31, 1983, Huffman-Wolfe Company (Wallace) entered into a subcontract with HCB/Peck Contractors, the prime contractor, to provide all labor and materials necessary to furnish and install certain mechanical work for the Farmers Insurance Building. USF & G, as surety, and Wallace, as principal, issued a subcontract labor & material bond and a subcontract performance bond in favor of the prime contractor on February 1, 1983. As of the date of the bankruptcies, certain items of contract, corrective, and warranty work required under the subcontract remained unfinished. At that time, there was a balance remaining in the Wallace subcontract with the prime contractor in the sum of $328,618.75, which represented $39,899.75 in progress payments and $288,-719.00 in retainage withheld pursuant to the terms of the subcontract. Also as of that date, certain subcontractors to Wallace were owed for labor and materials furnished pursuant to their subcontracts.
On September 12, 1984, the prime contractor transmitted to USF & G the sum of $187,394.00 from the balance which remained in the subcontract. USF & G distributed this money to Wallace's unpaid subcontractors. The prime contractor incurred $31,030.25 in expenses in completing the contract. After deducting the $187,-394.00 paid to USF & G and the $31,030.25 for the prime contractors' expense in completing the subcontract obligations, the balance remaining in the Wallace subcontract totaled $110,194.50.
Three of the Wallace subcontractors paid by USF & G did not perfect mechanics' liens. In fact, the rights of each of these three subcontractors to perfect a mechanics' lien expired prior to the dates upon which USF & G received notice of, or paid, their claims. One of these materialmen filed an untimely mechanics' lien which was released in exchange for payment by USF & G. Four subcontractors timely filed and perfected mechanics' liens relating to the Farmers Project in the amount of $79,-588.00. There is insufficient evidence, however, to determine whether some of the other subcontractors had perfected mechanics' lien rights.
Bank asserts a claim to $107,806.00 of the $187,394.00 previously paid to USF & G and to the $110,194.50 balance in the Wallace subcontract. Bank does not assert priority to the $79,588.00 paid to perfected lien claimants or to the $31,030.25 expended by the prime contractor to complete the project. As a result of competing claims to this sum, USF & G and Bank agreed that the $110,194.50 contract balance held by the prime contractor would be paid to Win-stead, McGuire, Sechrest & Minick as escrow agent to be held in escrow until entitlement to the funds was agreed by settlement or awarded by final judgment. This money is currently held in the escrow account.
Ohio State Life Insurance Project, Columbus, Ohio
On January 31, 1983, The Huffman-Wolfe Company (Wallace) entered into a subcontract with the prime contractor, HCB/Peck Contractors, whereby Wallace agreed to provide all labor and materials and services necessary to furnish and install certain mechanical work for the Ohio State Insurance Project. USF & G, as surety, and the Wallace Company, as principal, executed a subcontract labor & material bond and a subcontract performance bond in favor of the prime contractor on February 1, 1983. As of the date of the bankruptcies, there was a $176,079.02 re-tainage balance remaining in the Wallace subcontract which the prime contractor had withheld pursuant to the terms of the subcontract. Wallace owed certain subcontractors for labor and materials so the prime contractor made demand upon USF & G that it perform pursuant to its payment bond on the project.
On September 12, 1984, the prime contractor transmitted $132,429.00 to USF & G from the balance which remained in the subcontract with Wallace. The prime contractor incurred costs and expenses in the sum of $33,844.52 in completing the contract. After deducting the $132,429.00 paid to USF & G and the $33,844.52 for the prime contractor's expense in completing the subcontract obligations, the balance remaining in the Wallace subcontract totaled $9,805.50.
Three of Wallace's subcontractors timely filed and perfected liens relating to the Ohio State Project in the amount of $58,-003.88. The other subcontractors paid by USF & G failed to timely file and perfect mechanics' and materialmen's liens. Bank asserts a claim to the $9,805.50 balance in the Wallace subcontract with the prime contractor on the Ohio State Project. As a result of competing claims to this sum, the prime contractor, USF & G, and Bank entered into a compromise settlement agreement whereby the parties agreed that the $9,805.50 would be paid to Winstead, McGuire, Sechrest & Minick as escrow agent to be held in escrow until such time as entitlement to such funds was agreed by settlement or awarded by final judgment. Bank also asserts a claim to $64,619.62 of the $132,429.00 previously paid to USF & G by the prime contractor. Bank does not assert a claim to the remainder of $58,-003.88 which USF & G paid to satisfy perfected lien claimants.
