Title: United States Fidelity & Guaranty Co. v. First St. Bank
Citation: 208 Kan. 738, 494 P.2d 1149
Docket Number: 46,189
State: Kansas
Issuer: Kansas Supreme Court
Date: March 4, 1972

208 Kan. 738 (1972)
494 P.2d 1149
UNITED STATES FIDELITY AND GUARANTY COMPANY, Appellant,
v.
FIRST STATE BANK OF SALINA, Appellee, and L.R. FOY CONSTRUCTION CO., INC.
No. 46,189

Supreme Court of Kansas.
Opinion filed March 4, 1972.
Larry Withers, of Kahrs, Nelson, Fanning, Hite and Kellogg of Wichita, argued the cause, and Roger Sherwood, of the same firm, was with him on the brief for the appellant.
James T. Graves, of Clark, Mize, Graves, Linville and Miller, Chartered of Salina, argued the cause and was on the brief for the appellee.
*739 The opinion of the court was delivered by
FOTH, C.:
This case represents another round in the perennial struggle for priority between the surety on the performance bond of a defaulting building contractor and a bank which has advanced money to the contractor on the faith of an assignment of the contract proceeds. The new element here is the presence of the Uniform Commercial Code (UCC), K.S.A. Ch. 84. The primary question we are called upon to decide is the effect, if any, the UCC has on the priorities which would otherwise obtain  although there is some preliminary dispute as to just what those priorities should be.
The facts were stipulated below and are not in dispute.
The L.R. Foy Construction Co., Inc., ("Foy") of Hutchinson, Kansas, was awarded a contract in January, 1967, to construct a student dormitory at Chadron State College, Chadron, Nebraska. (The parties are in agreement that Kansas law should control.) Foy's role in this litigation is that of stakeholder, a role assumed in most cases of this character by the owner.
On January 25, 1967, Foy entered into a subcontract with Mid-Continent Fireproofing and Insulating Co., Inc. ("Mid-Continent") to furnish and install insulation and wall board for a contract price of $13,451.50. The contract called for periodic partial payments on approved estimates, with 10% as the retained percentage pending completion. Mid-Continent agreed to pay for all labor and materials and hold Foy harmless from any claims arising out of its failure to comply with the terms of the contract. In the event there arose any claim for which Foy or the owner "might become liable," Foy was entitled to retain from moneys then or thereafter due Mid-Continent enough to indemnify itself. Mid-Continent was required to furnish a bond or bonds "guaranteeing performance and payment of labor and material bills."
The required bond was furnished by the appellant United States Fidelity and Guaranty Company (the "surety") on January 31, 1967. By its contract the surety bound itself to Foy on the condition that Mid-Continent faithfully perform its subcontract, which was incorporated by reference. No question is raised but that the surety's guarantee included Mid-Continent's contractual obligation to pay laborers and materialmen  i.e., that it was a "payment" bond as well as a "performance" bond.
The relevant default provision was that, if the surety should be required to remedy a default, so much as might be required to reimburse the surety for its outlays should be paid to the surety out *740 of the balance of the subcontract price then in the hands of Foy "at the times and in the manner as said sums would have been payable to [Mid-Continent] had there been no default under the subcontract." This provision is considered by the parties as a contractual assignment of Mid-Continent's interest in its contract with Foy to secure the surety  albeit a conditional assignment. The failure of the surety to file under the UCC the bond containing this "security agreement" is appellee's most strongly urged claim to priority in this case.
In customary fashion, Mid-Continent went contract-in-hand to the appellee, The First State Bank of Salina (the "bank") to secure a line of credit to carry out its contract. There, on February 13, 1967, it executed a security agreement, assigning to the bank all its rights under its contract with Foy, to secure any and all obligations it might then or thereafter have to the bank. The bank gave Foy timely notice of the assignment, requesting that Foy make any payments under the contract payable jointly to Mid-Continent and the bank. It is stipulated that the bank's purpose in agreeing to extend credit (apart from its 7% interest) was to enable Mid-Continent to pay for materials and labor needed to fulfill the contract with Foy.
Mid-Continent had had prior dealings with the bank. Almost a year before, on April 13, 1966, the bank had lent money to Mid-Continent in an unrelated transaction, and had duly filed a "financing statement" under the UCC covering Mid-Continent's "Accounts receivable for goods sold or for services rendered together with equipment used by the business." It is agreed that this financing statement was broad enough to include the "security agreement" (assignment) of February 13, 1967, covering as an "account receivable" Mid-Continent's interest in the Foy contract.
