Acuity, a Mut. Ins. Co. v. Planters Bank, Inc.

• Decision Date: 28 March 2005
• Docket Number: No. CIV.A. 3:03CV-367-H.,CIV.A. 3:03CV-367-H.
• Citation: 362 F.Supp.2d 885
• Parties: ACUITY, A MUTUAL INSURANCE COMPANY Plaintiff v. PLANTERS BANK, INC. Defendant.
• Court: U.S. District Court — Western District of Kentucky

362 F.Supp.2d 885

ACUITY, A MUTUAL INSURANCE COMPANY Plaintiff v. PLANTERS BANK, INC. Defendant.

No. CIV.A. 3:03CV-367-H.

United States District Court, W.D. Kentucky, at Louisville.

March 28, 2005.

COPYRIGHT MATERIAL OMITTED

Thomas E. Crafton, Keith D. Heath, Alber Crafton, Louisville, KY, Clifford E. Yuknis, Lawrence R. Moelmann, Michael J. Leech, Hinshaw & Culbertson, Chicago, IL, for Plaintiff.

Janet P. Jakubowicz, Elisabeth S. Gray, James W. Herr, Greenebaum Doll & McDonald, Louisville, KY, for Defendant.

Roberta S. Dunlap, Trustee in Bankruptcy, Dunlap & Nesmith LLC, Evansville, IN, for Star Construction, Inc. Third Party Defendant.

MEMORANDUM OPINION

HEYBURN, Chief Judge.

This dispute arises because a contractor, Star Construction, Inc. ("Star"), defaulted on both its construction contract with the Commonwealth of Kentucky (the "Commonwealth") and its loan repayment with Planters Bank (the "Bank"). The contractor's surety, Acuity, claims the right to contract funds that the Bank had set off from Star's account. To resolve the conflict between the surety's rights in subrogation and the bank's rights as creditor, the Court must clarify: (1) the precise extent of a subrogee's rights and the bank creditor's rights; (2) the ownership of progress payments deposited in the contractor's account; and (3) whether any legal or equitable theory allows the surety to pursue the contract funds now held by a third party.

The Court's duty is to clarify and untangle the interaction of various long-standing principles and, ultimately, to predict how Kentucky courts would apply that law to our circumstances. Davis v. Ford, 244 F.supp.2d 784 (W.D.Ky.2003); Dinsmore Instrument Co. v. Bombardier, Inc., 199 F.3d 318, 320 (6th Cir.1999). In doing so, it has the benefit of excellent argument by very knowledgeable counsel on each side.

I.

The setting for the current dispute arose as follows. Star had a longstanding business relationship with Acuity. In July, 1999, the two had entered into a General Indemnity Agreement that governed the terms under which Acuity, a Mutual Insurance Company, would issue surety bonds. In March, 2001, the Commonwealth contracted with Star for work on a public construction project at Western Kentucky University (the "WKU contract"). Pursuant to a contract requirement, Acuity provided payment and performance bonds for Star guaranteeing its completion of the WKU contract.

In 2002, Star obtained a line of credit with Planters Bank. As a condition of the credit, Star kept its general business accounts with the Bank and allowed the Bank to set off funds from that account in the event of a default. Ultimately, Star drew on that line of credit to the extent of approximately $1,700,000 for its general business operations. For reasons apparently unrelated to the current dispute, Star's business deteriorated. In early 2003, Star was unable to make scheduled interest payments and fell into default on its line of credit.

The default alerted the Bank to Star's financial problems. The Bank monitored Star's bank account. Within a day after Star deposited a WKU contract progress payment of $410,602.34 in its account, the Bank seized those funds to reduce Star's debt. Several months later, Star's financial condition deteriorated such that it could not complete the WKU job. Eventually, the Commonwealth declared Star in default and called upon Acuity to complete the WKU contract. Acuity did so and completed all its obligations under its payment and performance bonds. One of those obligations was to pay Star's subcontractors for work performed and billed, but which was unpaid.

After learning of the Bank's setoff, Acuity filed this lawsuit to assert its rights in subrogation to the funds that the Bank had taken from Star's account. The Bank has moved for summary judgment on the grounds that it had a legal right to take funds from Star's corporate bank account and that no special trust provisions covered the funds. Soon afterwards, Acuity moved for leave to amend its complaint and responded that Star had indeed held the construction funds in trust and that the Bank surely knew it.¹

II.

Acuity primarily asserts rights in subrogation. The first step in the Court's analysis is to describe as nearly as possible the extent of those rights.