International Pavilion Project, New Orleans, Louisiana
On December 2, 1982, Carl P. Wallace, Louisiana, entered into a subcontract with the prime contractor, J.A. Jones Construction Company, whereby Wallace agreed to furnish all labor and materials necessary for the installation of certain mechanical work for the International Pavilion Project. On December 10, 1982, USF & G, as surety, and Wallace, as principal, executed a subcontract payment bond and a subcontract performance bond in favor of the prime contractor. As of the date of the Wallace bankruptcies, Wallace had completed the performance of the work under its subcontract on the International Pavilion Project. At that time, there was a balance remaining in the Wallace subcontract of $327,554.55.
On the date of the bankruptcies, Wallace owed various subcontractors and suppliers $548,745.46 for materials and labor, including $91,200.00 owed to Grinnell Fire Protection Systems Company. The prime contractor paid Grinnell $27,700.00, and Grin-nell timely filed and perfected a mechanics' lien in the amount of $63,500.00 for the balance. USF & G paid the claims of some of the Wallace subcontractors totalling $122,455.66, including a $63,500.00 payment to Grinnell in exchange for a release of Grinnell's timely perfected mechanics' and materialmen's lien.
Bank does not assert a claim to the $27,-700.00 paid by the prime contractor to Grin-nell. Deducting this sum, the balance remaining in the Wallace subcontract totals $299,854.55, which represents $129,016.65 in progress payments and $170,837.90 in retainage. Through declaratory judgment actions, USF & G and Bank have each asserted a claim to the retainage still held by the prime contractor. Bank has conceded, however, that USF & G has a superi- or right to the $63,500.00 paid to Grinnell in exchange for a release of its lien.
Surety's Rights to Equitable Subrogation
USF & G has not sought to legally en force any contractual rights, but instead has relied upon the doctrine of equitable subrogation. Based upon the stipulated facts, the trial court filed the following conclusions of law with respect to USF & G's claim:
Upon satisfaction of Wallace's debts and subcontract obligations to the prime contractors, USF & G is subrogated to the position and rights of . the defaulting contractor Wallace.
USF & G's rights of subrogation are equitable principals [sic] and do not depend upon an assignment, a lien, or contract.
Subrogation is said to be of two types: conventional and legal. The latter type is often referred to as equitable subrogation. This type is not dependent upon contract but arises by operation of law or by implication in equity to prevent injustice. For purposes of Texas law, equitable subrogation has been defined as "a legal fiction by force of which an obligation, extinguished by payment made by a third person, is treated as still subsisting for his benefit" or "the procedure by which the equitable rights of one person are worked out through the legal rights of another." Texas Co. v. Miller, 165 F.2d 111, 115 (5th Cir.1947); see also 73 AM.JUR.2d Subrogation § 2 & 3 (1964); 83 C.J.S. Subrogation § 3 (1953). Application of the doctrine is said to be "the purest of equities," and the courts of Texas are said to be particularly hospitable to it. Yonack v. Interstate Sec. Co., 217 F.2d 649, 651 (5th Cir.1954). The doctrine has been widely applied, both as to governmental and private projects, where the obligation of a contractor under a construction contract is backed by payment bonds issued by a commercial surety. E.g., Pearlman v. Reliance Ins. Co., 371 U.S. 132, 141, 83 S.Ct. 232, 237, 9 L.Ed.2d 190 (1962); Trinity Universal Ins. Co. v. United States, 382 F.2d 317, 320-21 (5th Cir.1967); Trinity Universal Ins. Co. v. Bellmead State Bank, 396 S.W.2d 163,168 (Tex.Civ.App.—Dallas 1965, writ ref'd n.r. e.); see also Cushman, The Surety's Right of Equitable Priority to Contract Balances in Relation to the Uniform Commercial Code, 39 TEMP.L.Q. 239 (1966).