The bank, relying on its security agreement backed by the filed financing statement, commenced lending money to Mid-Continent on February 28, 1967, taking a series of notes. The trial court concluded that the bank had an "attached" security interest in Mid-Continent's contract with Foy as of that date, and that conclusion is not contested. (We note here that a creditor's security interest "attaches" under UCC 9-204 (1) when "value is given, and the debtor has rights in the collateral." As to the collateral, the proceeds of the contract, the debtor Mid-Continent acquired "rights" as and when it performed. This was certainly no earlier than February 28, 1967.)
*741 In due course Mid-Continent defaulted; Foy terminated its contract with Mid-Continent and completed the work itself. After deducting its cost of completion from the balance of Mid-Continent's contract price Foy holds $3492.24 which would have been due Mid-Continent had it not defaulted. This is the prize for which the parties here are competing.
The surety was presented with and, on February 2, 1968, paid claims of materialmen who had furnished Mid-Continent with material for the project which, by our calculation, amounted to $7409.19, taking assignments of the materialmen's claims and remedies. The bank lent Mid-Continent money at various times from February 28 to June 23, 1967, and after deducting payments on account, claims a balance due it as of July 9, 1967 of $2647.40.
The surety sued Foy for the balance in Foy's hands, asserting its right of subrogation, and joined the bank as a potential claimant to the fund. Foy tendered the money in its hands into court; the bank in its answer asserted its assignment (security agreement) as a lien with priority over the claim of the surety.
The issues thus joined together with the facts, stipulated in accord with the foregoing recitation, were submitted to the trial court for a decision as a matter of law. In a memorandum of September 24, 1969, it recited:
"The court finds as follows:
Nevertheless, the trial court on June 3, 1970, entered a "Pre-Trial Conference Order" in which it recited, inter alia:
This order thus reopened some of the issues apparently decided by the September 24 memorandum, and interjected at least one new issue, i.e., the surety's right to be subrogated to the position of Foy, as set out in subparagraph B. All issues were resolved in a journal entry of the same date in which the September 24 memorandum was incorporated by reference, and in which the court found generally that the bank had a first and prior right to the amount held by Foy for the account of Mid-Continent.
From this determination the surety has appealed, claiming error in several particulars. In essence, it urges that the trial court misconceived a surety's right of legal or equitable subrogation, and misapplied the UCC both to the surety and to the various rights derived and asserted by it as a result of such subrogation.
Our first effort, then, is to determine the status of surety vis-a-vis bank, without regard to the UCC. Perhaps the leading authorities in this area are a series of cases decided by the United States Supreme Court involving government building projects, beginning with Prairie State Bank v. United States, 164 U.S. 227, 41 L. Ed. 412, 17 S. Ct. 142 (1896) and running through Pearlman v. Reliance Ins. Co., 371 U.S. 132, 9 L. Ed. 2d 190, 83 S. Ct. 232 (1962). This judicial saga was recounted in the latter case (in which the surety on a payment bond was claiming priority over the contractor's *743 trustee in bankruptcy to the retained percentage in the government's hands). The Court said (371 U.S., at 137-8):
As to the distinguishing feature noted in the last sentence quoted, the Court went on to observe that in Henningsen v. U.S. Fidelity &amp; Guaranty Co., 208 U.S. 404, 52 L. Ed. 547, 28 S. Ct. 389, the distinction between a surety who performs and one who pays was obliterated, saying (371 U.S., at 139):
*744 The Miller Act, 40 U.S.C. § 270a et seq., requiring separate bonds for performance and payment, was held not to evidence a congressional intent "to repudiate equitable principles so deeply imbedded in our commercial practices, our economy, and our law as those spelled out in the Prairie Bank and Henningsen Cases." (371 U.S., at 140.)
Finally, the Court dispelled any questions raised by dicta contained in United States v. Munsey Trust Co., 332 U.S. 234, 91 L. Ed. 2022, 67 S. Ct. 1599, by limiting its effect to the narrow holding that the government could exercise "the well-established common-law right of debtors to offset claims of their own against their creditors," and thereby defeat a surety's equitable claim to money in the government's hands. (Munsey Trust had, however, extended the surety's claim to earned but unpaid progress payments as well as the retained percentages.)
