Kevin Schlosser Authors, "Surety's Subrogation Rights Rejected in Court's Latest Decision on Lien Law"

Publication Source: New York Law Journal

In its recent decisions, the New York Court of Appeals has made clear that anyone seeking to battle the Lien Law had better find a more vulnerable opponent. In West-Fair Electric Contractors v. Aetna Casualty and Surety Co.,(1) for example, the Court struck down a “pay-when-paid” provision in a subcontract because it operated as a waiver of a subcontractor’s rights under the Lien Law and therefore violated not only the Lien Law but the public policy of this state to ensure that those who work on a Construction project receive payment for their labors.

Less than a year later, in Canron Corp. v. The City of New York, (2) the Court of Appeals significantly bolstered the protective net of Article 3-A of the Lien Law trust fund provisions, ruling that a municipality could not offset unrelated debts due from a contractor against Contract funds earned by that contractor on a public improvement project.(3)

In an important new decision, in City of New York v. Cross Boy Contracting Corp., (4) the Court of Appeals has continued its vigorous course in enhancing the broad protections of the New York Lien Law. The latest casualty is a surety that provided performance and payment bonds on a public project, thinking that it would be subrogated to the rights of the municipality after paying certain claims of suppliers on the project. In bolstering the protections of the Lien Law, the Court rejected 60 years of case law acknowledging the subrogation rights of sureties.

Article 3-A of the Lien Law creates a “trust” over certain funds used in connection with any construction project.(5) The Lien Law generally requires that funds received by contractors on a construction project must be used for the benefit of the subcontractors and suppliers engaged to work on that project before those funds may be used for any other purpose.(6) As relevant here, the Court of Appeals in Cross Bay noted:

[A] “trust” under Article 3-A can include assets of every conceivable type and form arising from the work.... Even rights of action for payment “due or earned or to become due or earned' can constitute a trust...“Certainly money paid by the owner to anyone in satisfaction of the contract would be impressed with this broadly inclusive trust'...(7)

In addition to subcontractors, suppliers and others who work directly on the construstion project, a trust is imposed for 'claims for taxes and for unemployment insurance and other contributions, due by reason of employment and for amounts of taxes withheld or required to be withheld.'(8) When the trust funds are distributed, these claims receive the highest preference in payment. (9)

'Cross Bay' Decision

In Cross Bay Contracting Corp., the factual context was one often seen in construction projects. The City of New York awarded a contract to Cross Bay Contracting Corporation to work on a landfill in Staten Island. The contract contained a common provision permitting the City to 'deduct from the amounts certified under this Contract to be due to the Contractor the sum or sums due and owing from the Contractor to the subcontractors.(10) Because it was a public job, the contractor procured a payment bond (providing for the payment of any claims by subcontractors and suppliers) and a performance bond (assuring the proper performance of the job by the contractor) from a surety.

During the course of the job, the contractor failed to pay various suppliers of labor and materials. Pursuant to its bond, the surety paid about $127,000 of these claims, and had received additional claims of approximately $188,000.

The City had also withheld payments from the contractor as a result of the outstanding claims by its sub-contractors and suppliers. The contractor and surety then commenced a special proceeding against the City to compel payment of these funds. The parties settled that action pursuant to a stipulation in which the City agreed to pay the surety certain funds that had been approved for payment to the contractor “upon the satisfaction, discharge, release or cancellation of all those valid liens, levies, restraints and encumbrances filed with the Liens and Disbursements Clerk in the office of The New York City Department of Finance which have a superior or greater legal or equitable right than [the Surety] to said earned funds.” (11)

Thereafter, the City initiated an interpleader action by paying the amount outstanding in court and naming as defendants the contractor, the surety and the U.S. government by and through the Internal Revenue Service.

The IRS was named a party to the interpleader action because the contractor failed to pay federal tax withholdings on behalf of its employees who worked on the project. As relevent here, the IRS argued that it had a superior right to the funds being held by the City because it was a Lien Law trust fund beneficiary and held a priority pursuant to Lien Law §77(8)(a).

In the interpleader action, the surety was granted summary judgment by the Appellate Division, ruling that the surety was entitled to the Interpleaded funds. The Court of Appeals reversed, rejecting the surety’s “subrogation” claims.

The surety argued that it had a superior right to the funds withheld by the City under long-standing principles of equitable subrogation. That is, once it had paid subcontractors and suppilers of the contractor pursuant to the payment bond, the surety asserted that it became equitably subrogated to the rights of the City and, specifically, to the City’s right to withhold funds from the contractor for amounts due and owing from the contractor to subcontractors. Thus, the surety argued that the contractor never became entitled to the funds withheld by the City and, therefore, these funds could not have been deemed an Article 3-A trust over which the IRS could become a beneficiary.

In fact, the surety’s argument was fully supported by Court of Appeals decisions dating back over 60 years acknowledging a surety’s equitable subrogation rights where the surety has satisfied claims under its payment bond and, as a result, stepped into the shoes of the owner. The surety relied upon a “trilogy of cases” with fact patterns almost identical to those before the Court in Cross Bay.