In Trinity Universal Ins. Co. v. Bellmead State Bank, a case involving a private construction contract, this Court addressed the proper disposition of conflicting claims to retainage asserted by a surety, which had discharged the obligation of its principal, and by a garnishing bank creditor of the contractor. Chief Justice Williams on that occasion, in holding that the surety was entitled to priority over the bank in the retainage, justified the holding on the following principles of subrogation:
That a surety has an independent right growing out of its relationship as such to require the retainage to be applied to contract obligations is well settled by the courts, both federal and state.... It is further well-settled in our law that the surety whose funds go to discharge contractor's obligations is thereby subrogat-ed to the rights of the owner to apply the contract balances to the completion of the project in payment of bills incurred in that connection.... Simply stated, the right of subrogation of the surety is founded solely upon the equitable principle of having paid, pursuant to a bound obligation so to do, what in equity should have been paid by the contractor....
Id. at 168.
It is established that as the assignee of a perfected security interest in the accounts and proceeds of a contractor, a lender is entitled to the same right to the funds as his assignor. See TEX.BUS. & COM. CODE ANN. § 9.106 (Vernon Supp.1988). Such an assignee cannot, however, take greater rights than his assignor. See TEX. BUS. & COM.CODE ANN. § 9.318(a) (Vernon Supp.1988). Here, it is clear that when Wallace granted Bank a security interest in its accounts receivable, Wallace's rights were already subject to USF & G's subro-gation rights in the event that Wallace failed to satisfy its obligations under the various contracts.
On each project, Wallace's contract with the respective prime contractor expressly required payment of all subcontract suppliers' bills as a condition of completion of the contract obligations. Similar contract language was construed in Corpus Christi Bank and Trust v. Smith, where the supreme court held that such a retain-age provision was intended to provide incentive for the contractor to finish the project, provide completion funds in case the contractor abandoned the project, and provide funds to remedy defects. 525 S.W.2d 501, 504-05 (Tex.1975). As a result, the retainage provision does not make the laborers and materialmen third party beneficiaries or deprive the contractor of an interest in the retainage. Thus, Bank's position as assignor of Wallace clearly prevails over the position of laborers and ma-terialmen having no perfected liens. Id. at 505; see Citizens Nat'l Bank v. Texas & Pacific Ry. Co., 136 Tex. 333, 340-41, 150 S.W.2d 1003, 1007 (1941).
Because of the holding in the Corpus Christi case, USF & G cannot defeat Bank's claim to the retainages simply by paying off the laborers and materialmen and thereby succeeding to their rights. USF & G can defeat Bank's claim only by establishing that, because of the posture of the parties, equitable considerations dictate that the retainages be utilized in the first instance to help defray the surety's obligations of satisfying all lienable claims of laborers and materialmen, whether perfected or not. Directly impacting these equitable considerations is the legal issue of whether the traditional right of a surety to equitable subrogation survived the enactment of the secured transactions provisions of Article Nine of the Uniform Commercial Code.
jEffect of UCC on Surety's Subrogation Rights
Although there is some minor difference of opinion on this legal issue, the majority rule clearly appears to be the one which was sanctioned by Justice Robert Braucher in his definitive analysis of the subject in Canter v. Schlager, 358 Mass. 789, 267 N.E.2d 492 (1971). According to Justice Braucher's analysis, a surety's sub-rogation rights are not security interests within the purview of Article Nine. Id. at 494. This being the case, the promulgation of the UCC and the enactment of its progeny (such as the Texas Business and Commerce Code) do not adversely affect the pre-Code subrogation rights traditionally afforded to sureties. Id.; see 2 WHITE & SUMMERS, UNIFORM COMMERCIAL CODE § 23-6 (3d ed. 1988) (surety's subro-gation rights not a security interest); accord National Shawmut Bank v. New Amsterdam Casualty Co., 411 F.2d 843, 847 (1st Cir.1969). Further, it necessarily follows from Braucher's analysis that a surety's right to equitable subrogation is not adversely affected by the lack of perfection of lien claimants' rights if the surety is obliged to satisfy all lienable claims of laborers and materialmen, whether perfected or not.