The result was (371 U.S., at 141):
This holding is squarely applicable here, reading "Foy" for "the Government" and "Mid-Continent" for "the contractor." While the holding itself would appear to subrogate the surety to the rights of all three  the Government, the laborers and materialmen and the contractor  three members of the Pearlman court concurred specially, putting their reliance on the right of the surety to stand in the shoes of the government, rather than in those of the laborers and materialmen it paid under what they read the majority rationale to be. Either way, the result is the same, and it is generally held that the surety may do both, as well as acquiring the rights of its principal, the contractor.
The First Circuit has referred to this as a "unique accumulation of subrogation rights," serving to "induce a function that is neither ordinary insurance nor ordinary financing." (National Shawmut Bk. of Boston v. New Amsterdam Cas. Co., 411 F.2d 843, 845 [1st Cir.1969].)
The function thus "induced," that of guaranteeing completion of building contracts, is one which is vital both to government and to *745 our economy, dictated by statute in the case of public projects and by prudence in the private sector. Rights are given to the surety, however, neither as a reward nor as an inducement, but because equity requires it. Those rights are described in the following language from National Shawmut Bk., supra:
From our examination of the numerous authorities cited to us we are convinced that the foregoing represents the general rule, accepted overwhelmingly if not universally throughout the various jurisdictions in this country. No contrary decisions have come to our attention. Applying it here, we have the surety asserting the rights of Mid-Continent, of the materialmen, and of Foy. Mid-Continent's claim is non-existent here, because of its assignment to the bank. The materialmen had their equitable claim upon the retained amounts. Henningsen, supra; Pearlman, supra. Foy had an equitable obligation to pay for material used in the project and for which it was compensated by the owner. In addition it had a right of set off under its subcontract with Mid-Continent, allowing it to apply any money in its hands otherwise due Mid-Continent to any claims for labor or material for which it or the owner "might become liable."
As to the last point the bank argues that, since Foy's prime contract is not in evidence, there is no showing that Foy was bound to pay Mid-Continent's unpaid materialmen. In response to a similar contention it was said:
The same equitable obligation rests here on Foy, and on the owner, which was assumed is the state of Nebraska or one of its instrumentalities. (That obligation would also be sufficient, in our view, to make the "might become liable" clause of the subcontract operative, if that were needed to bulwark the surety's claim.)
The bank suggests, however, that Kansas has deviated from the main course of American law and charted its own way in this area. Its chief reliance is on Deposit Co. v. City of Stafford, 93 Kan. 539, 144 Pac. 852; and Fidelity and Guaranty Co. v. City of Pittsburg, 115 Kan. 740, 225 Pac. 83.
In the City of Stafford case the surety completed its defaulting principal's contract with the city. Prior to default the contractor had assigned the proceeds of the contract to the bank to secure a credit of $2,000. The bank advanced money only on signed bills for labor and material, each advance being represented by a check drawn to a laborer or materialman. The city, despite the claim of the surety, paid the bank $2,000 in full payment of its claim, and the surety brought suit against both city and bank. In an extensive opinion this court reviewed the decided cases, including Prairie State Bank and Henningsen, before concluding that equity required the bank to share pro rata with the surety in the loss, and thus account to the surety for a portion of its $2,000. The bank here cites particularly the court's observation:
We do not construe this comment as a total rejection of otherwise accepted principles. The holding in that case was based on the court's feeling that:
The net effect of the holding was that, where its money clearly went penny for penny directly into labor and materials the bank *747 enjoyed subrogation rights equal to but not greater than those of the surety.
The peculiar nature of the facts in City of Stafford was recognized in Bank v. Insurance Co., 109 Kan. 562, 200 Pac. 281, where a bank attempted to recoup its advances to a contractor by an action against the contractor's surety. The notes taken by the bank recited a purpose of paying for labor and material (as did Mid-Continent's loan agreement with the bank here), and the bank claimed to be subrogated to the rights of laborers and materialmen who might have been paid from the loan proceeds. Subrogation was denied, the court noting:
As to the decision in City of Stafford, the court said, "It was distinctly held that the case should be determined by rules applicable to the particular state of facts." (Id., at 565.)