Subrogation is a "creature of equity" common in the construction industry. See Louisville Trust Co. v. Royal Indemnity Co., 230 Ky. 482, 20 S.W.2d 71 (1929). Some time ago, Chief Judge Hiram Church Ford in the Eastern District of Kentucky set out its principles that remain valid today. National Surety Corporation v. Allen-Codell Co., 70 F.Supp. 189, 191-192 (E.D.Ky.1947). Subrogation allows an equitable adjustment among parties where one performs another's obligation. A surety is subrogated to the rights of another when it performs on a construction bond and fulfills the obligations of its principal. In our case, a surety, such as Acuity, who performs the obligations of its bonds, may be subrogated to all the rights and remedies of a contractor in default, such as Star; the owner, such as the Commonwealth; or even subcontractors whom it pays. Id.

The principles of equity govern the specific remedies available under subrogation. The rights and remedies of the subrogee-the surety-are never greater than those of its subrogor-the contractor-and, in fact, are subject to any pre-existing defenses and limitations. As a general proposition, therefore, the surety that performs a contract, acquires all the contractor's rights under that construction contract. The most significant one is the right to receive all construction draws due for work already performed or that will be performed in the future. As grounds to recover funds due the contractor, some courts have termed the surety's interest an equitable lien on all funds due. See, e.g., Prairie State Bank v. United States, 164 U.S. 227, 229, 32 Ct.Cl. 614, 17 S.Ct. 142, 41 L.Ed. 412 (1896); In re Cummins Const. Corporation, 81 F.Supp. 193 (D.Md.1948). Under Prairie State and its progeny, it is beyond dispute that Acuity has a right to funds due under the WKU contract. Moreover, the security interest or retainage in a construction contract is reserved for the surety who completes the job. The surety's special equitable right to contract proceeds encourages performance on construction bonds. This preference in equity raises sureties above other creditors in a bankruptcy proceeding. Pearlman v. Reliance Ins. Co., 371 U.S. 132, 134-135, 83 S.Ct. 232, 9 L.Ed.2d 190 (1962).

The surety's right to contract funds arises at the time the bond is issued. However, its rights are said to be incomplete, inchoate and unenforceable until the surety suffers a loss on the bond by either performing or making a payment to subcontractors. Prairie State, 164 U.S. at 232, 237, 240, 17 S.Ct. 142. So long as the owner holds funds due for work performed, the surety standing in the shoes of the contractor has a priority to those funds. When a surety pays subcontractors and materialmen for work completed, it also becomes subrogated to their rights against others for payment. Pearlman, 371 U.S. 132, 83 S.Ct. 232.

III.

Some general rules of banking law also apply in these circumstances. First, in the event of a default, a bank may set off the funds of its debtor from funds maintained in the debtor's name at the bank. Ferguson Enterprises, Inc. v. Main Supply, Inc., 868 S.W.2d 98, 99 (Ky.App.1993). Here, no one denies that the Bank loaned money on the condition that Star maintain its general business account with the Bank and that Star authorized the Bank to set off funds from its account in the event of default. Neither does Star dispute the default or its agreement that the Bank may take funds from Star's account.

A second general rule of banking law amounts to a broad exception to the first. A bank may not apply a deposit consisting of trust funds or funds belonging to one other than the depositor, to the individual indebtedness of the depositor if "it knows, or can properly be charged with knowledge of, the trust character or true ownership of the funds." AMJUR BANK § 887; National Bank of Owenton v. Greene at al., 114 S.W. 322, 323 (Ky.1908); See also Mitchell v. First National Bank, 203 Ky. 770, 263 S.W. 15 (Ky.1924) (a bank paying out deposit of check made payable to one as agent on individual account is liable to principal). Courts have applied this rule in a variety of circumstances: to funds received by the debtor in its capacity as executor, administrator, trustee, agent, guardian, curator, or various other types of fiduciaries or representatives. Id.

Kentucky courts have applied these principles and sometimes struggled to articulate them since the turn of the last century. In First National Bank of Owenton v. Greene et al., the Court of Appeals of Kentucky held that "where a check for a ward's share of an estate was payable to both the ward and the guardian, and the bank where it was deposited knew that the money was the ward's" the bank will be held liable for applying the proceeds of the check to pay the debt due from the guardian individually. (Not reported in Ky. Reports), 114 S.W. 322, 323 (Ky.1908); see also Fidelity & Deposit Co. of Maryland v. Commonwealth, 249 Ky. 170, 60 S.W.2d 345 (1933); Farmers' & Traders' Bank v. Fidelity & Deposit Co. of Maryland, 108 Ky. 384, 56 S.W. 671 (1900); Hill v. Flemming, 128 Ky. 201, 107 S.W. 764 (Ky.1908) ; Bank One, Pikeville v. Commonwealth, 901 S.W.2d 52, 54-55 (Ky.App.1995) (finding that an escrow agreement transfers title and interest of the funds).² In each of these cases, the Kentucky Court of Appeals found an exception to the setoff rule where title or interest in the funds was held for or in the name of a third party. In our case, this means that an evidentiary and legal defense to a bank's setoff is that (1) the funds actually belong to or were held for the benefit of a third party, not the...