For example, in Scarsdale National Bank & Trust Co. v. United States Fidelity & Guarantee Co., (12) the Court of Appeals held that the surety’s equitable subrogation rights took precedence over the claims of an assignee to a contractor on a public improvement project in which the municipality had the right to deduct expenses and losses incurred in completing the project in the event the contractor defaulted. The Court of Appeals held that the surety stepped into the shoes of the owner — municipality and therefore could take possession of and withhold the “earned monies” of the contractor to the exclusion of the contractor’s assignee.

Similarly, in United States Fidelity & Guarantee Co. v. Triborough Bridge Authority (13) under the same equitable subrogation theory, the surety in another public improvement job was able to trump the claims of the IRS, which had a lien for income taxes against the contractor. The Court of Appeals held that the surety “succeeded - under principles of subrogation - to all rights which [the municipality] might have against the contractor, including that of withholding money due the contractor and of applying it to the payment of unsatisfied claims for labor and materials furnished.' (14) Specifically, the Court held that “the contractor’s rights to the funds were clearly subordinate to the right of [the municipality] — and, by subrogation, of [the surety] — to withhold and apply those monies to the payment of unsatisfied claims of labor and materials. So long as such claims were outstanding and unpaid and so long as [the municipality] had the right to withhold and apply; the contractor had no rights to the fund, and, consequently, had no property interest therein upon which [the IRS] could place a lien.' (15)

Finally, in Aetna Casualty & Surety Co. v. United States,(16) the surety obtained priority, once again, over federal tax liens which arose out of a contractor’s failure to turn over to the government the withholding and employment taxes collected from its workers. The specific issue was whether the contractor had any interest in the funds being withheld by the municipality to which a tax lien could attach. Interpreting a provision similar to the one in Cross Bay (authorizing the municipality to withhold money if there were unsatisfied claims of subcontractors and suppliers), the Court of Appeals held that the contractor was not entitled to the withheld funds and, therefore, those funds were not “property and rights to property” for which tax liens could attach.

Given this strong “trilogy of cases” it was not at all clear that the Court of Appeals in Cross Bay would reject the surety’s claims, in the face of the Lien Law, however, that is precisely what the Court of Appeals did.

First, the Court of Appeals found that the “trilogy” of subrogation cases was neither relevant nor binding because none of the cases actually analyzed whether the funds withheld from the contractors were trust funds under Article 3-A of the Lien Law. Thus, the Court summarily rejected the subrogation argument. The Court also observed that the surety’s argument that the funds never became due to or earned by the contractor was disingenuous because the surety admitted in its motion papers that the funds were “earned contract funds” - obviously earned by and for the contractor.

More important, however, in reasoning quite reminiscent of its decision in West-Fair, the Court found that viewing the withheld funds as “not earned” by the contractor would unleash an unwelcome assault upon the statutory framework of the Lien Law:

Additionally, it appears that [the surety’s] analysis regarding [the contractor’s] lack of entitlement to the funds, if applied, would have implications beyond those related to Article 3-A trust claims. If we were to find that these funds were never due to [the contractor], then it would also follow that these funds could not form the basis of a mechanic’s lien with respect to this public improvement. The law permits a lien on a public improvement only ‘to the extent of the amount due or to become due’ on the contract from the public corporation to the contractor...Thus, to treat the “earned contract funds” at issue here as never due or to become due to [the contractor] would disrupt several statutory schemes and would not comport with the intent of the legislature in enacting these mechanisms for the protection of those providing labor and materials for public improvement (citing Canron Corp. v. City of New York).(17)

Finally, having found that the withheld funds were subject to an Article 3-A trust, the Court found that the surety’s claims “to the trust fund, even as a surety with potential subrogation rights, do not garner a priority over various trust claims, including the IRS claim for taxes ‘required to be held’ in connection with the [contractor’s] contract...' (18)

Implications

By refusing to apply the long-standing law of equitable subrogation t enforce the surety’s claims, the Court of Appeals in Cross Bay has not only enhanced the protective net of the Lien Law, but it very well could have struck a damaging blow to the rights of sureties. Most significant is the Court’s rejection of the surety’s argument that it had exclusive right to the funds because the contractor’s competing rights never arose. Notwithstanding the Court’s position that the subrogation cases were distinguishable, the Court’s reasoning in Cross Bay appears to extend fully to the same facts and circumstances in each of those cases cited by the surety - even in the absence of Article 3-A trust claims.

For those representing sureties, therefore, careful attention must be given to the Court of Appeals decision in Cross Bay - to avoid unwanted or unintended consequences (such as the loss of subrogation rights). Among other things, sureties will argue that the decision did not address the principle of equitable subrogation in general, but only as it applied to a preferred trust claim, such as the IRS’s.

On the other hand, those competing with the claims of sureties may find ample ammunition in Cross Bay’s sweeping pronouncements. For example, as noted by the Court of Appeals in Cross Bay, a subcontractor’s right to file a mechanic’s lien on a public improvement is based upon 'the amount due or to become due on' the contract between the general contractor and the municipality.(19) Insofar as the Court in Cross Bay found that a surety’s subrogation rights would prevent a general contractor from claiming the amount that it earned was “due or to become due” on -its contract with the municipality, it would appear that the surety’s subrogation claims are vulnerable to attack. These issues are likely to engender further litigation.

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