The other case urged by the bank on this point is Fidelity and Guaranty Co. v. City of Pittsburg, supra. There the contractor borrowed money from a bank and assigned as security money then due him for work completed. The assignment was presented to and accepted by the city commission, which ordered payment to the bank, all before default. Only the adoption of an appropriation ordinance and the drawing of an order of payment occurred after default. It was held that the city could not be compelled to pay twice; that by its action in accepting the assignment it bound itself to pay the bank at a time when it could have paid the contractor. Its further action in carrying out its obligation to the bank did not subject it to liability to the surety.
Here, of course, Foy neither paid nor legally bound itself to pay the bank; on the contrary, it still holds the money. Further, the retained *748 money never became due Mid-Continent, because of Foy's contractual right to off-set unpaid claims for material.
Both City of Stafford and City of Pittsburg stand at best for the proposition that a creditor may make a valid assignment of money due him, and that such an assignment when honored by the debtor will be recognized. They do not stand for the proposition that one may assign any more than he is entitled to receive.
The bank's argument based on these cases is aptly answered in National Shawmut Bk. of Boston v. New Amsterdam Cas. Co., supra, 411 F.2d, at 847-8:
The net result is that, barring the UCC, the surety had an equitable lien through its right of subrogation dating back to the time it executed the bond, January 31, 1967; the bank's security interest attached no earlier than February 28, 1967. The remaining question is whether the surety lost the priority of its lien by failing to file under the UCC.
*749 The parties agree that the doctrine of subrogation, as such, survived the enactment of the UCC, citing § 1-103 that:
The bank argues, however, that priorities are governed by the Code, and particularly Article 9. This might well be so if the surety were relying on its contractual assignments of the rights of Mid-Continent or the materialmen. It might then be argued that it was claiming a "security interest" (defined in K.S.A. 84-1-201 [37]) in a "contract right," (defined in 84-9-106 as amended), in which case it would be covered (84-9-102) and filing would be necessary to "perfect" the lien (84-9-302, as amended). But the surety here prefers to abandon whatever contractual rights it may have, and to bottom its claim wholly on its purely equitable right of subrogation.
We have long recognized the distinction between "conventional" subrogation, based on contract, and "legal" or "equitable" subrogation which arises by operation of law without regard to any contractual relationship. We once put it this way:
And, more directly, in United States Fidelity &amp; Guaranty Co. v. Maryland Cas. Co., 186 Kan. 637, 643, 352 P.2d 70, we said:
The surety's right, then, does not depend on contract, while UCC § 9-102 (2) says that Article 9 applies to security interests "created by contract." It follows that a surety's claim to legal or equitable subrogation is not a "security interest" under Article 9 of the UCC, and is not affected by the surety's failure to file a financing statement.
Although this proposition is new to this court, it has been considered elsewhere with near unanimous results. One of the most recent is Canter v. Schlager, ___ Mass. ___, 267 N.E.2d 492 (1971), which surveys the decisions and effectively deals with the *750 few mavericks among them. The controversy there was between a nonfiling surety and the contractor's trustee in bankruptcy who, the court noted, had the rights of a lien creditor. In holding the UCC inapplicable the Massachusetts Supreme Judicial Court quoted with approval from Jacobs v. Northeastern Corp., 416 Pa. 417, 429, 206 A.2d 49, 55:
It went on to say (267 N.E.2d, at 494-95):
Some courts which have reached this conclusion have been impressed, as are we, by the rejection from the Code as adopted of a proposed § 9-312 (7) which would have specifically subordinated the lien of a surety to that of a later lender with a perfected security interest. The Editorial Board's reasons for the deletion of this proposal from the Code were:
We thus have a clear recognition of the prevailing rule on the part of the draftsmen of the Code and a considered and deliberate decision, made only after reaching a tentative conclusion to the contrary, that they should not propose a change. We think this convincingly demonstrates an intent, imputed to the legislature which adopted it, that the Code should not be applicable to or alter the long established priorities in this area. As the First Circuit put it (National Shawmut Bk. of Boston v. New Amsterdam Cas. Co., supra, 411 F.2d, at 849):
We therefore conclude that the trial court erred in finding that the bank had a first and prior right to the contract proceeds in the *752 hands of Foy. The surety, having paid out more than that amount, is entitled to the entire fund.
The judgment is therefore reversed with directions to enter an appropriate judgment in favor of the surety, United States Fidelity and Guaranty Company, in accordance with the views expressed herein.
APPROVED BY THE COURT.