The overwhelming and essentially unanimous post-UCC decisions have held that the interest of a surety, such as USF & G, continues to be superior to the claim of a contract assignee, such as Bank. Trans-america Ins. Co. v. Barnett Bank, 540 So.2d 113, 117 (Fla.1989); Mid-Continent Casualty Co. v. First Nat'l Bank & Trust Co., 531 P.2d 1370,1377 (Okl.1975); accord National Shawmut Bank v. New Amsterdam Casualty Co., 411 F.2d 843, 849 (1st Cir.1969); First Alabama Bank v. Hartford Accident & Indem. Co., 430 F.Supp. 907, 911 (N.D.Ala.1977); Fidelity & Casualty Co. v. Central Bank, 409 So.2d 788, 790 (Ala.1982); Alaska State Bank v. General Ins. Co., 579 P.2d 1362, 1368 (Alaska 1978); Argonaut Ins. Co. v. C & S Bank, 140 Ga.App. 807, 232 S.E.2d 135,140 (1976); United, States Fidelity & Guar. Co. v. First State Bank, 208 Kan. 738, 494 P.2d 1149,1159 (1972); Finance Co. of America v. United States Fidelity & Guar. Co., 277 Md. 177, 353 A.2d 249, 254 (1976); Canter v. Schlager, 358 Mass. 789, 267 N.E.2d 492, 497 (1971); Travelers Indem. Co. v. Clark, 254 So.2d 741, 745-46 (Miss.1971); Jacobs v. Northeastern Cory., 416 Pa. 417, 206 A.2d 49, 55 (1965); Third Nat'l Bank v. Highlands Ins. Co., 603 S.W.2d 730, 734 (Tenn.1980).
For the above reasons, it now becomes apparent that, although each of Bank's first five points of error may technically be well taken, such points do not singularly or collectively entitle Bank to priority in the retainages. With respect to the first point, even if Wallace had substantially performed all four subcontracts, Wallace's failure to meet the "final payment" prerequisite of satisfying all lienable claims for labor and materials would entitle the surety to priority in the retainages. With respect to the second point, although the prime contractor might not itself be legally entitled to pay the retainages directly to laborers and materialmen with unperfected liens, the surety's priority in the retainages is not dependent upon such rights of the prime contractor. With respect to the third point, although laborers and materialmen with unperfected liens may have no direct rights in the retainages, the surety's priority therein is not dependent upon such rights by these claimants. With respect to the fourth point, the surety's priority in the retainages is not dependent upon the perfection of liens by laborers and material-men since the surety was obliged to satisfy all lienable claims regardless of perfection. With respect to the fifth point, the surety's priority in the retainages is not dependent solely upon the express contractual agreements appearing in its principals' subcontracts; the symbiotic relationship existing between the prime contractor, its subcontractor, its subcontractor's surety, and its subcontractor's lender is of controlling importance. Accordingly, Bank's first five points of error are overruled.
With respect to Bank's sixth point, the surety is by Bank's concession entitled through subrogation to recoup the $63,-500.00 paid on the lien claim of Grinnell Fire Protection System. The surety is not entitled, however, to recover the stipulated $30,000.00 costs and expenses related to its processing of bond claims on the International Pavilion Project. To the extent this recovery of costs and expenses is dependent upon contract, it fails because of the surety's lack of a perfected security interest in the contract rights of its principal. To the extent it is dependent upon subrogation, it fails because a surety's subrogation rights cover only the amount it has paid to discharge its principal obligation. Phipps v. Fugua, 32 S.W.2d 660, 663 (Tex.Civ.App. —Amarillo 1930, writ ref'd). Accordingly, Bank's sixth point of error is sustained.
Having overruled Bank's first five points of error and having sustained Bank's sixth point of error, we modify the trial court's judgment by removing the $30,000.00 award in favor of USF & G for costs and expenses related to its processing of claims on the International Pavilion Project. As so modified, we affirm the trial court's judgment.
BURNETT, J., dissents.
. Carl P. Wallace Company, Inc., Huffman-Wolfe Company, Carl P. Wallace Company of Louisiana, Inc., and affiliated corporations.
. We shall refer to these undisbursed progress payments and retainages collectively as "retain-ages" unless the context indicates otherwise.
. Any legal contract rights of USF & G covering an assignment for the retainages would be inferior to similar contract rights of Bank because Bank held a perfected security interest therein whereas USF & G did not. On the other hand, an argument is sometimes made that those contractual rights which merely parallel the rights of equitable subrogation are entirely subsumed under equitable principles. 83 C.J.S. Subrogation § 3(b) (1953).
. Justice Braucher, formerly a professor of commercial law at Harvard Law School, assisted in the drafting of the secured transactions provisions of Article Nine of the Uniform Commercial Code.